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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the year ended December 31, 2003
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal period from __________ to ___________
Commission file number 2-80070
CASS INFORMATION SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
Missouri 43-1265338
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
13001 Hollenberg Drive, Bridgeton, Missouri 63044
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (314) 506-5500
Securities registered pursuant to Section 12(b) of the Act:
Title of each Class Name of each exchange on which registered
- ------------------- -----------------------------------------
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock par value $.50
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(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
As of March 5, 2004, 3,679,452 shares of common stock of the registrant
were outstanding; the aggregate market value of the shares of common stock of
the registrant held by non-affiliates was approximately $87,125,000 based upon
the Nasdaq Stock Market closing price of $31.84 for March 5, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of Registrant's Proxy Statement for the Annual Meeting of
Shareholders to be held on April 19, 2004 are incorporated by reference in
Part III hereof.
CASS INFORMATION SYSTEMS, INC.
FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I.
Item 1. BUSINESS ......................................................... 1
Item 2. PROPERTIES ....................................................... 3
Item 3. LEGAL PROCEEDINGS ................................................ 4
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS .............. 4
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS .............................................. 4
Item 6. SELECTED FINANCIAL DATA .......................................... 5
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ........................................ 5
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ....... 21
PART II.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ...................... 23
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE .............................. 47
Item 9A. CONTROLS AND PROCEDURES .......................................... 47
PART III.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ............... 47
Item 11. EXECUTIVE COMPENSATION ........................................... 47
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS ....................... 47
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ................... 47
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES ........................... 47
PART IV.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K .. 48
SIGNATURES ....................................................... 49
Forward-looking Statements - Factors That May Affect Future Results
This report may contain or incorporate by reference forward-looking statements
made pursuant to the safe harbor provisions of Section 27A of the Securities Act
of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. Forward-looking statements are not guarantees of future performance and
involve risks, uncertainties, and other factors which may cause future
performance to vary from expected performance summarized in the future-looking
statements, including those set forth in this paragraph. Important factors that
could cause our actual results, performance, or achievements to be materially
different from any future results, performance, or achievements expressed or
implied by those statements include, but are not limited to: the failure to
successfully execute our corporate plan, the loss of key personnel or inability
to attract additional qualified personnel, the loss of key customers, increased
competition, the inability to remain current with rapid technological change,
risks related to acquisitions, risks associated with business cycles and
fluctuations in interest rates, utility and system interruptions or processing
errors, rules and regulations governing financial institutions and changes in
such rules and regulations, credit risk related to borrowers' ability to repay
loans, concentration of loans to certain segments such as commercial
enterprises, churches and borrowers in the St. Louis area which creates risks
associated with adverse factors that may affect these groups and volatility of
the price of our common stock. We undertake no obligation to publicly update or
revise any forward-looking statements to reflect changed assumptions, the
occurrence of anticipated or unanticipated events, or changes to future results
over time.
PART I.
ITEM 1. BUSINESS
Description of Business
Cass Information Systems, Inc. ("Cass" or "the Company") is a leading provider
of payment and information processing services to large manufacturing,
distribution and retail enterprises across the United States. The Company
provides freight invoice rating, payment, audit, cost accounting and
transportation information to many of the nation's largest companies. It is also
a leading processor and payer of utility invoices in the United States,
including electricity, gas, water, telecommunication and refuse collection. In
addition, the Company, through its wholly-owned bank subsidiary, Cass Commercial
Bank ("the Bank"), provides banking services in the commercial, industrial and
residential areas it serves. Its primary focus is to support the Company's
payment operations and provide banking services to its target markets, which
include privately-owned businesses and churches and church-related ministries.
Services include commercial, real estate and personal loans; checking, savings
and time deposit accounts and other cash management services. The Company,
through its subsidiary, Government e-Management Solutions, Inc. ("GEMS"), also
develops, licenses and installs integrated financial, property and human
resource management systems to the public sector, primarily cities and counties.
The principal offices of the Company are at 13001 Hollenberg Drive, Bridgeton,
Missouri, 63044. Other operating locations are in Columbus, Ohio and Boston,
Massachusetts. The Bank's headquarters are also located at the Bridgeton
location and operates four other branches in the St. Louis metropolitan area.
GEMS' offices are located in St. Louis County, Missouri.
Company Strategy and Core Competencies
Cass is an information services company with a primary focus on processing
payables and payables-related transactions for large United States corporations.
Cass possesses four core competencies that envelop most of its processing
services.
Data acquisition - This refers to the gathering of data elements from diverse,
heterogeneous sources and the building of complete databases for our customers.
Data is the raw material of the information economy. Cass gathers vital data
from complex and diverse input documents, electronic media, proprietary
databases and data feeds, including data acquired from vendor invoices as well
as customer procurement and sales systems. Through its numerous methods of
obtaining streams and pieces of raw data, Cass is able to assemble vital data
into centralized data management systems and warehouses, thus producing an
engine to create the power of information for managing critical corporate
functions and processing systems.
Data management - Once data is assembled, Cass is able to utilize the power from
derived information to produce significant savings and benefits for its clients.
This information is used to integrate into customers' unique financial and
accounting systems, eliminating the need for internal accounting processing and
to provide internal and external support for these critical systems. Information
is also used to produce management and exception reporting for operational
control, feedback, planning assistance and performance measurement.
Information delivery - Receiving information in the right place at the right
time and in the required format is paramount for business survival. Cass'
information delivery solutions provide reports, digital images, data files and
retrieval capabilities through the Internet or directly into customer internal
systems. Cass' proprietary Internet management delivery system is the foundation
for driving these critical functions. Transaction, operational, control, status
and processing exception information are all delivered through this system
creating an efficient, accessible and highly reliable asset for Cass customers.
Financial exchange - Since Cass is unique among its competition in that it owns
a commercial bank, it is also able to manage the movement of funds from its
customers to their suppliers. This is a distinguishing factor which clearly
requires the processing capability, operating systems and financial integrity of
a banking organization. Cass provides immediate, accurate, controlled and
protected funds management and transfer system capabilities for all of its
customers. Old and costly check processing and delivery mechanisms are replaced
with more efficient electronic cash management and funds transfer systems. Funds
are managed and protected by our top-rated financial institution.
Cass' core competencies allow it to perform the highest levels of transaction
processing in an integrated, efficient and systematic approach. Not only is Cass
able to process the transaction, it is also able to collect the data defining
the transaction and effect the financial payment governing its terms.
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Cass' shared business processes - Accounting, Human Resources and Technology -
support its core competencies. Cass' accounting function provides the internal
control systems to ensure the highest levels of accountability and protection
for customers. Cass' human resources provide experienced people dedicated to
streamlining business procedures and reducing expenses. Cass' technology is
proven and reliable. The need to safeguard data and secure the efficiency, speed
and timeliness that governs its business is a priority within the organization.
The ability to leverage technology over its strategic units allows Cass the
advantage of deploying technology in a proven and reliable manner without
endangering clients' strategic business and system requirements.
These core competencies enhanced through shared business processes drive Cass'
strategic business units. Building upon these foundations Cass continues to
explore new business opportunities that leverage these competencies and
processes.
Marketing, Customers and Competition
The Company is one of the largest firms in the freight bill payment industry in
the United States based on the total dollars of freight bills paid and items
processed. Competition consists of two primary competitors and numerous small
freight bill audit firms located throughout the United States. While offering
freight payment services, few of these audit firms compete on a national basis.
These competitors compete mainly on price, functionality and service levels.
The Company also competes with other companies, located throughout the United
States, that pay utility bills and provide management reporting. Available data
indicates that the Company is one of the largest providers of utility
information processing and payment services. Due to the fact that this is a new
market, the competitive environment for utility bill processing and payment is
difficult to assess and is changing rapidly. Cass is unique among these
competitors in that it is not exclusively affiliated with any one energy service
provider (ESP). The ESPs market the Company's services adding value with their
unique auditing, consulting and technological capabilities. Many of Cass'
services are customized with the ESPs, providing a full-featured solution
without any development costs to the ESP.
The Bank is organized as a Missouri trust company with banking powers and was
founded in 1906. Due to its ownership of a federally insured commercial bank,
the Company is a bank holding corporation and was originally organized in 1982
as Cass Commercial Corporation under the laws of Missouri and was approved by
the Board of Governors of the Federal Reserve System in February 1983. The
Company changed its name to Cass Information Systems, Inc. in January 2001. The
Company's bank subsidiary encounters competition from other banks located
throughout the St. Louis metropolitan area and other areas in which the Bank
competes. Savings banks, credit unions, other financial institutions and
non-bank providers of financial services also provide competition. The principal
competition however, is represented by large bank holding companies that are
able to offer a wide range of banking and related services through extensive
branch networks.
The governmental software unit, GEMS, was acquired on January 2, 2001 when the
Company's bank subsidiary foreclosed on the operating assets of a software
company in order to protect its financial interests. The Bank sold these assets
to a wholly owned subsidiary, and invested in and stabilized this business. From
the date of foreclosure through December 31, 2002, these assets were accounted
for as a foreclosed asset held for sale. On January 1, 2003, the Company
reclassified the foreclosed assets relating to its software subsidiary, GEMS,
from held for sale to held and used and consolidated its operations into those
of the Company. GEMS markets its software applications and services to middle
market cities and counties throughout the United States. GEMS competes with
several competitors that market similar products to these governmental units.
These firms compete on price, functionality and support. No one firm appears to
have a dominant position in the marketplace.
The Company holds several trademarks for the payment and rating services it
provides. These include: FreightPay(R), Transdata(R), TransInq(R), Ratemaker(R),
Rate Advice(R), First Rate(R), Best Rate(R) and Rate Exchange(R). The Company
and its subsidiaries are not dependent on any one customer for a significant
portion of its business. It has a varied client base with no individual client
exceeding 10% of total revenue. The Bank does however, target its services to
privately-held businesses located in the St. Louis, Missouri area and church and
church-related institutions located in St. Louis, Missouri and other selected
cities located throughout the United States.
Employees
The Company and its subsidiaries had 633 full-time and 119 part-time employees
as of December 31, 2003. Of these employees, the bank subsidiary had 64
full-time and 7 part-time employees and the bank's software subsidiary had 63
full-time and 3 part-time employees.
2
Supervision and Regulation
The Company and its bank subsidiary are extensively regulated under federal and
state law. These laws and regulations are intended to protect depositors, not
shareholders. The Bank is subject to regulation and supervision by the Missouri
Division of Finance, the Federal Reserve Bank (the "FRB") and the Federal
Deposit Insurance Corporation (the "FDIC"). The Company is a bank holding
company within the meaning of the Bank Holding Company Act of 1956, as amended,
and as such, it is subject to regulation, supervision and examination by the
FRB. The Company is required to file quarterly and annual reports with the FRB
and to provide to the FRB such additional information as the FRB may require,
and it is subject to regular inspections by the FRB. Bank regulatory agencies
use Capital Adequacy Guidelines in their examination and regulation of bank
holding companies and banks. If the capital falls below the minimum levels
established by these guidelines, the agencies may force certain remedial action
to be taken. The Capital Adequacy Guidelines are of several types and include
risk-based capital guidelines, which are designed to make capital requirements
more sensitive to various risk profiles and account for off-balance sheet
exposure; guidelines which consider market risk, which is the risk of loss due
to change in value of assets and liabilities due to changes in interest rates;
and guidelines that use a leverage ratio which places a constraint on the
maximum degree of risk to which a bank holding company may leverage its equity
capital base. For further discussion of the capital adequacy guidelines and
ratios, please refer to Item 7 "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and Item 8, Note 2 of this
report.
The FRB also has extensive enforcement authority over bank holding companies,
including, among other things, the ability to assess civil money penalties, to
issue cease and desist or removal orders and to require that a holding company
divest subsidiaries (including its bank subsidiaries). In general, enforcement
actions may be initiated for violations of law or regulations or for unsafe or
unsound practices. Both the FRB and Missouri Division of Finance also have
restrictions on the amount of dividends that banks and bank holding companies
may remit.
As a bank holding company, the Company must obtain prior approval from the FRB
before acquiring ownership or control of more than 5% of the voting shares of
another bank or bank holding company or acquiring all or substantially all of
the assets of such a company. In many cases, prior approval is also required for
the Company to engage in similar acquisitions involving a non-bank company or to
engage in new non-bank activities. Any change in applicable laws or regulations
may have a material effect on the business and prospects of the Company.
Website Availability of SEC Reports
Cass will, as soon as practicable after they are electronically filed with the
Securities and Exchange Commission (SEC), make available free of charge on its
website each of its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,
Current Reports of Form 8-K, all amendments to those reports, and its definitive
proxy statements. The address of Cass's website is: www.cassinfo.com. All
reports filed with the SEC are available at the SEC's Public Reference Room at
450 Fifth Street, NW, Washington, DC 21549 or for more information call the
Public Reference Room at 1-800-SEC-0330. The SEC also makes all filed reports
available on their website at www.sec.gov.
The reference to our website address does not constitute incorporation by
reference of the information contained on the website and should not be
considered part of this report.
Financial Information about Segments
The revenues from external customers, net income (loss) and total assets by
segment, for the three years ended December 31, 2003 are set forth in Item 8,
Note 15 of this report.
Statistical Disclosure by Bank Holding Companies
For the statistical disclosure by bank holding companies refer to Item 7
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
ITEM 2. PROPERTIES
The Company's headquarters are located at 13001 Hollenberg Drive, Bridgeton,
Missouri. This location is owned by the Company, and includes a building with
approximately 61,500 square feet of office space. In March 2001, the Company
moved into a newly-owned production facility of approximately 45,500 square feet
located at 2675 Corporate Exchange Drive, Columbus, Ohio. The Company operates
an additional production facility in Lowell, Massachusetts where approximately
25,800 square feet of office space is leased through October 31, 2005.
3
Cass Commercial Bank's headquarters are also located at 13001 Hollenberg Drive,
Bridgeton, Missouri, 63044. The Bank leases approximately 20,500 square feet of
the 61,500 square foot building. In addition, the Bank owns a banking facility
near downtown St. Louis that consists of approximately 1,600 square feet with
adjoining drive-up facilities. The Bank has additional leased facilities in
Maryland Heights, Missouri (2,500 square feet); Fenton, Missouri (1,250 square
feet) and Chesterfield, Missouri (2,850 square feet).
Government e-Management Solutions' headquarters are located at 121 Hunter Avenue
- - Suite 100, St. Louis, Missouri, 63124. GEMS leases approximately 9,486 square
feet.
ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are not involved in any pending proceedings
other than ordinary routine litigation incidental to their businesses.
Management believes none of these proceedings, if determined adversely, would
have a material effect on the business or financial condition of the Company or
its subsidiaries.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 2003.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock trades on The Nasdaq Stock Market(R) under the symbol
"CASS". As of March 5, 2004 there were 224 holders of record of the Company's
common stock. High and low bid prices, as reported by Nasdaq and restated for
stock dividends, for each quarter of 2003 and 2002 were as follows:
2003 2002
---- ----
High Low High Low
---- --- ---- ---
1st Quarter $25.255 $22.183 $22.727 $20.009
2nd Quarter 30.455 23.364 22.615 20.779
3rd Quarter 30.773 25.782 23.160 19.524
4th Quarter 31.745 26.555 23.409 19.870
Cash dividends paid per share, restated for stock dividends, by the Company
during the two most recent fiscal years were as follows:
2003 2002
---- ----
March 15 $.191 $.173
June 15 .191 .173
September 15 .191 .173
December 15 .191 .191
Refer to Item 8 Notes 2 and 10 to the consolidated financial statements for
additional shareholder information.
4
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial information for each of the five
years ended December 31, 2003. The selected financial data should be read in
conjunction with the Company's consolidated financial statements and
accompanying notes included in Item 8 of this report.
(Dollars in thousands, except per share data) 2003 2002 2001 2000 1999
====================================================================================================================================
Fee revenue and other income $40,067 $28,030 $23,243 $21,114 $21,444
Interest income on loans (1) 25,601 26,197 29,069 27,716 20,371
Interest income on debt and equity securities 2,033 4,733 4,323 5,264 4,722
Other interest income 609 687 2,790 4,085 5,782
Total interest income 28,243 31,617 36,182 37,065 30,875
Interest expense on deposits 1,847 2,240 3,863 5,165 4,357
Interest expense on short-term borrowings 14 33 9 20 9
Total interest expense 1,861 2,273 3,872 5,185 4,366
Net interest income 26,382 29,344 32,310 31,880 26,509
Provision for loan losses 190 500 60 750 --
Net interest income after provision 26,192 28,844 32,250 31,130 26,509
Operating expense 54,904 46,575 44,729 41,236 38,344
Income before income tax expense 11,355 10,299 10,764 11,008 9,609
Income tax expense 3,453 2,987 3,739 3,861 3,411
- ------------------------------------------------------------------------------------------------------------------------------------
Net income $7,902 $7,312 $7,025 $7,147 $6,198
====================================================================================================================================
Basic earnings per share (2) $2.15 $1.98 $1.88 $1.78 $1.42
Diluted earnings per share (2) 2.13 1.96 1.86 1.75 1.39
Dividends per share (2) .764 .710 .693 .693 .658
Dividend payout ratio 35.61% 35.94% 36.71% 38.95% 46.61%
====================================================================================================================================
Average total assets $620,801 $598,566 $572,724 $515,308 $491,450
Average net loans 438,072 399,018 371,367 323,515 254,353
Average debt and equity securities 57,729 97,668 72,111 84,949 78,903
Average total deposits 249,951 240,640 214,954 186,684 190,661
Average total shareholders' equity 61,346 57,300 54,929 54,308 57,118
====================================================================================================================================
Return on average total assets 1.27% 1.22% 1.23% 1.39% 1.26%
Return on average total shareholders' equity 12.88 12.76 12.79 13.16 10.85
Average equity to assets ratio 9.88 9.57 9.59 10.54 11.62
Equity to assets ratio at year-end 10.13 10.67 9.22 9.33 11.29
Net interest margin 4.85 5.60 6.27 6.69 5.87
Allowance for loan losses to loans at year-end 1.17 1.22 1.29 1.32 1.54
Nonperforming assets to loans and foreclosed
Assets 1.12 3.50 1.60 .30 .15
Net loan (recoveries) charge-offs to average
loans outstanding (.01) .03 .01 .04 .06
====================================================================================================================================
1. Interest income on loans includes net loan fees.
2. Per share information has been restated to reflect the 10% stock dividend
declared in February 2004.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Overview
Cass Information Systems, Inc. provides payment and information processing
services to national manufacturing, distribution and retail enterprises from its
processing centers in St. Louis, Missouri, Columbus, Ohio, and Boston,
Massachusetts. The Company's services include freight invoice rating, payment
processing, auditing, and the generation of cost accounting and transportation
information. Cass also processes and pays utility invoices, including
electricity, gas and telecommunications. Cass extracts, stores and presents
information from freight and utility invoices, assisting our customers'
transportation and energy managers in making decisions that will enable them to
improve their operating performance. The Company receives data from multiple
sources, electronic and otherwise, and processes the data to accomplish the
specific operating requirements of its customers. It then provides the data in a
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central repository for access and archiving. The data is finally transformed
into information through the Company's databases that allow client interaction
as required and provide Internet-based tools for analytical processing. The
Company also, through its St Louis, Missouri based bank subsidiary, provides
banking services in the St Louis metropolitan area and other selected cities in
the United States. In addition to supporting the Company's payment operations,
it also provides banking services to its target markets, which include privately
owned businesses and churches and church-related ministries. The Company,
through the Bank's subsidiary, GEMS, also develops and licenses integrated
financial, property and human resource management systems to the public sector.
The specific payment and information processing services provided to each
customer are developed individually to meet each customer's specific
requirements. These requirements can vary greatly from customer to customer. In
addition, the degree of automation such as electronic data interchange (EDI),
imaging, and web-enhanced solutions varies greatly among customers and
industries. These factors combine so that pricing varies greatly among the
customer base. In general however, Cass is compensated for its processing
services through service fees and account balances that are generated during the
payment process. The amount, type and calculation of service fees vary greatly
by service offering, but generally follow the volume of transactions processed.
Interest income from the balances generated during the payment processing cycle
is affected by the amount of time Cass holds the funds prior to payment and the
dollar volume processed. Both the number of transactions processed and the
dollar volume processed are therefore key metrics followed by management. Other
factors will influence revenue and profitability however, such as changes in the
general level of interest rates which has a significant affect on net interest
income. The funds generated by these processing activities are invested in
overnight investments, investment grade securities and loans generated by the
Bank. The Bank earns most of its revenue from net interest income, or the
difference between the interest earned on its loans and investments and the
interest expense on its deposits. The Bank also assesses fees on other services
such as cash management services. GEMS earns most of its revenue from the
license of its enterprise software solutions and its installation and
maintenance services.
Industry-wide factors that impact the Company include the acceptance by large
corporations of the outsourcing of key business functions such as freight and
utility payment. The benefits that can be achieved by outsourcing transaction
processing and the management information generated by Cass' systems can be
influenced by factors such as the competitive pressures within industries to
improve profitability, the general level of transportation costs and the
deregulation of energy costs. Economic factors that impact the Company include
the general level of economic activity that can affect the volume and size of
invoices processed, the ability to hire and retain qualified staff and the
growth and quality of our loan portfolio. The general level of interest rates
has a significant effect on the revenue of the Company. Finally, the general
fiscal condition of the counties and municipalities that can benefit from GEMS'
enterprise software can impact licenses sold and related revenue.
Currently, management views Cass' major opportunity and challenge as the
continued expansion of its payment and information processing service offerings
and customer base. Management intends to accomplish this by maintaining our lead
in applied technology, which, when combined with the security and processing
controls of the Company's Bank, makes Cass unique in the industry. This trend
has been positive over the past years and management anticipates that this
should continue in 2004. The low level of interest rates has had a significant
negative impact on net income over the past few years. While management doesn't
anticipate that these rates will rise in the near term, the Company is well
positioned to take advantage of rising rates when they occur. Management is
pleased with the growth in software revenue generated by GEMS and is making
additional investments to continue this trend. Management intends to continue to
refine risk management practices, monitor and manage the quality of the loan
portfolio and maintain a strong financial and liquidity position.
Critical Accounting Policies
The Company has prepared all of the consolidated financial information in this
report in accordance with accounting principles generally accepted in the United
States of America (U.S. GAAP). In preparing the consolidated financial
statements in accordance with U.S. GAAP, management makes estimates and
assumptions that affect the reported amount of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenue and expenses during the
reporting period. These estimates have been generally accurate in the past, they
have been consistent and have not required any material changes. There can be no
assurances that actual results will not differ from those estimates. Certain
accounting policies that require significant management estimates and are deemed
critical to our results of operations or financial position have been discussed
with the Audit Committee of the Board of Directors and are described below.
Allowance for Loan Losses. The Company performs periodic and systematic detailed
reviews of its loan portfolio to assess overall collectability. The level of the
allowance for loan losses reflects management's estimate of the collectability
of the loan portfolio. Although these estimates are based on established
methodologies for determining allowance requirements, actual results can differ
significantly from estimated results. These policies affect all segments of the
Company with the exception of governmental software services. The impact and
associated risks related to these policies on our business operations are
discussed in the " Allowance and Provision for Loan Losses" section of this
report.
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Impairment of Assets. Management periodically evaluates certain long-term assets
such as intangible assets including goodwill, foreclosed assets, internally
developed software and investments in private equity securities for impairment.
Generally, these assets are initially recorded at cost, and recognition of
impairment is required when events and circumstances indicate that the carrying
amounts of these assets will not be recoverable in the future. If impairment
occurs, various methods of measuring impairment may be called for depending on
the circumstances and type of asset, including quoted market prices, estimates
based on similar assets, and estimates based on valuation techniques such as
discounted projected cash flows. Assets held for sale are carried at the lower
of cost or fair value less costs to sell. These policies affect all segments of
the Company and require significant management assumptions and estimates that
could result in materially different results if conditions or underlying
circumstances change.
Results of Operations
The results of 2003 compared to 2002 include the following significant items:
Payment and processing fees increased $3,818,000 or 16% to $28,440,000 as
the number of transactions processed increased 2,993,000 or 12% to
27,977,000. This increase was driven by the expansion of the Company's
customer base and number of services provided as well as an increase in
national freight activity during the second half of the year.
Net interest income after provision for loan losses decreased $2,652,000
or 9% to $26,192,000 due to the dramatic decline in interest rates during
the past few years. This decline occurred despite the fact that total
loans, typically our highest-yielding asset for any given maturity, grew
$34,343,000 or 8% to $469,032,000 and average earning assets grew
$19,060,000 or 4% to $563,071,000. The growth in average earning assets
was derived from both increases in deposits and accounts and drafts
payable. Gains from the sale of securities were comparable to last year,
$1,454,000 in 2003 and $1,477,000 in 2002.
On January 1, 2003, the Company reclassified the foreclosed assets
relating to its software subsidiary, GEMS, from held for sale to held and
used and consolidated its operations into those of the Bank subsidiary. On
January 2, 2001, the Company's bank subsidiary foreclosed on these
operating assets in order to protect its financial interests. The Bank
sold these assets to a wholly owned subsidiary, and invested in and
stabilized this business. From the date of foreclosure through December
31, 2002, these assets were accounted for as a foreclosed asset held for
sale. Statement of Financial Accounting Standards (SFAS 144), "Accounting
for the Impairment or Disposal of Long-Lived Assets", adopted by the
Company on January 1, 2002, requires that if certain criteria are not met
for long-lived asset (disposal) groups classified as held for sale by the
end of the fiscal year in which SFAS 144 is initially applied, the related
long-lived assets shall be reclassified as held and used. In 2003 revenues
for this segment were $7,696,000 and operating profits were $107,000.
Bank service fees increased $147,000 or 9% to $1,806,000 due primarily to
the fact that as the earnings credit rate granted customers on their
account balances decreases with the general level of interest rates, the
amount of service fees charged increases. Other income increased $399,000
or 147% to $671,000 due mainly to an investment in bank owned life
insurance during 2002. Operating expenses, excluding the effects of the
GEMS consolidation, increased a modest $996,000 or 2% to $47,571,000 due
mainly to increases in salaries and health and worker's compensation
insurance expenses.
The results of 2002 compared to 2001 include the following significant items:
Payment and processing fees increased $3,132,000 or 15% to $24,622,000 as
the number of transactions processed increased 2,151,000 or 9% to
24,984,000. This increase was driven by the expansion of the Company's
customer base and the services provided and offset the negative impact on
processing volumes and fees caused by a decrease in national freight
activity.
Net interest income after provision for loan losses decreased $3,406,000
or 11% to $28,844,000 due to the dramatic decline in the general level of
interest rates. This decline occurred despite the fact that total loans,
typically the Company's highest-yielding asset for any given maturity,
grew $53,237,000 or 14% to $434,689,000 and average earning assets grew
$22,737,000 or 4% to $544,011,000. The growth in average assets was
derived from growth in Bank deposits, both interest and noninterest
bearing. Gains from the sale of securities were $1,477,000 in 2002, which
mitigated some of the impact of the decline in interest rates. No gains
were realized in 2001.
7
Bank service fees increased $137,000 or 9% to $1,659,000 due to fact that
as the earnings credit rate granted customers on their account balances
decreases with the general level of interest rates, the amount of service
fees charged increases. Operating expenses increased $1,846,000 or 4% to
$46,575,000 due mainly to increased personnel expenses, equipment expenses
and other expenses related to the increased volume and service offerings.
Fee Revenue and Other Income
The Company's fee revenue is derived mainly from freight and utility payment and
processing fees. As the Company provides its freight and utility processing and
payment services, it is compensated by service fees which are typically
calculated on a per-item basis and by the accounts and drafts payable balances
generated in the payment process which can be used to generate interest income.
Processing volumes related to fees and accounts and drafts payable for the years
ended December 31, 2003, 2002 and 2001 are as follows:
December 31,
--------------------------------------
(In thousands) 2003 2002 2001
================================================================================
Transportation Information Services:
Invoice Transaction Volume 23,359 21,549 20,095
Invoice Dollar Volume $8,673,993 $7,715,588 $7,294,586
Utility Information Services:
Transaction Volume 4,618 3,435 2,738
Transaction Dollar Volume $3,340,375 $2,634,269 $2,481,086
- --------------------------------------------------------------------------------
Fee revenue and other income in 2003 compared to 2002 include the following
significant pre-tax components:
Freight and utility payment and processing fee revenue increased
$3,818,000 or 16% to $28,440,000. Of the total payment and processing
revenue, fees related to utility payment and processing increased
$2,484,000 or 37% to $9,134,000 and fees relating to freight payment and
processing services increased $1,334,000 or 7% to $19,306,000. These
increases both relate to new customers and new product offerings. Utility
processing volume and revenue, which represents a newer market, had higher
percentage increases.
Software revenue in 2003 of $7,696,000 represents the revenue of the
Bank's software subsidiary GEMS, which develops and licenses integrated
financial, property and human resource management systems to the public
sector. Prior to December 31, 2002, GEMS was accounted for as an asset
held for sale and its operating results were not consolidated with those
of the Company. SFAS 144, adopted by the company in 2002, now requires
that GEMS be reclassified as an asset held and used. Consequently, Cass
reclassified the entity's net assets and consolidated its operations with
the parent company on January 1, 2003. Although unconsolidated in 2002 and
2001, software revenue was $5,526,000 and $4,187,000, respectively.
Bank service fees increased $147,000 or 9% to $1,806,000. This increase
was due primarily to the fact that service fees increase as the value of
noninterest bearing deposits, used to compensate the Bank for services
provided, decrease as the general level of interest rates decreases.
During 2003 the Company recorded net gains of $1,454,000 on the sales of
securities with a fair value of $38,454,000. During 2002, net gains of
$1,477,000 were recorded on the sales of securities with a fair value of
$63,945,000. These sales of securities were transacted to adjust the
portfolio to reflect the changes in the interest rate environment, growth
in the loan portfolio during the past two years and to offset the loss of
interest income due to the dramatic decline in the general level of
interest rates.
Other income increased $399,000 or 147% to $671,000. This increase was
primarily due to income recognized from the increase in the cash surrender
value of bank owned life insurance purchased by the Company in 2002.
Fee revenue and other income in 2002 compared to 2001 include the following
significant pre-tax components:
Freight and utility payment and processing fee revenue increased
$3,132,000 or 15% to $24,622,000. Of the total payment and processing
revenue, fees related to utility payment and processing increased
$2,188,000 or 49% to $6,650,000 and fees relating to freight payment and
processing services increased $944,000 or 6% to $17,972,000. These
increases both relate to new customers and new product offerings. Utility
processing volume and revenue, which represents a newer market, had higher
8
percentage increases. Freight rating services revenue, a component of
freight processing revenue, decreased $738,000 or 55% to $610,000. A
change in the strategic direction of the Company from selling rating
software to a new Internet-based delivery system of carrier rates occurred
during 2000 and 2001. After December 31, 2001 the Company ceased support
of the old product and therefore no longer recognized maintenance revenue.
This new system offers the shipping community an expanded level of
features, capabilities and ease of access.
Bank service fees increased $137,000 or 9% to $1,659,000. This increase
was due primarily to the fact that service fees increase as the value of
noninterest bearing deposits, used to compensate the Bank for services
provided, decreases as the general level of interest rates decreases.
During 2002 the Company recorded net gains of $1,477,000 on the sales of
securities with a fair value of $63,945,000. There were no gains realized
in 2001. The sales of securities were transacted to adjust the portfolio
to reflect the changes in the interest rate environment, growth in the
loan portfolio and to offset the loss of interest income due to the
dramatic decline in the general level of interest rates.
Other miscellaneous income increased $41,000 or 18% to $272,000. This
increase was primarily due to income recognized from the increase in the
cash surrender value of bank owned life insurance purchased by the Company
in 2002.
Net Interest Income
Net interest income is the difference between interest earned on loans,
investments, and other earning assets and interest expense on deposits and other
interest-bearing liabilities. Net interest income is a significant source of the
Company's revenues.
Net interest income in 2003 compared to 2002:
On a tax-equivalent basis, net interest income for 2003 totaled $27,310,000, a
decrease of $3,156,000 or 10% from 2002. The net interest margin for 2003 was
4.85% compared to 5.60% in 2002. The following factors account for this decrease
in net interest income and net interest margin:
The dramatic decrease in the general level of interest rates significantly
impacted the Company's net interest income and margin. The prime rate
decreased from 9.50% at the beginning of 2001 to 4.00% at the end of 2003
and the 5-year Treasury note rate decreased from 4.80% to 3.22% during
this same period. The average yield on earning assets decreased to 5.18%
in 2003 from 6.02% in 2002. The Company is negatively affected by
decreases in the level of interest rates due to the fact that its rate
sensitive assets significantly exceed its rate sensitive liabilities.
Conversely, the Company is positively affected by increases in the level
of interest rates. This is primarily due to the noninterest-bearing
liabilities generated by the Company in the form of accounts and drafts
payable. Changes in interest rates will affect some earning assets such as
federal funds sold and floating rate loans immediately and some earning
assets, such as fixed rate loans and municipal bonds, over time. More
information is contained in Item 7A of this report.
The Company partially offset the decrease in net interest income through
both an increase in earning assets and shift of earning assets to higher
yielding asset classes. Total average earning assets increased $19,060,000
or 4% to $563,071,000. This increase was funded by both an increase in
accounts and drafts payable due to the increase in payments processed and
an increase in bank deposits due to the expansion of the Banks' customer
base.
Total average loans increased $39,359,000 or 10% to $443,452,000. This
increase was attributable to new business relationships and was funded by
the increase in accounts and drafts payable, growth in bank deposits and
reallocation of earning assets from the investment portfolio. Although not
enough to offset the decline in the level of interest rates, this increase
in loans had a positive affect on interest income and the net interest
margin due to the fact that loans are one of the Company's highest
yielding earning assets for any given maturity.
Total average investment in debt and equity securities decreased
$39,939,000 or 41% to $57,729,000. This decrease was used partially to
fund the increase in loans and partially shifted into federal funds sold
and overnight investments.
Total average federal funds sold and other short-term investments
increased $19,640,000 or 46% to $61,890,000. This increase provides
additional liquidity and positions the Company to take advantage of higher
interest rates should they occur.
9
Net interest income in 2002 compared to 2001:
On a tax-equivalent basis, net interest income for 2002 totaled $30,466,000, a
decrease of $2,194,000 or 7% from 2001. The net interest margin for 2002 was
5.60% compared to 6.27% in 2001. The following factors account for this decrease
in net interest income and net interest margin:
The dramatic decrease in the general level of interest rates significantly
impacted the Company's net interest income and margin. The prime rate
decreased from 9.50% at the beginning of 2001 to 4.25% at the end of 2002
and the 5-year Treasury note rate decreased from 4.80% to 2.89% during
this same period. The average yield on earning assets decreased to 6.02%
in 2002 from 7.01% in 2001. The Company is negatively affected by
decreases in the level of interest rates due to the fact that its rate
sensitive assets significantly exceed its rate sensitive liabilities.
Conversely, the Company is positively affected by increases in the level
of interest rates. This is primarily due to the noninterest-bearing
liabilities generated by the Company in the form of accounts and drafts
payable. Changes in interest rates will affect some earning assets such as
federal funds sold and floating rate loans immediately and some earning
assets, such as fixed rate loans and municipal bonds, over time. More
information is contained in Item 7A of this report.
The Company partially offset the decrease in net interest income through
both an increase in earning assets and shift of investments to higher
yielding assets. Total average earning assets increased $22,737,000 or 4%
to $544,011,000. This increase was funded by an increase in deposits
generated by the Bank. The Bank saw increases in both interest bearing
deposits, as a result of increased marketing efforts, and noninterest
bearing deposits, mainly from bank customers that maintained higher
balances to compensate the Bank for services and to avoid increased
service fees in a lower rate environment.
Total average loans increased $27,818,000 or 7% to $404,093,000. This
increase was attributable to new business relationships and funded by the
increase in deposit liabilities and a reallocation of assets. This
increase in loans had a positive effect on interest income and the net
interest margin due to the fact that loans are one of the Company's
highest yielding earning assets for any given maturity.
Total average investment in debt and equity securities increased
$25,557,000 or 35% to $97,668,000. In addition to this increased
investment, the Company shifted its purchase of securities from taxable to
tax-exempt due to the higher tax-equivalent yield such investments
produce. This increase and shift also allowed the Company to partially
offset the effect of lower interest rates.
Total average federal funds sold and other short-term investments
decreased $30,638,000 or 42% to $42,250,000. These are the lowest yielding
earning assets so decreases in these funds have a positive effect on net
interest margin. In another attempt to offset the effect of declining
interest rates, the Company shifted excess short-term funds to higher
yielding investments.
Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rate and
Interest Differential
The following table contains condensed average balance sheets for each of the
periods reported, the tax-equivalent interest income and expense on each
category of interest-earning assets and interest-bearing liabilities, and the
average yield on such categories of interest-earning assets and the average
rates paid on such categories of interest-bearing liabilities for each of the
periods reported.
10
2003 2002 2001
-------------------------- ------------------------- --------------------------
Interest Interest Interest
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate
===================================================================================================================================
Assets (1)
Earning assets:
Loans (2),(3):
Taxable $437,807 $25,319 5.78% $398,060 $25,897 6.51% $364,792 $28,435 7.79%
Tax-exempt (4) 5,645 427 7.56 6,033 455 7.54 11,483 961 8.37
Debt and equity securities (5):
Taxable 22,183 499 2.25 55,591 2,839 5.11 71,038 4,276 6.02
Tax-exempt (4) 35,546 2,317 6.52 42,077 2,861 6.80 1,073 70 6.52
Federal funds sold and other
short-term investments 61,890 609 .98 42,250 687 1.63 72,888 2,790 3.83
- -----------------------------------------------------------------------------------------------------------------------------------
Total earning assets 563,071 29,171 5.18 544,011 32,739 6.02 521,274 36,532 7.01
Nonearning assets:
Cash and due from banks 19,136 24,324 23,448
Premises and equipment, net 14,918 16,281 16,542
Other assets 29,056 19,025 16,368
Allowance for loan losses (5,380) (5,075) (4,908)
- -----------------------------------------------------------------------------------------------------------------------------------
Total assets $620,801 $598,566 $572,724
- -----------------------------------------------------------------------------------------------------------------------------------
Liabilities And Shareholders'
Equity (1)
Interest-bearing liabilities:
Interest-bearing demand
deposits $ 52,630 $ 371 .70% $ 56,705 $ 632 1.11% $ 56,124 $ 1,544 2.75%
Savings deposits 36,192 281 .78 41,837 528 1.26 53,757 1,761 3.28
Time deposits of
$100 or more 44,793 844 1.88 36,158 902 2.49 8,245 363 4.40
Other time deposits 15,545 351 2.26 5,467 178 3.26 3,986 195 4.89
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 149,160 1,847 1.24 140,167 2,240 1.60 122,112 3,863 3.16
Short-term borrowings 943 14 1.48 1,485 33 2.22 362 9 2.49
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing
liabilities 150,103 1,861 1.24 141,652 2,273 1.60 122,474 3,872 3.16
Noninterest-bearing liabilities:
Demand deposits 100,791 100,473 92,842
Accounts and drafts payable 300,577 293,442 294,608
Other liabilities 7,984 5,699 7,871
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities 559,455 541,266 517,795
Shareholders' equity 61,346 57,300 54,929
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities and
shareholders' equity $620,801 $598,566 $572,724
- -----------------------------------------------------------------------------------------------------------------------------------
Net interest income $27,310 $30,466 $32,660
Net interest margin 4.85% 5.60% 6.27%
Interest spread 3.94% 4.42% 3.85%
- -----------------------------------------------------------------------------------------------------------------------------------
1. Balances shown are daily averages.
2. For purposes of these computations, nonaccrual loans are included in the
average loan amounts outstanding. Interest on nonaccrual loans is recorded
when received as discussed further in Item 8, Note 1 of this report.
3. Interest income on loans includes net loan fees of $90,000, $441,000 and
$301,000 for 2003, 2002 and 2001, respectively.
4. Interest income is presented on a tax-equivalent basis assuming a tax rate
of 34%. The tax-equivalent adjustment was approximately $928,000,
$1,122,000 and $350,000 for 2003, 2002 and 2001, respectively.
5. For purposes of these computations, yields on investment securities are
computed as interest income divided by the average amortized cost of the
investments.
Analysis of Net Interest Income Changes
The following table presents the changes in interest income and expense between
years due to changes in volume and interest rates.
2003 Over 2002 2002 Over 2001
---------------------------------- ----------------------------------
(Dollars in thousands) Volume (1) Rate (1) Total Volume (1) Rate (1) Total
- ----------------------------------------------------------------------------------------------------------------
Increase (decrease) in interest income:
Loans (2),(3):
Taxable $ 2,450 $(3,028) $ (578) $ 2,441 $(4,979) $(2,538)
Tax-exempt (4) (29) 1 (28) (419) (87) (506)
Debt and equity securities:
Taxable (1,212) (1,128) (2,340) (847) (590) (1,437)
Tax-exempt (4) (430) (114) (544) 2,788 3 2,791
Federal funds sold and other
short-term investments 251 (329) (78) (888) (1,215) (2,103)
- ----------------------------------------------------------------------------------------------------------------
Total interest income 1,030 (4,598) (3,568) 3,075 (6,868) (3,793)
- ----------------------------------------------------------------------------------------------------------------
Interest expense on:
Interest-bearing demand deposits (43) (218) (261) 16 (928) (912)
Savings deposits (64) (183) (247) (327) (906) (1,233)
Time deposits of $100 or more 189 (247) (58) 757 (218) 539
Other time deposits 242 (69) 173 60 (77) (17)
Short-term borrowings (10) (9) (19) 25 (1) 24
- ----------------------------------------------------------------------------------------------------------------
Total interest expense 314 (726) (412) 531 (2,130) (1,599)
- ----------------------------------------------------------------------------------------------------------------
Net interest income $ 716 $(3,872) $(3,156) $ 2,544 $(4,738) $(2,194)
================================================================================================================
11
1. The change in interest due to the combined rate/volume variance has been
allocated in proportion to the absolute dollar amounts of the change in
each.
2. Average balances include nonaccrual loans.
3. Interest income includes net loan fees.
4. Interest income is presented on a tax-equivalent basis assuming a tax rate
of 34%.
Loan Portfolio
Interest earned on the loan portfolio is a primary source of income for the
Company. The loan portfolio was $469,032,000 and represented 73% of the
Company's total assets as of December 31, 2003 and generated $25,601,000 in
revenue during the year then ended. The following tables shows the composition
of the loan portfolio at the end of the periods indicated and remaining
maturities for loans as of December 31, 2003.
Loans by Type
(At December 31)
(Dollars in thousands) 2003 2002 2001 2000 1999
====================================================================================================================================
Commercial and industrial $103,638 $101,116 $115,316 $136,482 $106,444
Real estate:
Mortgage 330,150 282,125 215,504 182,538 129,482
Construction 19,298 39,175 32,715 29,464 29,633
Industrial revenue bonds 5,373 5,773 6,155 15,804 7,265
Installment 1,911 1,918 1,787 2,533 1,541
Other 8,662 4,582 9,975 5,399 3,978
- ------------------------------------------------------------------------------------------------------------------------------------
Total loans $469,032 $434,689 $381,452 $372,220 $278,343
====================================================================================================================================
Loans by Maturity
(At December 31, 2003)
Over One Year Over
Through Five Years Five Years
---------------------- ---------------------
One Year Fixed Floating Fixed Floating
(Dollars in thousands) or less Rate Rate(1) Rate Rate(1) Total
===================================================================================================================================
Commercial and industrial $ 73,926 $ 18,505 $10,605 $ -- $602 $103,638
Real estate:
Mortgage 41,542 248,575 38,595 1,123 315 330,150
Construction 17,887 554 857 -- -- 19,298
Industrial revenue bonds 1,146 1,247 -- 2,980 -- 5,373
Installment 1,837 74 -- -- -- 1,911
Other 8,610 -- -- 52 -- 8,662
- -----------------------------------------------------------------------------------------------------------------------------------
Total loans $144,948 $268,955 $50,057 $4,155 $917 $469,032
===================================================================================================================================
(1)Loans have been classified as having "floating" interest rates if the rate
specified in the loan varies with the prime commercial rate of interest.
The Company has no concentrations of loans exceeding 10% of total loans, which
are not otherwise disclosed in the loan portfolio composition table and
discussed in Item 8, Note 4 of this report. As can be seen in the loan
composition table above and discussed in Item 8, Note 4, the Company's primary
market niche for banking services is privately-held commercial companies and
churches and church-related ministries.
Loans to the commercial entities are generally secured by the business assets of
the company, including accounts receivable, inventory, machinery and equipment,
and the real estate from which the company operates. Operating lines of credit
to these companies generally are secured by accounts receivable and inventory,
with specific percentages of each determined on a customer by customer basis
based on various factors including the type of business. Intermediate term
credit for machinery and equipment is generally provided at some percentage of
the value of the equipment purchased, depending on the type of machinery or
equipment purchased by the entity. Loans secured exclusively by real estate to
businesses and churches are generally made with a maximum 80% loan to value
ratio, depending upon the Company's estimate of the resale value and ability of
the property to generate cash. The Company's loan policy requires an independent
appraisal for all loans over $250,000 secured by real estate. Company management
monitors the local economy in an attempt to determine whether it has had a
significant deteriorating effect on such real estate credits. When problems are
identified, appraised values are updated on a continual basis, either internally
or through an updated external appraisal.
12
Loan portfolio changes from December 31, 2002 to December 31, 2003:
Total loans increased $34,343,000 or 8% to $469,032,000. This increase was
due mainly to the expansion of church and church-related loans in the St.
Louis metropolitan area and selected areas across the United States. At
year-end, church and church-related real estate and construction credits
totaled $162,307,000, which represented a 15% increase over 2002.
Additional details regarding the types and maturities of the loan
portfolio are contained in the tables above and in Item 8, Note 4.
Loan portfolio changes from December 31, 2001 to December 31, 2002:
Total loans increased $53,237,000 or 14% to $434,689,000. This increase
was due mainly to the expansion of church and church-related loans in the
St. Louis metropolitan area and selected areas across the United States.
At year-end, church and church-related real estate and construction
credits totaled $141,532,000, which represented a 37% increase over 2001.
Additional details regarding the types and maturities of the loan
portfolio are contained in the tables above and in Item 8, Note 4.
Provision and Allowance for Loan Losses
The Company recorded a provision for loan losses of $190,000 in 2003, $500,000
in 2002 and $60,000 in 2001. The provisions were due to the Company's quarterly
analysis of the allowance for loan losses in relation to probable losses in the
loan portfolio. The larger provisions made in 2002 partially resulted from the
increase in average loans outstanding and an increase in nonperforming loans.
The amount of the provision will fluctuate as determined by these quarterly
analyses. The Company had net loan recoveries of $23,000 for 2003 and net loan
charge-offs of $113,000 in 2002 and $51,000 in 2001. The allowance for loan
losses was $5,506,000 at December 31, 2003, compared to $5,293,000 at December
31, 2002 and $4,906,000 at December 31, 2001. The year-end 2003 allowance
represented 1.17% of outstanding loans, compared to 1.22% at year-end 2002 and
1.29% at year-end 2001. From December 31, 2002 to December 31, 2003 the level of
nonperforming loans decreased $4,801,000 from $9,194,000 to $4,393,000, which
represents .94% of outstanding loans. Nonperforming loans are more fully
explained in the section entitled "Nonperforming Assets" in Item 7 of this
report.
The allowance for loan losses has been established and is maintained to absorb
losses inherent in the loan portfolio. An ongoing assessment of risk of loss is
performed to determine if the current balance of the allowance is adequate to
cover probable losses in the portfolio. A charge or credit is made to expense to
cover any deficiency or reduce any excess. The current methodology employed to
determine the appropriate allowance consists of two components, specific and
general. The Company develops specific valuation allowances on commercial,
commercial real estate, and construction loans based on individual review of
these loans and our estimate of the borrower's ability to repay the loan given
the availability of collateral, other sources of cash flow and collection
options available to us. The general component relates to all other loans, which
are evaluated based on loan grade. The loan grade assigned to each loan is
typically evaluated on an annual basis, unless circumstances require interim
evaluation. The Company assigns a reserve amount consistent with each loan's
rating category. The reserve amount is based on derived loss experience over
prescribed periods. In addition to the amounts derived from the loan grades, a
portion is added to the general reserve to take into account other factors
including national and local economic conditions, downturns in specific
industries including loss in collateral value, trends in credit quality at the
Company and the banking industry, and trends in risk rating changes. As part of
their examination process, federal and state agencies review the Company's
methodology for maintaining the allowance for loan losses and the balance in the
account. These agencies may require the Company to increase the allowance for
loan losses based on their judgments and interpretations about information
available to them at the time of their examination.
13
Summary of Loan Loss Experience
December 31,
------------------------------------------------------------------
(Dollars in thousands) 2003 2002 2001 2000 1999
======================================================================================================================
Allowance at beginning of year $ 5,293 $ 4,906 $ 4,897 $ 4,282 $ 4,428
- ----------------------------------------------------------------------------------------------------------------------
Loans charged-off:
Commercial and industrial loans and
industrial revenue bonds (IRB's) -- 152 110 183 255
Real estate:
Mortgage -- -- -- -- --
Construction -- -- -- -- --
Installment -- -- -- -- 1
Other 2 -- -- -- --
- ----------------------------------------------------------------------------------------------------------------------
Total loans charged-off 2 152 110 183 256
- ----------------------------------------------------------------------------------------------------------------------
Recoveries of loans previously charged-off:
Commercial, industrial and IRB's 25 39 59 48 109
Real estate:
Mortgage -- -- -- -- --
Construction -- -- -- -- --
Installment -- -- -- -- 1
- ----------------------------------------------------------------------------------------------------------------------
Total recoveries of loans previously charged-off 25 39 59 48 110
======================================================================================================================
Net loans (recovered) charged-off (23) 113 51 135 146
Provision charged to expense 190 500 60 750 --
- ----------------------------------------------------------------------------------------------------------------------
Allowance at end of year $ 5,506 $ 5,293 $ 4,906 $ 4,897 $ 4,282
======================================================================================================================
Loans outstanding:
Average $ 443,452 $ 404,093 $ 376,275 $ 327,962 $ 258,742
December 31 469,032 434,689 381,452 372,220 278,343
Ratio of allowance for loan losses to
loans outstanding:
Average 1.24% 1.31% 1.30% 1.49% 1.65%
December 31 1.17% 1.22% 1.29% 1.32% 1.54%
Ratio of net (recoveries) charge-offs to
average loans outstanding (.01)% .03% .01% .04% .06%
======================================================================================================================
Allocation of allowance for loan losses(1):
Commercial, industrial and IRB's $ 2,575 $ 2,167 $ 2,129 $ 3,159 $ 3,844
Real estate:
Mortgage 2,761 2,780 2,442 416 19
Construction 152 302 303 1,317 419
Installment 10 10 10 5 --
Other loans 8 34 22 -- --
- ----------------------------------------------------------------------------------------------------------------------
Total $ 5,506 $ 5,293 $ 4,906 $ 4,897 $ 4,282
======================================================================================================================
Percent of categories to total loans:
Commercial and industrial and IRB's 23.2% 24.6% 31.8% 40.9% 40.9%
Real estate:
Mortgage 70.4 64.9 56.5 49.0 46.5
Construction 4.1 9.0 8.6 7.9 10.6
Installment .4 .4 .5 .7 .6
Other 1.9 1.1 2.6 1.5 1.4
- ----------------------------------------------------------------------------------------------------------------------
Total 100.0% 100.0% 100.0% 100.0% 100.0%
======================================================================================================================
(1) Although specific allocations exist the entire allowance is available to
absorb losses in any particular loan category.
Nonperforming Assets
It is the policy of the Company to continually monitor its loan portfolio and to
discontinue the accrual of interest on any loan on which payment of principal or
interest in a timely manner, in the normal course of business, is doubtful.
Subsequent payments received on such loans are applied to principal if there is
any doubt as to the collectibility of such principal; otherwise, these receipts
14
are recorded as interest income. Interest on nonaccrual and renegotiated loans,
which would have been recorded under the original terms of the loans, was
approximately $272,000 for the year ended December 31, 2003. Of this amount,
approximately $164,000 was actually recorded as interest income on such loans.
The total renegotiated loans of $2,721,000 at December 31, 2003 relates to two
borrowers, both of which are current under the new terms of the loans. The
balance of nonaccrual real-estate mortgage loans of $1,207,000 consists of one
loan for $752,000 that is collateralized by real estate and has a SBA guarantee.
There has been delinquency in loan payments due to slower than expected lease-up
of real estate property. The remaining balance consists of two other loans
totaling $455,000 relating to property that is for sale. These loans are
collateralized by the property and a specific reserve has been established for
the potential shortfall. Nonaccrual commerical loans consist primarily of one
loan for $276,000 relating to a business that is no longer operating, although
payments are being made as the inventory of the business is being sold and a
specific reserve has been established for the potential shortfall.
The total foreclosed assets of $859,000 at December 31, 2003 consist of real
estate property that was foreclosed on August 8, 2001. This property is being
carried as other real estate owned at what management believes to be fair value
less cost to sell the property.
At December 31, 2003, approximately $3,234,000 of loans not included in the
table below were identified by management as having potential credit problems.
These loans are excluded from the table due to the fact they are current under
the original terms of the loans, but circumstances have raised doubts as to the
ability of the borrowers to comply with the current loan repayment terms.
The Company does not have any foreign loans. The Company's loan portfolio does
not include a significant amount of single family real estate mortgage or
installment credits, as the Company does not market its services to retail
customers.
The Company does not have any other interest-earning assets which would have
been included in nonaccrual, past due or restructured loans if such assets were
loans.
Summary of Nonperforming Assets
December 31,
---------------------------------------------------
(Dollars in thousands) 2003 2002 2001 2000 1999
- -----------------------------------------------------------------------------------------------
Commercial, industrial and IRB's:
Nonaccrual $ 318 $ 51 $ 157 $ 84 $ 170
Contractually past due 90 days
or more and still accruing -- -- 18 -- 167
Renegotiated loans 2,240 -- -- -- 70
Real estate-construction on nonaccrual -- -- 265 1,043 --
Real estate-mortgage:
Nonaccrual 1,207 -- 32 -- --
Contractually past due 90 days
or more and still accruing 147 3,388 -- -- --
Renegotiated loans 481 4,252 -- -- --
Installment loans contractually past due
90 days or more and still accruing -- -- -- 4 --
Other loans contractually past due 90
days and still accruing -- 1,503 -- -- --
- -----------------------------------------------------------------------------------------------
Total nonperforming loans 4,393 9,194 472 1,131 407
- -----------------------------------------------------------------------------------------------
Total foreclosed assets 859 6,241 5,710 -- --
- -----------------------------------------------------------------------------------------------
Total nonperforming assets $ 5,252 $15,435 $ 6,182 $ 1,131 $ 407
===============================================================================================
Operating Expenses
Operating expenses in 2003 compared to 2002 include the following significant
pre-tax components:
Salaries and employee benefits expense increased $5,747,000 or 18% to
$37,152,000. Of this increase the consolidation of GEMS amounted to
$4,139,000. The remaining increase primarily relates to annual salary
increases and increases in health and worker's compensation insurance
expense.
15
Occupancy expense increased $282,000 or 19% to $1,782,000. Of this
increase $237,000 relates to the consolidation of GEMS. Equipment expense
increased $168,000 or 4% to $4,478,000. GEMS contributed $433,000 of
equipment expense. Excluding GEMS, equipment expense decreased $265,000
primarily due to decreases in computer equipment maintenance from the
consolidation of equipment within the transportation processing division.
Other operating expense increased $2,132,000 or 23% to $11,492,000. The
consolidation of GEMS contributed $2,524,000 to other operating expense.
Excluding GEMS, other operating expenses decreased $392,000 or 4%. More
details on the components of other operating expenses are contained in
Item 8, Note 11 of this report.
Operating expenses in 2002 compared to 2001 include the following significant
pre-tax components:
Salaries and employee benefits expense increased $936,000 or 3% to
$31,405,000. This increase primarily relates to increased staff in both
the transportation and utility processing divisions to accommodate the
increase in production. The Company also experienced an increase in
pension and health insurance expense.
Occupancy expense decreased $158,000 or 10% to $1,500,000 primarily due to
a decrease in rent expense after moving the Company's Columbus operations
from leased space to a newly-acquired building, closing of the Chicago
office, which was the facility used to support the rating software
business that was discontinued in 2002 and closing one of the two bank
subsidiary branches located in downtown St. Louis. Equipment expense
increased $479,000 or 13% to $4,310,000 and other operating expense
increased $589,000 or 7% to $9,360,000. These increases relate mainly to
the expansion of utility payment processing capabilities, increased
investment in freight payment processing and Internet capabilities and
other normal operating expense fluctuations. More details on the
components of other operating expenses are contained in Item 8, Note 11 of
this report.
Income Tax Expense
Income tax expense in 2003 totaled $3,453,000 compared to $2,987,000 in 2002 and
$3,739,000 in 2001. When measured as a percent of income before income taxes,
the Company's effective tax rate was 30% in 2003, 29% in 2002 and 35% in 2001.
The primary reason for the decline in the effective rate in 2002 was the
Company's investment in tax-exempt municipal bonds and bank owned life
insurance.
Investment Portfolio
Investment portfolio changes from December 31, 2002 to December 31, 2003:
U.S. Government Treasury securities increased from $0 to $17,103,000. This
increase occurred due to a decision to decrease holdings in U.S.
Government corporations and agencies given changes in the relative yields
of these securities.
U.S. Government corporation and agency securities decreased $22,557,000 or
83% to $4,690,000. This decrease was due to a decision to reinvest in U.S.
Government Treasury securities given the small differential in yields
between these types of securities in 2003.
State and political subdivision securities increased $5,854,000 or 14% to
$46,777,000. This was the result of a decision to invest in longer-term,
higher-yielding investments.
Investment portfolio changes from December 31, 2001 to December 31, 2002:
The balance of $12,284,000 invested in U.S. Government Treasury securities
at December 31, 2001 matured during 2002 and these funds were invested in
higher-yielding securities and used to fund loan growth.
U.S. Government corporation and agency securities decreased $50,066,000 or
65% to $27,249,000. The decrease was primarily from the sales of these
securities, which were transacted to adjust the portfolio to reflect the
changes in the interest rate environment, accommodate growth in the loan
portfolio and to recognize gains to offset the loss in interest income due
to the dramatic decline in the general level of interest rates.
State and political subdivision securities increased $38,824,000 to
$40,923,000. This increase was due to the decision to invest in
longer-term, higher-yielding investments.
16
There was no single issuer of securities in the investment portfolio at December
31, 2003, other than U.S. Government corporations and agencies, for which the
aggregate amortized cost exceeded ten percent of total shareholders' equity.
Investment by Type
December 31,
-----------------------------
(Dollars in thousands) 2003 2002 2001
================================================================================
U.S. Treasury securities $17,103 $ -- $12,284
U.S. Government corporations and agencies 4,690 27,247 77,313
State and political subdivisions 46,777 40,923 2,099
Stock of the Federal Home Loan Bank 376 1,000 433
Stock of the Federal Reserve Bank 201 201 201
- --------------------------------------------------------------------------------
Total investments $69,147 $69,371 $92,330
================================================================================
Investment in Debt Securities by Maturity
(At December 31, 2003)
Within Over 1 to Over 5 to Over
(Dollars in thousands) 1 Year 5 Years 10 Years 10 Years Yield
===========================================================================================
U.S. Treasury securities $14,104 $ 2,999 $ -- $ -- 1.24%
U.S. Government corporations and
agencies -- 4,690 -- -- 3.04%
State and political subdivisions(1) -- 1,087 14,427 31,263 6.31%
- -------------------------------------------------------------------------------------------
Total investment in debt securities $14,104 $ 8,776 $14,427 $31,263 4.79%
- -------------------------------------------------------------------------------------------
Weighted average yield 1.05% 2.88% 6.50% 6.29%
===========================================================================================
1. Weighted average yield is presented on a tax-equivalent basis assuming a tax
rate of 34%.
Equity Investment
During 2003, the Company converted its $2,000,000 investment in a private
imaging company from a convertible debenture into common stock. As part of the
conversion, the Company committed to invest an additional $1,100,000 if certain
conditions were met. As of December 31, 2003, the total investment of the
Company in this entity was $2,908,000 and is included in other assets in the
accompanying consolidated balance sheets. The Company now has an effective
19.93% ownership interest in this entity and the Chairman and CEO of the Company
is a member of the entity's Board of Directors. No business has been transacted
between the companies during the year.
The Company made its initial investment in this entity in 2001 through a
convertible debenture. The business has since performed poorly and during 2003
received a commitment of an additional $3,000,000 from a new non-affiliated
majority owner, in addition to the Company's additional commitment. The new
majority owner is currently in the process of stabilizing the business and
improving its financial performance. The primary condition for any additional
investment by the Company is the amount of the new majority owner's actual
financial investment. Should this business fail to meet its objectives, the
Company's investment could be subject to future impairment.
The Company accounts for this investment, along with its other non-marketable
equity investments, under the cost method. Under the cost method of accounting,
investments are carried at cost and are adjusted only for other-than-temporary
declines in fair value, distributions of earnings and additional investments.
The Company periodically evaluates whether any declines in fair value of its
investments are other than temporary. In performing this evaluation, the Company
considers various factors including any decline in market price, where
available, the investee's financial condition, results of operations, operating
trends and other financial ratios.
Deposits and Accounts and Drafts Payable
Noninterest-bearing demand deposits increased $5,282,000 or 5% from December 31,
2002 to $114,634,000 at December 31, 2003. The average balances remained level
from 2002 to 2003, recording a slight $318,000 or less than 1% increase to
$100,791,000. The increase in ending balances relates to normal daily
fluctuations in these accounts.
Interest-bearing deposits increased $23,628,000 or 18% from December 31, 2002 to
$157,794,000 at December 31, 2003. The average balances of these deposits
increased $8,993,000 or 6% from 2002 to $149,160,000 in 2003. These increases
relate mainly to the Bank's increased marketing efforts to attract more
deposits.
17
Accounts and drafts payable generated by the Company in its payment processing
operations increased $70,148,000 or 31% from December 31, 2002 to $293,769,000
at December 31, 2003. The average balances of these funds increased $7,135,000
or 2% from 2002 to $300,577,000 in 2003. These increases relate to the increase
in dollars processed. Due to the Company's payment processing cycle, average
balances are much more indicative of the underlying activity than period-end
balances since point-in-time comparisons can be misleading if the comparison
dates fall on different days of the week.
The composition of average deposits and the average rates paid on those deposits
is represented in the table entitled "Distribution of Assets, Liabilities and
Stockholders' Equity; Interest Rate and Interest Differential" which is included
earlier in this discussion. The Company does not have any significant deposits
from foreign depositors.
Maturities of Certificates of Deposits of $100,000 or More
(At December 31, 2003)
(Dollars in thousands)
================================================================================
Three months or less $18,779
Three to six months 4,945
Six to twelve months 5,562
Over twelve months 13,990
- --------------------------------------------------------------------------------
Total $43,276
================================================================================
Short-term Borrowings
Short-term borrowings decreased $37,315,000 or 99.7% from December 31, 2002 to
$123,000 at December 31, 2003. Average balances of these funds decreased
$542,000 or 36% from 2002 to $943,000 during 2003. These funds consist primarily
of federal funds purchased and can also include tax deposits of the United
States Treasury. The borrowings at December 31, 2002 were used to fund a
decrease in accounts and drafts payable due to a combination of special year-end
funding arrangements with large customers, seasonality and the last day of the
year being the low point of the weekly payment cycle. These balances can vary
significantly from day to day due to the Company's payment cycle and therefore
balances on any particular day are not necessarily reflective of balances
throughout the year. For more information on borrowings please refer to Item 8,
Note 9 of this report.
Liquidity
The discipline of liquidity management as practiced by the Company seeks to
ensure that funds are available to fulfill all payment obligations relating to
the freight and utility invoices processed as they become due, meet depositor
withdrawal requests and borrower credit demands while at the same time
maximizing profitability. This is accomplished by balancing changes in demand
for funds with changes in the supply of funds. Primary liquidity to meet demand
is provided by short-term liquid assets that can be converted to cash, maturing
securities and the ability to obtain funds from external sources. The Company's
Asset/Liability Committee (ALCO) has direct oversight responsibility for the
Company's liquidity position and profile. Management considers both on-balance
sheet and off-balance sheet transactions in its evaluation of liquidity.
The balances of liquid assets consists of cash and cash equivalents, which
include cash and due from banks, federal funds sold, and money market funds, and
were $62,367,000 at December 31, 2003, an increase of $32,361,000 or 108% from
December 31, 2002. At December 31, 2003 these assets represented 10% of total
assets. These funds are the Company's and its subsidiaries' primary source of
liquidity to meet future expected and unexpected loan demand, depositor
withdrawals or reductions in accounts and drafts payable.
Secondary sources of liquidity include the investment portfolio and borrowing
lines. Total investment in debt and equity securities was $69,147,000 at
December 31, 2003, a slight decrease of $224,000 from December 31, 2002. These
assets represented 11% of total assets at December 31, 2003. Of this total, 67%
were state and political subdivision securities, 25% were U.S. Treasury
securities, 7% were U.S. government agencies and 1% were other securities. Of
the total portfolio, 20% mature in one year, 13% matures in one to five years,
and 67% matures in five or more years. During the year the Company sold
securities with a market value of $38,454,000 and a portion of these funds were
reinvested in state and political subdivision securities and the loan portfolio.
The Bank has unsecured lines at correspondent banks to purchase federal funds up
to a maximum of $33,000,000. Additionally, the Bank maintains a line of credit
at an unaffiliated financial institution in the maximum amount of $79,661,000
collateralized by securities sold under repurchase agreements.
18
The deposits of the Company's banking subsidiary have historically been stable,
consisting of a sizable volume of core deposits related to customers that
utilize many other commercial products of the Bank. The accounts and drafts
payable generated by the Company has also historically been a stable source of
funds.
Net cash flows provided by operating activities for the years 2003, 2002 and
2001 were $12,131,000, $8,978,000 and $7,792,000 respectively. Net income plus
the adjustment for depreciation and amortization accounts for most of the
operating cash provided and has grown consistently over the past three years.
Net cash flows from investing and financing activities fluctuate greatly as the
Company actively manages its investment and loan portfolios and customer
activity influences changes in deposit and accounts and drafts payable balances.
Further analysis of the changes in these account balances is discussed earlier
in this report. Due to the daily fluctuations in these account balances, the
analysis of changes in average balances, also discussed earlier in this report,
can be more indicative of underlying activity than the period-end balances used
in the statements of cash flows. Management anticipates that cash and cash
equivalents, maturing investments and cash from operations will continue to be
sufficient to fund the Company's operations and capital expenditures in 2004.
Other Off-Balance Sheet Activities
In the normal course of business, the Company is party to activities that
contain credit, market and operational risk that are not reflected in whole or
in part in the Company's consolidated financial statements. Such activities
include traditional off-balance sheet credit-related financial instruments and
commitments under operating leases.
The Company provides customers with off-balance sheet credit support through
unused loan commitments to extend credit, standby letters of credit and
commercial letters of credit. Summarized credit-related financial instruments,
including both commitments to extend credit and letters of credit and operating
lease commitments at December 31, 2003 are as follows:
Amount of Commitment Expiration per Period
------------------------------------------
Less than 1-3 3-5
(Dollars in thousands at December 31, 2003) Total 1 year Years Years
----------------------------------------------------------------------------------------------
Unused loan commitments $20,941 $12,422 $ 8,519 $ --
Standby letters of credit 4,516 3,759 694 63
Commercial letters of credit 347 347 -- --
Operating lease commitments 736 461 268 7
Since many of the unused credit-related commitments are expected to expire or be
only partially used, the total amount of these commitments in the preceding
table does not necessarily represent future cash requirements.
Capital Resources
One of management's primary objectives is to maintain a strong capital base to
warrant the confidence of customers, shareholders, and bank regulatory agencies.
A strong capital base is needed to take advantage of profitable growth
opportunities that arise and to provide assurance to depositors and creditors.
The Company and its banking subsidiary continue to exceed all regulatory capital
requirements, as evidenced by the capital ratios at December 31, 2003 as shown
in Item 8, Note 2 of this report.
In 2003, cash dividends paid were $.764 per share for a total of $2,814,000, a
7% increase over the prior year, which is attributable to an increase in the per
share amount paid and additional shares outstanding. On February 17, 2004 the
Company declared a 10% stock dividend payable to holders of record on March 5,
2004. All per share cash dividend amounts have been restated to reflect this
stock dividend.
Shareholders' equity was $64,792,000, or 10% of total assets, at December 31,
2003, an increase of $3,746,000 over the balance at December 31, 2002. This
increase resulted from net income of $7,902,000, proceeds from the exercise of
stock options of $260,000 and other items of $233,000, which was partially
offset by cash dividends paid of $2,814,000, repurchases of stock of $1,764,000
and a decrease in other comprehensive income of $71,000.
Dividends from the bank subsidiary are a significant source of funds for payment
of dividends by the Company to its shareholders. The only restrictions on
dividends are those dictated by regulatory capital requirements and prudent and
sound banking principles. As of December 31, 2003, unappropriated retained
earnings of $8,922,000 were available at the Bank for the declaration of
dividends to the Company without prior approval from regulatory authorities.
19
Effect of Recent and Prospective Accounting Pronouncements
In November 2002, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees Including Indirect Guarantees of Indebtedness to Others, an
interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB
Interpretation No. 34." This interpretation elaborates on the disclosures to be
made by a guarantor in its financial statements about its obligation under
guarantees issued. The interpretation also clarifies that a guarantor is
required to recognize, at inception of a guarantee, a liability for the fair
value of the obligation undertaken. The initial recognition and measurement
provisions of the interpretation are applicable to guarantees issued or modified
after December 31, 2002 and did not have a material effect on the Company's
consolidated financial statements. The disclosure requirements are effective for
financial statements of periods ending after December 15, 2002 and are included
in "Other Off-Balance Sheet Activities" in this section of the report.
In December 2002, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure, an amendment of FASB Statement No. 123." This statement amends SFAS
123 "Accounting for Stock-Based Compensation", to provide alternative methods of
transition for a voluntary change to the fair value method of accounting for
stock-based employee compensation. In addition, this statement amends the
disclosure requirements of SFAS 123 to require prominent disclosures in both the
annual and interim financial statements. Certain of the disclosure modifications
are required for fiscal years ending after December 15, 2002 and are included in
Item 8, Note 1 of this report.
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003),
"Consolidation of Variable Interest Entities" (FIN 46R), which addresses how a
business enterprise should evaluate whether it has controlling financial
interest in an entity through means other than voting rights and accordingly
should consolidate the entity. FIN 46R replaces FIN 46, "Consolidation of
Variable Interest Entities, an interpretation of Accounting Research Bulletin
No. 51," issued in January 2003. Companies are required to apply FIN 46R to
variable interest entities (VIEs) created after December 31, 2003. For variable
interest in VIEs created before January 1, 2004, FIN 46R will be applied
beginning on January 1, 2005. The Company is currently not a primary beneficiary
of a VIE and therefore adoption of FIN 46R is not expected to have a material
impact on the consolidated financial statements.
In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
133. The new guidance amends SFAS 133 for decisions made: (a) as part of the
Derivatives Implementation Group process that effectively required amendments to
SFAS 133, (b) in connection with other Board projects dealing with financial
instruments, and (c) regarding implementation issues raised in relation to the
application of the definition of derivative. The amendments set forth in SFAS
149 improve financial reporting by requiring that contracts with comparable
characteristics be accounted for similarly. SFAS 149 is generally effective for
contracts entered into or modified after June 30, 2003 and for hedging
relationships designated after June 30, 2003. The provisions of SFAS 149 did not
have a material impact on the Company's consolidated financial statements.
In May 2003, the FASB issued SFAS 150, "Accounting for Certain Instruments with
Characteristics of Both Liabilities and Equity," which establishes standards for
how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. This statement requires that an
issuer classify a financial instrument that is within its scope, which may have
previously been reported as equity, as a liability (or an asset in some
circumstances). This statement is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003, except for mandatory
redeemable financial instruments of nonpublic companies. The Company currently
does not have any instruments that fall within the scope of SFAS 150 and
therefore the adoption of SFAS 150 did not have a material impact on its
consolidated financial statements.
In November 2003, the Emerging Issues Task Force (EITF) reached a consensus on
certain disclosure requirements under EITF Issue No. 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments." The
new disclosure requirements apply to investments in debt and marketable equity
securities that are accounted under SFAS 115, "Accounting for Certain
Investments in Debt and Equity Securities," and SFAS 124, "Accounting for
Certain Investments Held by Not-for-Profit Organizations." Effective for fiscal
years ending after December 15, 2003 companies are required to disclosure
information about debt or marketable equity securities with market values below
carrying values. The Company has adopted the disclosure requirements of EITF
Issue No. 03-1 and they are included in Item 8, Note 3 of this report.
20
In December 2003, the FASB issued SFAS 132 (Revised 2003), "Employers'
Disclosures about Pensions and Other Postretirement Benefits," which increases
the disclosure requirements of the original statement by requiring more details
about pension plan assets, benefit obligations, cash flows, benefit costs and
related information and also requires companies to disclose various elements of
pension and postretirement benefit costs in interim-period financial statements
for quarters beginning after December 15, 2003. Additional disclosures
pertaining to benefit payments are required for fiscal years ending after June
30, 2004. The disclosure requirements of SFAS 132 (Revised 2003) that is
required for fiscal years ending after December 15, 2003 are included in Item 8,
Note 10 of this report.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Sensitivity
The Company faces market risk to the extent that its net interest income and its
fair market value of equity are affected by changes in market interest rates.
The asset/liability management discipline as applied at the Company seeks to
limit the volatility, to the extent possible, of both net interest income and
the fair market value of equity that can result from changes in market interest
rates. This is accomplished by limiting the maturities of fixed rate
investments, loans, and deposits; matching fixed rate assets and liabilities to
the extent possible; and optimizing the mix of fees and net interest income.
However, as discussed below, the Company's asset/liability position differs
significantly from most other bank holding companies with significant positive
cumulative "gaps" shown for each time horizon presented. This asset sensitive
position is caused primarily by the operations of the Company, which generates
large balances of accounts and drafts payable. These balances, which are
noninterest bearing, contribute to the Company's historical high net interest
margin but cause the Company to become susceptible to changes in interest rates,
with a decreasing net interest margin and fair market value of equity in periods
of declining interest rates and an increasing net interest margin and fair
market value of equity in periods of rising interest rates.
The Company's Asset/Liability Management Committee (ALCO) measures the Company's
interest rate risk sensitivity on a quarterly basis to monitor and manage the
variability of earnings and fair market value of equity in various interest rate
environments. The ALCO evaluates the Company's risk position to determine
whether the level of exposure is significant enough to hedge a potential decline
in earnings and value or whether the Company can safely increase risk to enhance
returns. The ALCO uses gap reports, twelve-month net interest income
simulations, and fair market value of equity analyses as its main analytical
tools to provide management with insight into the Company's exposure to changing
interest rates.
Management uses a gap report to review any significant mismatch between the
repricing points of the Company's rate sensitive assets and liabilities in
certain time horizons. A negative gap indicates that more liabilities reprice in
that particular time frame and, if rates rise, these liabilities will reprice
faster than the assets. A positive gap would indicate the opposite. Gap reports
can be misleading in that they capture only the repricing timing within the
balance sheet, and fail to capture other significant risks such as basis risk
and embedded options risk. Basis risk involves the potential for the spread
relationship between rates to change under different rate environments and
embedded options risk relates to the potential for the alteration of the level
and/or timing of cash flows given changes in rates.
Another measurement tool used by management is net interest income simulation,
which forecasts net interest income during the coming twelve months under
different interest rate scenarios in order to quantify potential changes in
short term accounting income. Management has set policy limits specifying
acceptable levels of interest rate risk given multiple simulated rate movements.
These simulations are more informative than gap reports because they are able to
capture more of the dynamics within the balance sheet, such as basis risk and
embedded options risk. A table containing simulation results as of December 31,
2003 from an immediate and sustained parallel change in interest rates is shown
below.
While net interest income simulations do a good job of capturing interest rate
risk to short term earnings, they do not capture risk within the current balance
sheet beyond twelve