ITEM 1. BUSINESS
The Company was incorporated under the laws of the State of Indiana on February 8, 1983. As used herein, the term "Company" refers to Lakeland Financial Corporation, or if the context dictates, Lakeland Financial Corporation and its wholly-owned subsidiary, Lake City Bank, an Indiana state bank headquartered in Warsaw, Indiana. Also included in the consolidated financial statements is LCB Investments Limited, a wholly-owned subsidiary of Lake City Bank which is a Bermuda corporation that manages a portion of the Bank's investment portfolio. All intercompany transactions and balances are eliminated in consolidation.
General
Company's Business. The Company is a bank holding company as defined in the Bank Holding Company Act of 1956, as amended. The Company owns all of the outstanding stock of Lake City Bank, Warsaw, Indiana, a full service commercial bank organized under Indiana law (the "Bank"). In trust, the Bank recognizes a wholly-owned subsidiary, LCB Investments Limited, which manages a portion of the Bank's investment portfolio. The Company conducts no business except that incident to its ownership of the outstanding stock of the Bank and the operation of the Bank.
The Bank's deposits are insured by the Federal Deposit Insurance Corporation. The Bank's activities cover all phases of commercial banking, including checking accounts, savings accounts, time deposits, the sale of securities under agreements to repurchase, commercial and agricultural lending, direct and indirect consumer lending, real estate mortgage lending, safe deposit box service and trust and brokerage services.
The Bank's main banking office is located at 202 East Center Street, Warsaw, Indiana. As of December 31, 2003 the Bank had 43 offices in twelve counties throughout northern Indiana.
Market Overview. While the Company operates in twelve counties, it currently defines operations by three primary geographical markets. They are the South Region, which includes Kosciusko and contiguous counties; the North Region, which includes Elkhart and St. Joseph Counties; and the East Region, which includes Allen and DeKalb Counties. The South Region includes the city of Warsaw and is the location of the Company's headquarters. The Company has had a presence in this region since 1872 . It has been in the North Region, which includes the cities of Elkhart, South Bend and Goshen, since 1990, The Company opened its first office in the East Region, which includes the cities of Fort Wayne and Auburn, in 1999.
The Company believes that these are well-established, and fairly diverse economic regions. The Company's markets include a mix of industrial and service companies with no business or industry concentrations. Furthermore, no single industry or employer dominates any of the markets. Fort Wayne represents the largest population center served by the Company with a population of 206,000, according to 2000 U.S. Census Bureau data. South Bend, with a 2000 population of 108,000, is the second largest city served by the Company. Elkhart, with a 2000 population of 52,000, is the third largest city that the Company currently serves. As a result of the presence of offices in twelve counties that are widely dispersed, no single city or industry represents an undue concentration.
Expansion Strategy. The Company's expansion strategy is driven primarily by the potential for increased penetration in existing markets where opportunities for market share growth exists. Additionally, the Company considers growth in new markets with a close geographic proximity to its current operations. These markets are considered when the Company believes they would be receptive to its strategic plan to deliver broad based financial services with a local flavor. The Company has recently focused on growth through de novo branching in locations that management believes have potential for creating new market opportunities or for further penetrating existing markets. In new markets, the Company believes it is critical to attract experienced local management with a similar philosophy in order to provide a basis for success.
The Company also considers opportunities beyond current markets when the Company's board of directors and management believes that the opportunity will provide a desirable strategic fit without posing undue risk. The Company does not currently have any definitive understandings or agreements for any acquisitions.
Products and Services. The Company is a full service commercial bank and provides commercial, retail, trust and investment services to its customers. Commercial products include commercial loans and technology-driven solutions to commercial customers' cash management needs such as CommerciaLink Internet business banking and on-line cash management services. Retail banking clients are provided a wide array of traditional retail banking services, including lending, deposit and investment services. Retail lending programs are focused on mortgage loans, home equity lines of credit and traditional retail installment loans. The Company also has an Honors Private Banking program that is positioned to serve the more financially sophisticated customer with a menu including brokerage and trust services, executive mortgage programs and access to financial planning seminars and programs. The Bank's Prospero Program is dedicated to serving the expanding financial needs of the Latino community. The Company provides trust clients with traditional personal and corporate trust services. The Company also provides retail brokerage services, including an array of financial and investment products such as annuities and life insurance.
Forward-looking Statements
This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.
The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors, which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following:
o The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets.
o The economic impact of past and any future terrorist attacks, acts of war or threats thereof and the response of the United States to any such threats and attacks.
o The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters.
o The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company's assets) and the policies of the Board of Governors of the Federal Reserve System.
o The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.
o The inability of the Company to obtain new customers and to retain existing customers.
o The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.
o Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.
o The ability of the Company to develop and maintain secure and reliable electronic systems.
o The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.
o Consumer spending and saving habits, which may change in a manner that affects the Company's business adversely.
o Business combinations and the integration of acquired businesses, which may be more difficult or expensive than expected.
o The costs, effects and outcomes of existing or future litigation.
o Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies, the Financial Accounting Standards Board, the Securities and Exchange Commission and the Public Company Accounting Oversight Board.
o The ability of the Company to manage the risks associated with the foregoing as well as anticipated.
These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with the Securities and Exchange Commission.
Business Developments
The Company conducts no business except that which is incident to its ownership of the stock of the Bank, the collection of dividends from the Bank, and the disbursement of dividends to shareholders.
Lakeland Statutory Trust II (the "Trust"), a statutory business trust, was formed under Connecticut law pursuant to a trust agreement dated October 1, 2003 and a certificate of trust filed with the Connecticut Secretary of State on October 1, 2003. Through a private placement, the trust issued $30.0 million in trust preferred securities. The Trust exists for the exclusive purposes of (i) issuing the trust securities representing undivided beneficial interests in the assets of the Trust, (ii) investing the gross proceeds of the trust securities in the subordinated debentures issued by the Company, and (iii) engaging in only those activities necessary, advisable, or incidental thereto. The subordinated debentures are the only assets of the Trust, and payments under the subordinated debentures are the only revenue of the Trust. The Trust has a term of 35 years, but may be terminated earlier as provided in the trust agreement.
Competition
The Bank was originally organized in 1872 and has continuously operated under the laws of the State of Indiana since its organization. The Bank's activities cover all phases of commercial banking, including checking accounts, savings accounts, time deposits, the sale of securities under agreements to repurchase, commercial and agricultural lending, direct and indirect consumer lending, real estate mortgage lending, safe deposit box services and trust and brokerage services. The interest rates for both deposits and loans, as well as the range of services provided, are nearly the same for all banks competing within the Bank's service area.
The Bank competes for loans principally through a high degree of customer contact, timely loan review and approval, market-driven competitive loan pricing in certain situations and the Bank's reputation throughout the region. The Bank believes that its convenience, quality service and hometown
approach to banking enhances its ability to compete favorably in attracting and retaining individual and business customers. The Bank actively solicits deposit-related customers and competes for customers by offering personal attention, professional service and competitive interest rates.
The Bank's primary service area is northern Indiana. In addition to the banks located within its service area, the Bank also competes with savings and loan associations, credit unions, farm credit services, finance companies, personal loan companies, insurance companies, money market funds, and other non-depository financial intermediaries. Also, financial intermediaries such as money market mutual funds and large retailers are not subject to the same regulations and laws that govern the operation of traditional depository institutions and accordingly may have an advantage in competing for funds.
The Bank competes with other major banks for large commercial deposit and loan accounts. The Bank is presently subject to an aggregate maximum loan limit to any single account pursuant to Indiana law. The Bank currently enforces an internal limit of $12.0 million, which is less than the amount permitted by law. This maximum might occasionally limit the Bank from providing loans to those businesses or personal accounts whose borrowings periodically exceed this amount. In the event this were to occur, the Bank maintains correspondent relationships with other financial institutions. The Bank may participate with other banks in the placement of large borrowings in excess of its lending limit. The Bank is also a member of the Federal Home Loan Bank of Indianapolis in order to broaden its mortgage lending and investment activities and to provide additional funds, if necessary, to support these activities.
Foreign Operations
The Company has no investments with any foreign entity other than two nominal demand deposit accounts. One is maintained with a Canadian bank in order to facilitate the clearing of checks drawn on banks located in other countries. The other is maintained with a bank in Bermuda for LCB Investments Limited to be used for administrative expenses. There are no foreign loans.
Employees
At December 31, 2003, the Company, including its subsidiaries, had 426 full-time equivalent employees. Benefit programs include a pension plan, 401(k) plan, group medical insurance, group life insurance and paid vacations. Effective April 1, 2000, the defined benefit pension plan was frozen and employees can no longer accrue new benefits under that plan. The Bank is not a party to any collective bargaining agreement, and employee relations are considered good. The Company also has a stock option plan under which stock options may be granted to employees and directors.
Internet Website
The Company maintains an Internet site at www.lakecitybank.com. The Company makes available free of charge on this site its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and other reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the Securities and Exchange Commission. The Company's code of conduct and the charters of its various committees of the Board of Directors are also available on the website.
SUPERVISION AND REGULATION
General
Financial institutions, their holding companies and their affiliates are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company may be affected not only by management decisions and general economic conditions, but also by the requirements of federal and state statutes and by the regulations and policies of various bank regulatory authorities, including the Indiana Department of Financial Institutions (the "DFI"), the Board of Governors of the Federal Reserve System (the "Federal Reserve") and the Federal Deposit Insurance Corporation (the "FDIC"). Furthermore, taxation laws administered by the Internal Revenue Service and state taxing authorities and securities laws administered by the Securities and Exchange Commission (the "SEC") and state securities authorities have an impact on the business of the Company. The effect of these statutes, regulations and regulatory policies may be significant, and cannot be predicted with a high degree of certainty.
Federal and state laws and regulations generally applicable to financial institutions regulate, among other things, the scope of business, the kinds and amounts of investments, reserve requirements, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers and consolidations and the payment of dividends. This system of supervision and regulation establishes a comprehensive framework for the respective operations of the Company and its subsidiaries and is intended primarily for the protection of the FDIC-insured deposits and depositors of the Bank, rather than shareholders.
The following is a summary of the material elements of the regulatory framework that applies to the Company and its subsidiaries. It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of those that are described. As such, the following is qualified in its entirety by reference to applicable law. Any change in statutes, regulations or regulatory policies may have a material effect on the business of the Company and its subsidiaries.
Recent Regulatory Developments
National Bank Preemption. On January 7, 2004, the Office of the Comptroller of the Currency (the "OCC") issued two final rules that clarify the federal character of the national banking system. The first rule provides that, except where made applicable by federal law, state laws that obstruct, impair or condition national banks' ability to fully exercise their deposit-taking, lending and operational powers are not applicable to national banks. That rule further provides that the following types of state laws apply to national banks to the extent that they only incidentally affect the exercise of national banks' deposit-taking, lending and operational powers: contract, criminal, taxation, tort, zoning and laws relating to certain homestead rights, rights to collect debts, acquisitions and transfers of property and other laws as determined to apply to national banks by the OCC. The second rule affirms that, under federal law, with some exceptions, the OCC has exclusive visitorial authority (the power to inspect, examine, supervise and regulate) with respect to the content and conduct of activities authorized for national banks. These controversial rules give national banks, especially those that operate in multiple states, a significant competitive advantage over state-chartered banks and are therefore likely to be challenged by individuals and organizations that represent the interests of individual states and state-chartered banks. Both the U.S. House Committee on Financial Services and the New York Attorney General have already initiated such challenges.
FACT Act. On December 4, 2003, President Bush signed into law the Fair and Accurate Credit Transactions Act of 2003 (the "FACT Act"), which contains numerous amendments to the Fair Credit Reporting Act relating to matters including identity theft and privacy. Among its other provisions, the FACT Act requires financial institutions: (i) to establish an identity theft prevention program; (ii) to enhance the accuracy and integrity of information furnished to consumer reporting agencies; and (iii) to allow customers to prevent financial institution affiliates from using, for marketing solicitation purposes, transaction and experience information about the customers received from the financial institution. The FACT Act also requires the federal banking regulators, and certain other agencies, to promulgate regulations to implement its provisions. The various provisions of the FACT Act contain different effective dates including March 31, 2004, for those
provisions of the FACT Act that do not require significant changes to business procedures and December 1, 2004, for certain other provisions that will require significant business procedure changes.
The Company
General. The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the "BHCA"). In accordance with Federal Reserve policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where the Company might not otherwise do so. Under the BHCA, the Company is subject to periodic examination by the Federal Reserve. The Company is required to file with the Federal Reserve periodic reports of the Company's operations and such additional information regarding the Company and its subsidiaries as the Federal Reserve may require. The Company is also subject to regulation by the DFI under Indiana law.
Acquisitions, Activities and Change in Control. The primary purpose of a bank holding company is to control and manage banks. The BHCA generally requires the prior approval of the Federal Reserve for any merger involving a bank holding company or any acquisition by a bank holding company of another bank or bank holding company. Subject to certain conditions (including deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States. In approving interstate acquisitions, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws that require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.
The BHCA generally prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be "so closely related to banking ... as to be a proper incident thereto." This authority would permit the Company to engage in a variety of banking-related businesses, including the operation of a thrift, consumer finance, equipment leasing, the operation of a computer service bureau (including software development), and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.
Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of nonbanking activities, including securities and insurance underwriting and sales, merchant banking and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. As of the date of this filing, the Company has neither applied for nor received approval to operate as a financial holding company.
Federal law also prohibits any person or company from acquiring "control" of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator. "Control" is conclusively presumed to exist upon the acquisition of 25% or more of the outstanding voting securities of a bank or bank holding company, but may arise under certain circumstances at 10% ownership.
Capital Requirements. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital levels fall below the minimum required levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses.
The Federal Reserve's capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: (i) a risk-based requirement expressed as a percentage of total assets weighted according to risk; and (ii) a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others. For purposes of these capital standards, Tier 1 capital consists primarily of permanent stockholders' equity less intangible assets (other than certain loan servicing rights and purchased credit card relationships). Total capital consists primarily of Tier 1 capital plus certain other debt and equity instruments that do not qualify as Tier 1 capital and a portion of the company's allowance for loan and lease losses.
The risk-based and leverage standards described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve's capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets), well above the minimum levels. As of December 31, 2003, the Company had regulatory capital in excess of the Federal Reserve's minimum requirements.
Dividend Payments. The Company's ability to pay dividends to its shareholders may be affected by both general corporate law considerations and policies of the Federal Reserve applicable to bank holding companies. As an Indiana corporation, the Company is subject to the limitations of the Indiana General Business Corporation Law, which prohibit the Company from paying dividends if the Company is, or by payment of the dividend would become, insolvent, or if the payment of dividends would render the Company unable to pay its debts as they become due in the usual course of business. Additionally, policies of the Federal Reserve caution that a bank holding company should not pay cash dividends that exceed its net income or that can only be funded in ways that weaken the bank holding company's financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.
Federal Securities Regulation. The Company's common stock is registered with the SEC under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.
The Bank
General. The Bank is an Indiana-chartered bank, the deposit accounts of which are insured by the FDIC's Bank Insurance Fund ("BIF"). As an Indiana-chartered bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the DFI, the chartering authority for Indiana banks, and the FDIC, designated by federal law as the primary federal regulator of state-chartered, FDIC-insured banks that, like the Bank, are not members of the Federal Reserve System ("non-member banks").
Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their respective levels of capital and results of supervisory evaluations. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.
During the year ended December 31, 2003, BIF assessments ranged from 0% of deposits to 0.27% of deposits. For the semi-annual assessment period beginning January 1, 2004, BIF assessment rates will continue to range from 0% of deposits to 0.27% of deposits.
FICO Assessments. Since 1987, a portion of the deposit insurance assessments paid by members of the FDIC's Savings Association Insurance Fund ("SAIF") has been used to cover interest payments due on the outstanding obligations of the Financing Corporation ("FICO"). FICO was created in 1987 to finance the recapitalization of the Federal Savings and Loan Insurance Corporation, the SAIF's predecessor insurance fund. As a result of federal legislation enacted in 1996, beginning as of January 1, 1997, both SAIF members and BIF members became subject to assessments to cover the interest payments on outstanding FICO obligations until the final maturity of such obligations in 2019. These FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. During the year ended December 31, 2003, the FICO assessment rate for BIF and SAIF members was approximately 0.02% of deposits.
Supervisory Assessments. All Indiana banks are required to pay supervisory assessments to the DFI to fund the operations of the DFI. The amount of the assessment is calculated on the basis of the bank's total assets. During the year ended December 31, 2003, the Bank paid supervisory assessments to the DFI totaling $84,000.
Capital Requirements. Banks are generally required to maintain capital levels in excess of other businesses. The FDIC has established the following minimum capital standards for state-chartered FDIC-insured non-member banks, such as the Bank: (i) a leverage requirement consisting of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated banks with a minimum requirement of at least 4% for all others; and (ii) a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. For purposes of these capital standards, the components of Tier 1 capital and total capital are the same as those for bank holding companies discussed above.
The capital requirements described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, regulations of the FDIC provide that additional capital may be required to take adequate account of, among other things, interest rate risk or the risks posed by concentrations of credit, nontraditional activities or securities trading activities.
Further, federal law and regulations provide various incentives for financial institutions to maintain regulatory capital at levels in excess of minimum regulatory requirements. For example, a financial institution that is "well-capitalized" may qualify for exemptions from prior notice or application requirements otherwise applicable to certain types of activities and may qualify for expedited processing of other required notices or applications. Additionally, one of the criteria that determines a bank holding company's eligibility to operate as a financial holding company is a requirement that all of its financial institution subsidiaries be "well-capitalized." Under the regulations of the FDIC, in order to be "well-capitalized" a financial institution must maintain a ratio of total capital to total risk-weighted assets of 10% or greater, a ratio of Tier 1 capital to total risk-weighted assets of 6% or greater and a ratio of Tier 1 capital to total assets of 5% or greater.
Federal law also provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators' powers depends on whether the institution in question is "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized," in each case as defined by regulation. Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution's asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution.
As of December 31, 2003: (i) the Bank was not subject to a directive from the FDIC to increase its capital to an amount in excess of the minimum
regulatory capital requirements; (ii) the Bank exceeded its minimum regulatory capital requirements under FDIC capital adequacy guidelines; and (iii) the Bank was "well-capitalized," as defined by FDIC regulations.
Dividend Payments. The primary source of funds for the Company is dividends from the Bank. Indiana law prohibits the Bank from paying dividends in an amount greater than its undivided profits. The Bank is required to obtain the approval of the DFI for the payment of any dividend if the total of all dividends declared by the Bank during the calendar year, including the proposed dividend, would exceed the sum of the Bank's retained net income for the year to date combined with its retained net income for the previous two years. Indiana law defines "retained net income" to mean the net income of a specified period, calculated under the consolidated report of income instructions, less the total amount of all dividends declared for the specified period.
The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2003. As of December 31, 2003, approximately $19.8 million was available to be paid as dividends by the Bank. Notwithstanding the availability of funds for dividends, however, the FDIC may prohibit the payment of any dividends by the Bank if the FDIC determines such payment would constitute an unsafe or unsound practice.
Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company, on investments in the stock or other securities of the Company and the acceptance of the stock or other securities of the Company as collateral for loans made by the Bank. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company, to principal shareholders of the Company and to "related interests" of such directors, officers and principal shareholders. In addition, federal law and regulations may affect the terms upon which any person who is a director or officer of the Company or the Bank or a principal shareholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.
Safety and Soundness Standards. The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.
In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution's primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator's order is cured, the regulator may restrict the institution's rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.
Branching Authority. Indiana banks, such as the Bank, have the authority under Indiana law to establish branches anywhere in the State of Indiana, subject to receipt of all required regulatory approvals.
Federal law permits state and national banks to merge with banks in other states subject to: (i) regulatory approval; (ii) federal and state deposit concentration limits; and (iii) state law limitations requiring the merging bank to have been in existence for a minimum period of time (not to exceed five years) prior to the merger. The establishment of new interstate
branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is permitted only in those few states that authorize such expansion.
State Bank Investments and Activities. The Bank generally is permitted to make investments and engage in activities directly or through subsidiaries as authorized by Indiana law. However, under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.
Federal Reserve System. Federal Reserve regulations, as presently in effect, require depository institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts), as follows: for transaction accounts aggregating $45.4 million or less, the reserve requirement is 3% of total transaction accounts; and for transaction accounts aggregating in excess of $45.4 million, the reserve requirement is $1.164 million plus 10% of the aggregate amount of total transaction accounts in excess of $45.4 million. The first $6.6 million of otherwise reservable balances are exempted from the reserve requirements. These reserve requirements are subject to annual adjustment by the Federal Reserve. The Bank is in compliance with the foregoing requirements.
INDUSTRY SEGMENTS
While the Company's chief decision-makers monitor the revenue streams of the various Company products and services, the identifiable segments operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment -- commercial banking.
GUIDE 3 INFORMATION
On the pages that follow are tables that set forth selected statistical information relative to the business of the Company. This data should be read in conjunction with the consolidated financial statements, related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" as set forth in Items 7&8, below, herein incorporated by reference.
ANALYSIS OF LOAN PORTFOLIO (cont.) Comments Regarding Nonperforming Assets
PART A - CONSUMER LOANS
Consumer installment loans, except those loans that are secured by real estate, are not placed on nonaccrual status since these loans are charged-off when they have been delinquent from 90 to 180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness. Advances under Mastercard and Visa programs, as well as advances under all other consumer line of credit programs, are charged-off when collection appears doubtful.
PART B - NONPERFORMING LOANS
When a loan is classified as a nonaccrual loan, interest on the loan is no longer accrued and all accrued interest receivable is charged off. It is the policy of the Bank that all loans for which the collateral is insufficient to cover all principal and accrued interest will be reclassified as nonperforming loans to the extent they are unsecured, on or before the date when the loan becomes 90 days delinquent. Thereafter, interest is recognized and included in income only when received. Interest not recorded on nonaccrual loans is referenced in Footnote 4 in Item 8 below.
As of December 31, 2003, there were $553,000 of loans on nonaccrual status, some of which were also on impaired status. There were $3.0 million of loans classified as impaired.
PART C - TROUBLED DEBT RESTRUCTURED LOANS
Loans renegotiated as troubled debt restructurings are those loans for which either the contractual interest rate has been reduced and/or other concessions are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.
As of December 31, 2003 and 2002, there were no loans renegotiated as troubled debt restructurings.
PART D - OTHER NONPERFORMING ASSETS
Management is of the opinion that there are no significant foreseeable losses relating to nonperforming assets, as defined in the preceding table, or classified loans, except as discussed above in Part B - Nonperforming Loans and Part C - Troubled Debt Restructured Loans.
PART E - LOAN CONCENTRATIONS
There were no loan concentrations within industries, which exceeded ten percent of total assets. It is estimated that over 90% of all the Bank's commercial, industrial, agri-business and agricultural real estate mortgage, real estate construction mortgage and consumer loans are made within its basic service area.
Basis For Determining Allowance For Loan Losses:
Management is responsible for determining the adequacy of the allowance for loan losses. This responsibility is fulfilled by management in a number of ways, including the following:
1. Management reviews the larger individual loans (primarily in the commercial loan portfolio) for unfavorable collectibility factors and assesses the requirement for specific reserves on such credits. For those loans not subject to specific reviews, management reviews previous loan loss experience to establish historical ratios and trends in charge-offs by loan category. The ratios of net charge-offs to particular types of loans enable management to estimate charge-offs by loan category and thereby establish appropriate reserves for loans not specifically reviewed.
2. Management reviews the current economic conditions of its lending market to determine the effects on loan charge-offs by loan category, in addition to the effects on the loan portfolio as a whole.
3. Management reviews delinquent loan reports to determine risk of loan charge-offs. High delinquencies are generally indicative of an increase in future loan charge-offs.
Based upon these policies and objectives, $2.3 million, $3.1 million and $2.2 million were charged to the provision for loan losses and added to the allowance for loan losses in 2003, 2002 and 2001.
The allocation of the allowance for loan losses to the various lending areas is performed by management in relation to perceived exposure to loss in the various loan portfolios. However, the allowance for loan losses is available in its entirety to absorb losses in any particular loan category.
Within three months $ 45,842
Over three months, within six months 17,847
Over six months, within twelve months 10,208
Over twelve months 32,471 ------------
Total time certificates of deposit in denominations of $100,000 or more $ 106,368 ============
QUALITATIVE MARKET RISK DISCLOSURE
Management's market risk disclosure appears under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7, below, and is incorporated herein by reference in response to this item. The Company's primary market risk exposure is interest rate risk. The Company does not have a material exposure to foreign currency exchange rate risk, does not own any material derivative financial instruments and does not maintain a trading portfolio.
RETURN ON EQUITY AND OTHER RATIOS
The rates of return on average daily assets and stockholders' equity, the dividend payout ratio, and the average daily stockholders' equity to average daily assets for the years ended December 31, 2003, 2002 and 2001 were as follows:
2003 2002 2001 ----------- ----------- -----------
Percent of net income to: Average daily total assets 1.12% 1.08% 0.90%
Average daily stockholders' equity 15.88% 15.64% 14.45%
Percentage of dividends declared per common share to basic earnings per weighted average number of common shares outstanding (5,819,916 shares in 2003 and 5,813,984 shares in 2002 and 2001) 31.93% 31.92% 34.48%
Percentage of average daily stockholders' equity to average daily total assets 7.05% 6.88% 6.23%
SHORT-TERM BORROWINGS (in thousands of dollars)
The following is a schedule, at the end of the year indicated, of statistical information relating to securities sold under agreement to repurchase maturing within one year and secured by either U.S. Government agency securities or mortgage-backed securities classified as other debt securities. There were no other categories of short-term borrowings for which the average balance outstanding during the period was 30 percent or more of stockholders' equity at the end of each period.
2003 2002 2001 ------------ ------------ ------------
Outstanding at year end $ 102,601 $ 124,969 $ 149,117
Approximate average interest rate at year end 0.79% 1.03% 1.91%
Highest amount outstanding as of any month end during the year $ 108,270 $ 139,857 $ 160,628
Approximate average outstanding during the year $ 97,808 $ 116,214 $ 140,277
Approximate average interest rate during the year 0.83% 1.49% 3.72%
Securities sold under agreement to repurchase include fixed rate, term transactions initiated by the investment department of the Bank, as well as corporate sweep accounts.
ITEM 2.
ITEM 2. PROPERTIES
The Company conducts its operations from the following locations:
Branches/Headquarters Main/Headquarters 202 East Center St. Warsaw IN Warsaw Drive-up East Center St. Warsaw IN Akron 102 East Rochester Akron IN Argos 100 North Michigan Argos IN Auburn 1220 East 7th St. Auburn IN Bremen 1600 Indiana State Road 331 Bremen IN Columbia City 601 Countryside Dr. Columbia City IN Concord 4202 Elkhart Rd. Goshen IN Cromwell 111 North Jefferson St. Cromwell IN Elkhart Beardsley 864 East Beardsley St. Elkhart IN Elkhart East 22050 State Road 120 Elkhart IN Elkhart Hubbard Hill 58404 State Road 19 Elkhart IN Elkhart Northwest 1208 North Nappanee St. Elkhart IN Fort Wayne North 302 East DuPont Rd. Fort Wayne IN Fort Wayne Northeast 10411 Maysville Rd. Fort Wayne IN Fort Wayne Southwest 10429 Illinois Rd. Fort Wayne IN Fort Wayne Downtown 200 East Main St., Suite 600 Fort Wayne IN Goshen Downtown 102 North Main St. Goshen IN Goshen South 2513 South Main St. Goshen IN Granger 12830 State Road 23 Granger IN Huntington 1501 North Jefferson St. Huntington IN Kendallville East 631 Professional Way Kendallville IN LaGrange 901 South Detroit LaGrange IN Ligonier Downtown 222 South Cavin St. Ligonier IN Ligonier South 1470 U.S. Highway 33 South Ligonier IN Medaryville Main St. Medaryville IN Mentone 202 East Main St. Mentone IN Middlebury 712 Wayne Ave. Middlebury IN Milford Indiana State Road 15 North Milford IN Mishawaka 5015 North Main St. Mishawaka IN Nappanee 202 West Market St. Nappanee IN North Webster 644 North Main St. North Webster IN Pierceton 202 South First St. Pierceton IN Plymouth 862 East Jefferson St. Plymouth IN Rochester 507 East 9th St. Rochester IN Shipshewana 895 North Van Buren St. Shipshewana IN Silver Lake 102 Main St. Silver Lake IN South Bend Northwest 21113 Cleveland Rd. South Bend IN Syracuse 502 South Huntington Syracuse IN Warsaw East 3601 Commerce Dr. Warsaw IN Warsaw North 420 Chevy Way Warsaw IN Warsaw West 1221 West Lake St. Warsaw IN Winona Lake 99 Chestnut St. Winona Lake IN Winona Lake East 1324 Wooster Rd. Winona Lake IN
The Company leases from third parties the real estate and buildings for its Milford and Winona Lake East branches, and for its Fort Wayne Downtown office. In addition, the Company leases the real estate for its freestanding ATMs. All the other branch facilities are owned by the Company. The Company also owns parking lots in downtown Warsaw for the use and convenience of Company employees and customers, as well as leasehold improvements, equipment, furniture and fixtures necessary to operate the banking facilities.
In addition, the Company owns buildings at 110 South High St., Warsaw, Indiana, and 114-118 East Market St., Warsaw, Indiana, which it uses for various offices, a building at 113 East Market St., Warsaw, Indiana, which it uses for office and computer facilities, and a building at 109 South Buffalo St., Warsaw, Indiana, which it uses for training and development. The Company also leases from third parties facilities in Warsaw, Indiana, for the storage of supplies and in Elkhart, Indiana, for computer facilities.
None of the Company's assets are the subject of any material encumbrances.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no material pending legal proceedings other than ordinary routine litigation incidental to the business to which the Company and the Bank are a party or of which any of their property is subject.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the fourth quarter of 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
4th 3rd 2nd 1st Quarter Quarter Quarter Quarter ------- ------- ------- -------
Trading range (per share)* Low $33.510 $29.510 $24.400 $23.000 High $37.469 $34.400 $31.220 $25.750
Dividends declared (per share) $ 0.19 $ 0.19 $ 0.19 $ 0.19
Trading range (per share)* Low $22.220 $23.570 $20.100 $17.410 High $24.995 $29.760 $28.840 $20.450
Dividends declared (per share) $ 0.17 $ 0.17 $ 0.17 $ 0.17
* The trading ranges are the high and low as obtained from the Nasdaq Stock market.
The common stock of the Company began being quoted on The Nasdaq Stock Market under the symbol LKFN in August, 1997. On December 31, 2003, the Company had approximately 513 shareholders of record and estimates that is has approximately 2,000 shareholders in total.
The Company paid dividends as set forth in the table above. The Company's ability to pay dividends to shareholders is largely dependent upon the dividends it receives from the Bank, and the Bank is subject to regulatory limitations on the amount of cash dividends it may pay. See "Business - Supervision and Regulation - The Company - Dividend Payments" and "Business - Supervision and Regulation - The Bank - Dividend Payments" for a more detailed description of these limitations.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Lakeland Financial Corporation is the holding company for Lake City Bank. The Company is headquartered in Warsaw, Indiana and operates 43 offices in twelve counties in northern Indiana. The Company earned $13.9 million for the year ended 2003 versus $12.4 million for the year ended 2002, an increase of 12.1%. The increase was driven by a $3.6 million increase in non-interest income, an $802,000 decrease in the provision for loan losses and a $422,000 increase in net interest income. Offsetting these positive impacts was a $3.0 million increase in non-interest expense, driven by $804,000 expense related to debt extinguishment costs and an other real estate owned impairment of $300,000. The Company earned $12.4 million for the year ended 2002 versus $10.1 million for the year ended 2001, an increase of 22.3%. The increase was driven by a $4.4 million increase in net interest income and a $1.3 million increase in non-interest income. Offsetting these positive impacts were increases of $831,000 in the provision for loan losses and $841,000 in non-interest expense.
Basic earnings per share for the year ended 2003 was $2.38 per share versus $2.13 per share for the year ended 2002 and $1.74 for the year ended 2001. Diluted earnings per share reflect the potential dilutive impact of stock options granted under an employee stock option plan. Diluted earnings per share for the year ended 2003 was $2.31 per share versus $2.08 per share for the year ended 2002 and $1.73 for the year ended 2001.
RESULTS OF OPERATIONS
2003 versus 2002
The Company reported record net income of $13.9 million in 2003, an increase of $1.5 million, or 12.1%, versus net income of $12.4 million in 2002. Net interest income increased $422,000, or 1.0%, to $42.2 million versus $41.8 million in 2002. Net interest income increased due to a decrease in interest expense on time deposits and short-term borrowings, as well as growth in commercial loans, which offset some of the effect of the declining interest rates during the year. Despite growth in earning assets, interest income decreased $4.0 million, or 6.2%, from $64.3 million in 2002 to $60.3 million in 2003. The decrease was driven primarily by a 73 basis point reduction in the tax equivalent yield on average earning assets over the year. Interest expense decreased $4.4 million, or 19.6%, from $22.6 million in 2002 to $18.1 million in 2003. The decrease was primarily the result of a 55 basis point decrease in the Company's daily cost of funds over the year. The Company had a net interest margin of 3.82% in 2003 versus 4.02% in 2002. Average earning
assets increased by $74.7 million and totaled $1.1 billion in 2003 and 2002. The primary driver was a $76.7 million increase in the average daily loan balance. Deposits increased to fund the loan growth during 2003, driven primarily by increases of $69.6 million in the average daily interest bearing checking account balances and increases of $23.5 million in the average daily demand deposit balances. The Company believes that the growth in the loan portfolio will continue in conjunction with the strategic focus on commercial lending and the general expansion and penetration of the geographical markets the Company serves. During the fourth quarter of 2003, the Company completed the issuance of floating rate trust preferred securities and the redemption of its existing fixed rate trust preferred securities. The interest rate on subordinated debentures, which are tied to the trust preferred securities, changed from a 9% fixed rate to a variable rate of 305 basis points over the 3 month LIBOR rate in the fourth quarter of 2003. Interest expense on subordinated debentures is expected to decrease in 2004 compared to 2003 given the low interest rate environment and that the Company paid a higher fixed rate for a portion of 2003.
Nonaccrual loans were $553,000, or 0.06% of total loans, at year end versus $4.2 million, or 0.51% of total loans, at the end of 2002. There were two relationships totaling $3.0 million classified as impaired as of December 31, 2003 versus nine relationships totaling $7.3 million at the end of 2002. One commercial credit represented $2.9 million and $3.2 million of this amount in 2003 and 2002. The renewal of this loan has been complicated as more than one bank is involved, and it remains past maturity. The loan first became delinquent in 2002 and the maturity has not been extended. While this loan is current as to principal and interest, there can be no assurance that it will remain current given the circumstances involved. The decrease was the result of payments on six commercial loans, including one loan of $1.7 million. Net charge-offs were $1.6 million in 2003 versus $1.5 million in 2002, representing 0.18% and 0.19% of average daily loans in 2003 and 2002. Total nonperforming loans were $3.7 million, or 0.43% of total loans, at year end 2003 versus $7.6 million, or 0.92% of total loans, at the end of 2002. The provision for loan loss expense was $2.3 million in 2003, resulting in an allowance for loan losses at December 31, 2003 of $10.2 million, which represented 1.18% of the loan portfolio, versus a provision for loan loss expense of $3.1 million in 2002 and an allowance for loan losses of $9.5 million in 2002, or 1.16% of the loan portfolio. The lower provision in 2003 versus 2002 was attributable to a number of factors, but was primarily a result of the decrease in nonperforming loans during 2003. The continued challenging economic conditions during 2003 and the resulting impact on asset quality as evidenced by the percentage of internally classified loans in 2003 was also a factor in the determination of the provision for loan losses. The Company's management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions and other factors that may influence the assessment of the collectability of loans.
Noninterest income was $18.4 million in 2003 versus $14.9 million in 2002, an increase of $3.6 million, or 24.0%. The increase was driven by a $1.1 million, or 57.7%, increase in gains on sale of mortgages, from $1.9 million in 2002 to $3.0 million in 2003. This increase was a result of the increased level of mortgage activity during 2003. Additionally, noninterest income increased due to a $558,000 reduction in the charge for non-cash impairment of the Company's mortgage servicing rights, a $624,000 increase in the earnings on life insurance, a $445,000 increase in gains on securities sold and a $411,000 increase in operating lease income. The Company does not expect the level of mortgage activity seen during 2003 to continue and therefore does not expect mortgage sale gains to remain at the level seen during 2003. The increase in earnings on life insurance occurred primarily due to the life insurance not being put into place until the fourth quarter of 2002.
Noninterest expense increased $3.0 million, or 8.6% from $34.7 million in 2002 to $37.7 million in 2003. Salaries and wages increased $1.3 million, or 7.2%, to $19.8 million in 2003 versus $18.5 million in 2002. This increase was attributable to normal salary increases, increases related to the employee 401(k) plan, higher health care costs and staff additions. Net occupancy expense increased from $2.2 million in 2002 to $2.4 million in 2003 as a result of increased spending to refurbish several offices and higher real estate tax expense. Included in other expense was a $300,000 write-down on an ORE property, which was subsequently sold by year end. During the fourth quarter of 2003, the Company completed the issuance of floating rate trust preferred securities and the redemption of its existing fixed rate trust preferred securities. The redemption resulted in a loss on extinguishment of $804,000.
As a result of these factors, income before income tax expense increased $1.8 million, or 9.6%, from $18.9 million in 2002 to $20.7 million in 2003. Income tax expense was $6.8 million in 2003 versus $6.5 million in 2002. Income tax as a percentage of income before tax was 33.0% in 2003 versus 34.5% in 2002. The lower tax rate resulted from increased investment in tax advantaged securities and investments and an increase in the level of income derived from the investment subsidiary. Net income increased $1.5 million, or 12.1%, to $13.9 million in 2003 versus $12.4 million in 2002. Basic earnings per share in 2003 was $2.38, an increase of 11.7%, versus $2.13 in 2002. The
Company's net income performance represented a 16.5% return on January 1, 2003, stockholders' equity versus 16.8% in 2002. The net income performance resulted in a 1.12% return on average daily assets in 2003 versus 1.08% in 2002.
2002 versus 2001
The Company reported record net income of $12.4 million in 2002, an increase of $2.3 million, or 22.3%, versus net income of $10.1 million in 2001. Net interest income increased $4.4 million, or 11.7%, to $41.8 million versus $37.4 million in 2001. Net interest income increased primarily due to the implementation of a liability pricing strategy during 2001 that resulted in an improved net interest margin and growth in the loan portfolio. Interest income decreased $12.3 million, or 16.0%, from $76.6 million in 2001 to $64.3 million in 2002. The decrease was driven primarily by a 134 basis point reduction in the tax equivalent yield on average earning assets over the year. Interest expense decreased $16.7 million, or 42.5%, from $39.2 million in 2001 to $22.6 million in 2002. The decrease was primarily the result of a 163 basis point decrease in the Company's daily cost of funds over the year. The Company had a net interest margin of 4.02% in 2002 versus 3.71% in 2001. Average earning assets increased by $27.1 million to $1.1 billion in 2002 versus $1.0 billion in 2001. The primary driver was a $40.1 million increase in the average daily loan balance. Deposits increased to fund the loan growth during 2002, driven primarily by increases of $13.6 million in the average daily time deposit balances and increases of $13.2 million in the average daily demand deposit balances. The increase in average daily total deposits occurred despite the impact of the Company's September, 2001 branch divestiture, which included $70.3 million in deposits.
Nonaccrual loans were $4.2 million, or 0.51% of total loans, at year end versus $2.2 million, or 0.30% of total loans, at the end of 2001. There were nine relationships totaling $7.3 million classified as impaired as of December 31, 2002 versus six relationships totaling $10.0 million at the end of 2001. One commercial credit represented $3.2 million of this amount in 2002. The renewal of this loan was complicated as more than one bank was involved, and it was past maturity, however at year end 2002 the loan was current as to principal and interest. The removal of one credit that had a balance of $7.5 million at December 31, 2001 was offset by the addition of the aforementioned loan. The impaired loan that was removed from impaired status had been current on principal and interest for most of 2002 and was restructured as a personal loan to the principal of the corporate entity with the support of both the existing collateral and new collateral in the form of life insurance and additional pledged securities. In addition, full payment under the loan terms was expected. Net charge-offs were $1.5 million in 2002 versus $1.4 million in 2001, representing 0.19% and 0.19% of average daily loans in 2002 and 2001. The provision for loan loss expense was $3.1 million in 2002, resulting in an allowance for loan losses at December 31, 2002 of $9.5 million, which represented 1.16% of the loan portfolio, versus $7.9 million in 2001, or 1.08% of the loan portfolio. The higher provision in 2002 versus 2001 was attributable to a number of factors, but was primarily a result of the more challenging economic conditions during 2002 and the resulting impact on asset quality as evidenced by an increase in the percentage of internally classified loans in 2002. The growth of the commercial loan portfolio was also a factor in the determination of the provision for loan losses.
Noninterest income was $14.9 million in 2002 versus $13.6 million in 2001, an increase of $1.3 million, or 9.7%. The increase was driven by a $1.4 million, or 26.1%, increase in service charges on deposit accounts which was largely due to fees related to new deposit services which were implemented in the first quarter of 2002, as well as fees associated with business checking accounts. The increase in noninterest income was also reflective of the low interest rate environment which encouraged new mortgage and mortgage refinancing activity. The increased mortgage activity resulted in a rise in the gains on sale of mortgages, which were $1.9 million versus $1.2 million in 2001, an increase of 55.4%. Trust and brokerage fees decreased $197,000, or 7.4%, to $2.5 million versus $2.6 million in 2001 as a result of a reduction in brokerage income from $1.1 million in 2001 to $695,000 in 2002. During 2001, the Company sold five non-strategic branches resulting in a gain of $753,000.
Noninterest expense increased 2.5% from $33.9 million in 2001 to $34.7 million in 2002. Salaries and wages increased $1.2 million, or 6.8%, to $18.5 million in 2002 versus $17.3 million in 2001. This increase was attributable to normal salary increases, increases related to the employee 401(k) plan and an expanded incentive compensation plan. Net occupancy expense and equipment costs decreased from $4.9 million in 2001 to $4.7 million in 2002 as a result of the sale of five non-strategic branches during the second half of 2001 and reductions in some operating expenses.
As a result of these factors, income before income tax expense increased $4.0 million, or 27.1%, from $14.9 million in 2001 to $18.9 million
in 2002. Income tax expense was $6.5 million in 2002 versus $4.7 million in 2001. Income tax as a percentage of income before tax was 34.5% in 2002 versus 31.9% in 2001. The increase in income tax as a percentage of income before tax was primarily due to greater profitability, as well as the adoption of FASB 147 during 2002, which resulted in the Company reversing previously amortized goodwill and related taxes for the year of $378,000. Both of these resulted in a higher percentage of income being subject to state franchise tax combined with the Company being taxed at the 35% federal tax rate in 2002 versus the 34% rate in 2001. Net income increased $2.3 million, or 22.3%, to $12.4 million in 2002 versus $10.1 million in 2001. Basic earnings per share in 2002 was $2.13, an increase of 22.4%, versus $1.74 in 2001. The Company's net income performance represented a 16.8% return on January 1, 2002, stockholders' equity versus 15.6% in 2001. The net income performance resulted in a 1.08% return on average daily assets in 2002 versus 0.90% in 2001.
FINANCIAL CONDITION
As of December 31, 2003, the Company had 43 offices serving twelve counties in northern Indiana. The Company added two new offices during 2003. Since 1996, the Company has added seventeen new offices through acquisition and internal growth. The Company opened a thirteenth office in Kosciusko County and a fourth office in Allen County as part of its acquisition of Indiana Capital Management's Fort Wayne Office in 2003 and also continues to evaluate additional expansion opportunities. The Company will consider future acquisition and expansion opportunities with an emphasis on markets that it believes would be receptive to its business philosophy of local, independent banking. The Company sold five southern market branches during the third quarter of 2001 in order to help position the Company to focus on growth opportunities in its core northern markets, which are anchored by the cities of Warsaw, Fort Wayne, Elkhart and South Bend, Indiana.
Total assets of the Company were $1.271 billion as of December 31, 2003, an increase of $22.4 million, or 1.8%, when compared to $1.249 billion as of December 31, 2002.
Total cash and cash equivalents decreased by $29.7 million, or 34.1%, to $57.4 million at December 31, 2003 from $87.1 million at December 31, 2002. The decrease was primarily attributable to the funding of real estate mortgage loans due to an increase in demand resulting from falling interest rates during the first half of 2003.
Total securities available for sale increased by $7.3 million, or 2.6%, to $281.4 million at December 31, 2003 from $274.1 million at December 31, 2002. The increase was a result of a number of activities in the securities portfolio. Paydowns of $113.1 million were received, and the amortization of premiums, net of the accretion of discounts, was $1.5 million. Maturities, calls and sales of securities totaled $33.6 million. The fair value of the securities decreased $7.5 million as a result of generally lower interest rates. These portfolio decreases were offset by securities purchases totaling $162.5 million. The investment portfolio is managed to limit the Company's exposure to risk and contains mostly collateralized mortgage obligations and other securities which are either directly or indirectly backed by the federal government or a local municipal government. The investment portfolio did not contain any corporate debt instruments or trust preferred instruments as of December 31, 2003.
Real estate mortgages held for sale decreased by $7.0 million, or 67.0%, to $3.4 million at December 31, 2003 from $10.4 million at December 31, 2002. The balance of this asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. During 2003, $143.2 million in real estate mortgages were originated for sale and $150.2 million in mortgages were sold, compared to $93.8 and $91.8 in 2002.
Total loans, excluding real estate mortgages held for sale, increased by $48.2 million or 5.9%, to $870.9 million at December 31, 2003 from $822.7 million at December 31, 2002. The mix of loan types within the Company's portfolio extended a trend toward a higher percentage of the total loan portfolio being in commercial loans. The portfolio breakdown at year end 2003 reflected 78% commercial, 5% real estate and 17% consumer loans compared to 76% commercial, 6% real estate and 18% consumer loans at December 31, 2002.
At December 31, 2003, the allowance for loan losses was $10.2 million, or 1.18% of total loans outstanding, versus $9.5 million, or 1.16%, of total loans outstanding at December 31, 2002. The process of identifying probable credit losses is a subjective process. Therefore, the Company maintains a general allowance to cover probable incurred credit losses within the entire portfolio. The methodology management uses to determine the adequacy of the loan loss reserve includes the following considerations.
The Company has a relatively high percentage of commercial and commercial real estate loans, most of which are extended to small or medium-sized businesses. Commercial loans represent higher dollar loans to fewer customers and therefore higher credit risk. Pricing is adjusted to manage the higher credit risk associated with these types of loans. The majority of fixed rate mortgage loans, which represent increased interest rate risk, are sold in the secondary market, as well as some variable rate mortgage loans. The remainder of the variable rate mortgage loans and a small number of fixed rate mortgage loans are retained. Management believes the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, as a result of the difficult economic climate, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs, and delinquencies could rise and require further increases in the provision.
Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb probable incurred losses relating to specifically identified loans based on an evaluation, as well as other probable incurred losses inherent in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrower's ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. An appropriate level of general allowance is determined based on the application of historical loss percentages to graded loans by categories. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans - substandard, doubtful and loss. The regulations also contain a special mention category. Special mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management's close attention. Assets classified as substandard or doubtful require the institution to establish general allowances for loan losses. If an asset or portion thereof is classified as loss, the insured institution must either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off such amount. At December 31, 2003, on the basis of management's review of the loan portfolio, the Company had loans totaling $70.4 million on the classified loan list versus $75.0 million on December 31, 2002. As of December 31, 2003, the Company had $41.9 million of assets classified special mention, $27.7 million classified as substandard, $869,000 classified as doubtful and $0 classified as loss as compared to $47.6 million, $27.0 million, $211,000 and $200,000 at December 31, 2002.
Allowance estimates are developed by management in consultation with regulatory authorities, taking into account both actual loss experience and peer group loss experience and are adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the Company's loan portfolio and are applied to individual loans based on loan type. In accordance with FASB Statements 5 and 114, the allowance is provided for losses that have been incurred as of the balance sheet date and is based on past events and current economic conditions, and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions.
The Company has experienced growth in total loans over the last three years of $152.0 million, or 21.1%. The concentration of this loan growth was in the commercial loan portfolio. Commercial loans comprised 78%, 76% and 73% of the total loan portfolio at December 31, 2003, 2002 and 2001. Traditionally, this type of lending may have more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and geography. Management believes that it is prudent to continue to provide for loan losses in a manner consistent with its historical approach due to loan growth described above and current economic conditions.
As a result of the methodology in determining the adequacy of the allowance for loan losses, the provision for loan losses was $2.3 million in 2003 versus $3.1 million in 2002. At December 31, 2003 total nonperforming loans decreased by $3.9 million to $3.7 million from $7.6 million at December 31, 2002. Loans delinquent 90 days or more that were included in the accompanying financial statements as accruing totaled $3.2 million versus $3.4 million at December 31, 2002. Total impaired loans decreased by $4.3 million to $3.0 million at December 31, 2003 from $7.3 million at December 31, 2002. The decreases in nonperforming loans and impaired loans resulted from payments on six commercial loans including one loan of $1.7 million. The loans delinquent 90 days or more total includes one commercial credit for $2.9 million and $3.2 million in 2003 and 2002. The renewal of this loan has been
complicated as more than one bank is involved, and it remains past maturity. The loan first became delinquent in 2002 and the maturity has not been extended. While this loan is current as to principal and interest, there can be no assurance that it will remain current given the circumstances involved. The impaired loan total includes $127,000 in nonaccrual loans. The Company allocated $456,000 and $1.3 million of the allowance for loan losses to the impaired loans in 2003 and 2002. A loan is impaired when full payment under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
The Company believes that the improvement in total nonperforming loans is a reflection of the continued focus on enforcement of a strong credit environment, an aggressive position on loan work-out situations and a general improvement in the regional economic conditions. The allowance for loan loss to total loans percentage increased from 1.16% in 2002 to 1.18% in 2003. Despite these factors, the Company does not believe that it has experienced a dramatic change in overall asset quality. Nonetheless, the Company believes that its overall expansion strategy has employed a credit risk management approach that promotes diversification and therefore creates a balanced portfolio with appropriate risk parameters.
Total deposits increased by $13.1 million, or 1.4%, to $926.4 million at December 31, 2003 from $913.3 million at December 31, 2002. The increase resulted from increases of $80.5 million in NOW accounts, $49.6 million in Investors' Money Market accounts, $17.9 million in money market accounts and $8.1 million in savings accounts. Offsetting these increases were declines of $136.0 million in certificates of deposit and $7.1 million in demand deposit accounts. The Company believes that this shift from certificates of deposits to shorter term, liquid deposits is a reflection of the low interest rate environment.
Total short-term borrowings decreased by $207,000, or 0.1%, to $184.8 million at December 31, 2003 from $185.0 million at December 31, 2002. The decrease resulted from decreases of $22.4 million in securities sold under agreements to repurchase, $6.0 million in federal fund purchases and $840,000 in U.S. Treasury demand notes combined with a $29.0 million increase in Federal Home Loan Bank advances.
The Company believes that a strong, appropriately managed capital position is critical to long-term earnings and expansion. Bank regulatory agencies exclude the market value adjustment created by SFAS No. 115 (AFS adjustment) from capital adequacy calculations. Excluding this adjustment from the calculation, the Company had a total risk-based capital ratio of 12.8% and Tier I risk-based capital ratio of 11.8% as of December 31, 2003. These ratios met or exceeded the Federal Reserve's "well-capitalized" minimums of 10.0% and 6.0%, respectively.
The ability to maintain and grow these ratios is a function of the balance between net income and a prudent dividend policy. Total stockholders' equity increased by 7.3% to $90.0 million as of December 31, 2003, from $83.9 million as of December 31, 2002. The increase in 2003 resulted from net income of $13.9 million less the following factors:
o cash dividends of $4.4 million, o an unfavorable change in the AFS adjustment for the market valuation on securities held for sale of $4.9 million, net of tax, o a negative minimum pension liability adjustment of $331,000, net of tax, o $169,000 for the acquisition of treasury stock, o $819,000 related to stock option exercises and stock compensation expense and o $152,000 of treasury stock sold and distributed under the deferred directors' plan.
In addition, effective January 1, 2003, the Company's directors' deferred plan compensation plan was amended to no longer permit diversification outside of Company stock and to require that settlement of deferred balances be made in shares of Company stock. In accordance with EITF 97-14: "Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested," on the date of the plan change, the $949,000 current value of the liability for the Company shares was transferred to additional paid-in-capital from other liabilities. Subsequent payments under the deferred directors' plan of $204,000 were made to paid-in-capital under the new plan. Total stockholders' equity increased by 14.1% to $83.9 million as of December 31, 2002, from $73.5 million as of December 31, 2001.
The increase in 2002 resulted from net income of $12.4 million less the following factors:
o cash dividends of $3.9 million, o a favorable change in the AFS adjustment of $2.5 million, net of tax, o a negative minimum pension liability adjustment of $343,000, net of tax, and o $197,000 for the purchase of treasury stock.
The 2003 AFS adjustment reflected a 56 basis point increase in the two to five year U.S. Treasury rates during 2003. Due to the fact that the securities portfolio is primarily fixed rate, a negative equity adjustment would likely occur if interest rates increased. Management has factored this into the determination of the size of the AFS portfolio to assure that stockholders' equity is adequate under various scenarios.
Other than those indicated in this management's discussion, management is not aware of any known trends, events or uncertainties that would have a material effect on the Company's liquidity, capital and results of operations. In addition, management is not aware of any regulatory recommendations that, if implemented, would have such an effect.
Critical Accounting Policies
Certain of the Company's accounting policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, determining the fair value of securities and other financial instruments and the valuation of mortgage servicing rights.
The allowance for loan losses may be difficult to estimate due to changes in economic conditions, the financial condition of borrowers and the fact that there is not always a specific event that triggers a loss. The Company believes that the allowance for loan losses has closely reflected actual loss experience and expects this to continue as adjustments are made for changes occurring in the facts and circumstances affecting the analysis. Additional information detailing the analysis process and methodology is included previously under "Financial Condition".
Determining fair value for securities and other financial instruments may be difficult to estimate due to changing market conditions, difficulty in predicting these market changes and changes in interest rates. The Company believes the pricing obtained and rates applied in determining the fair value of securities and other financial instruments has been an accurate estimate of the instruments fair value at a point in time. The Company monitors the prices obtained and reviews the rates applied in determining fair value on a regular basis, making adjustments when situations warrant and expects the accuracy of these estimates at a point in time to continue.
The valuation of mortgage servicing rights may be difficult due to the number of assumptions that could be used to value the servicing retained and the servicing rights themselves are not tangible. The Company does not have a large mortgage origination business and feels that the business closely reflects industry standards for the amount of mortgage origination activity it conducts. Industry software is used to value the servicing rights, and there are no assumptions applied that could be considered outside industry standards.
Liquidity
Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit run-off that may occur in the normal course of business. The Company relies on a number of different sources in order to meet these potential liquidity demands. The primary sources are increases in deposit accounts and cash flows from loan payments and the securities portfolio. Given current prepayment assumptions, the cash flow from the securities portfolio is expected to provide approximately $49.8 million of funding in 2004.
In addition to these primary sources of funds, management has several secondary sources available to meet potential funding requirements. As of December 31, 2003, the Company had $110.0 million in Federal Fund lines with correspondent banks and may borrow up to $100.0 million at the Federal Home Loan Bank of Indianapolis. The Company has its securities in the available for sale (AFS) portfolio. Therefore the Company may sell securities to meet funding demands. Management believes that the securities in the AFS portfolio are of high quality and would therefore be marketable. Approximately 81.0% of this portfolio is comprised of Federal agency securities or mortgage-backed securities directly or indirectly backed by the Federal government. In addition, the Company has historically sold mortgage loans on the secondary market to reduce interest rate risk and to create an additional source of funding.
During 2003, cash and cash equivalents decreased $29.7 million from $87.1 million as of December 31, 2002 to $57.4 million as of December 31, 2003. The primary driver of this decrease was an increase in net loans of $51.7 million, which is net of approximately $143.2 million of loans originated and sold during 2003. A falling rate environment during the first half of the year contributed to an increase in demand for residential real estate mortgage loans. Other uses of funds were purchases of securities of $162.5 million and payments on long-term borrowings of $31.9 million. Sources of funds were proceeds from loan sales of $152.1 million and proceeds from maturities, calls and principal paydowns of securities of $132.4 million. Other sources of funds were proceeds from long-term borrowings of $40.9 million, proceeds from the sale of securities of $14.3 million and a net increase in deposits of $13.1 million.
During 2002, cash and cash equivalents increased $8.0 million from $79.1 million as of December 31, 2001 to $87.1 million as of December 31, 2002. A $119.9 million increase in deposit balances was the primary driver behind this change. Other sources of funds included proceeds from the sale of loans of $93.1 million, proceeds from calls and maturities of securities totaling $83.4 million and proceeds from long term borrowings of $20.0 million. Uses of funds were purchases of securities of $89.4 million, an increase in net loans of $86.0 million, which is net of approximately $93.8 million of loans originated and sold during 2002, and an increase in other assets of $11.0 million due primarily to payments for an investment in bank owned life insurance totaling $13.4 million.
During 2001, cash and cash equivalents decreased $9.9 million from $89.0 million as of December 2000 to $79.1 million as of December 31, 2001. The primary reason for this decrease was the effect of the branch sale. Other uses of funds were purchases of securities, an increase in loans and payments for the branch sale. Purchases of securities totaled $71.7 million. Net loans increased $46.6 million in 2001, which was net of approximately $68.3 million of loans originated and sold during 2001. Payments for the branch sale were $40.2 million. The major sources of funds included proceeds from sales, calls and maturities of securities of $96.5 million and proceeds from the sale of loans of $60.8 million. Lower interest rates created more demand for residential real estate mortgage loans and resulted in an increase in proceeds from the sale of mortgage loans.
The following tables disclose information on the maturity of the Company's contractual long-term obligations and commitments.
Inflation
The effects of price changes and inflation can vary substantially for most financial institutions. While management believes that inflation affects the growth of total assets, it believes that it is difficult to assess the overall impact. Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of the inflationary changes in the consumer price index ("CPI") coincides with changes in interest rates. The price of one or more of the components of the CPI may fluctuate considerably and thereby influence the overall CPI without having a corresponding affect on interest rates or upon the cost of those goods and services normally purchased by the Company. In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, thereby adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans. In addition, higher short-term interest rates caused by inflation tend to increase the cost of funds. In other years, the reverse situation may occur.
ITEM 7a.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Asset/Liability Management (ALCO) and Securities
Interest rate risk represents the Company's primary market risk exposure. The Company does not have material exposure to foreign currency exchange risk, does not own any material derivative financial instruments and does not maintain a trading portfolio. The Board of Directors annually reviews and approves the ALCO policy used to manage interest rate risk. This policy sets guidelines for balance sheet structure, which are designed to protect the Company from the impact that interest rate changes could have on net income, but does not necessarily indicate the effect on future net interest income. Given the Company's mix of interest bearing liabilities and interest bearing assets on December 31, 2003, the net interest margin could be expected to decline in a falling interest rate environment and conversely, to increase in a rising rate environment. The low rate environment at the end of 2002, resulting from interest rate reductions by the Federal Open Market Committee (the "FOMC") during 2001 and in November, 2002, continued to have an adverse impact on the Company's net interest margin. In June, 2003, the FOMC reduced the target for the Federal Funds rate 25 basis points from 1.25% to 1.00%. This action resulted in the Bank lowering its Base Rate from 4.25% to 4.00%. Due to the asset sensitive nature of the Company's balance sheet, this reduction in the prime rate had an additional adverse impact on the net interest margin during 2003. The Company utilizes a computer program to stress test the balance sheet under a wide variety of interest rate scenarios. The model quantifies the income impact of changes in customer preference for products, basis risk between the assets and the liabilities that support them and the risk inherent in different yield curves, as well as other factors. The ALCO committee reviews these possible outcomes and makes loan, investment and deposit decisions that maintain reasonable balance sheet structure in light of potential interest rate movements. Although management does not consider GAP
ratios in this planning, the information can be used in a general fashion to look at asset and liability mismatches. The Company's cumulative repricing GAP ratio as of December 31, 2003, for the next 12 months using a rates unchanged scenario was a negative 9.10% of earning assets.
The following tables provide information regarding the Company's financial instruments used for purposes other than trading that are sensitive to changes in interest rates. For loans, securities and liabilities with contractual maturities, the tables present principal cash flows and related weighted-average interest rates by contractual maturities, as well as the Company's historical experience of the impact of interest-rate fluctuations on the prepayment of residential and home equity loans and mortgage-backed securities. Loans are presented gross of the allowance for loan losses. For core deposits such as demand deposits, interest-bearing checking, savings and money market deposits that have no contractual maturity, the tables present principal cash flows and, as applicable, related weighted-average interest rates. These factors are based upon the Company's historical experience, management's judgment and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. Weighted-average variable rates are based upon rates existing at the reporting date.
These tables illustrate the Company's growth during 2003 and the effect of the rate cuts during fiscal years 2003 and 2002. The changes in the balances primarily reflect the growth of the Company's existing offices and acceptance of the one office opened during 2003. The increase in loans during 2003 was driven primarily by strong growth in the Company's commercial loan portfolio. The average interest rates show the effect of the low interest rate environment during the year.
The Company's investment portfolio consists of agencies, mortgage-backed securities and municipal bonds. During 2003, purchases in the securities portfolio consisted primarily of agency securities and municipal bonds. As of December 31, 2003, the Company's investment in mortgage-backed securities represented approximately 75% of total securities and consisted of CMOs and mortgage pools issued by GNMA, FNMA and FHLMC. The federal government backs these securities, directly or indirectly. All mortgage securities purchased by the Company are within risk tolerances for price, prepayment, extension and original life risk characteristics contained in the Company's investment policy. The Company uses Bloomberg analytics to evaluate and monitor all purchases. As of December 31, 2003, the securities in the AFS portfolio had approximately a three year average life with approximately 12% price depreciation in the event of a 300 basis points upward movement. The portfolio had approximately 6% price appreciation in the event of a 300 basis point downward movement in rates. As of December 31, 2003, all mortgage securities were performing in a manner consistent with management's original expectations.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation:
The consolidated financial statements include Lakeland Financial Corporation and its wholly-owned subsidiary, Lake City Bank, together referred to as (the "Company"). Also included in the consolidated financial statements is LCB Investments Limited, a wholly-owned subsidiary of Lake City Bank, which is a Bermuda corporation that manages a portion of the Bank's investment portfolio. All intercompany transactions and balances are eliminated in consolidation. As further discussed in Note 11, a trust that had previously been consolidated with the Company is now reported separately.
The Company provides financial services through its subsidiary, Lake City Bank (the "Bank"), a full-service commercial bank with 43 branch offices in twelve counties in northern Indiana. The Company provides commercial, retail, trust and investment services to its customers. Commercial products include commercial loans and technology-driven solutions to commercial customers' cash management needs such as CommerciaLink Internet business banking and on-line cash management services. Retail banking clients are provided a wide array of traditional retail banking services, including lending, deposit and investment services. Retail lending programs are focused on mortgage loans, home equity lines of credit and traditional retail installment loans. The Company also has an Honors Private Banking program that is positioned to serve the more financially sophisticated customer with a menu including brokerage and trust services, executive mortgage programs and access to financial planning seminars and programs. The Company's Prospero Program is dedicated to serving the expanding financial needs of the Latino community. The Company provides trust clients with traditional personal and corporate trust services. The Company also provides retail brokerage services, including an array of financial and investment products such as annuities and life insurance. Other financial instruments, which represent potential concentrations of credit risk, include deposit accounts in other financial institutions.
Use of Estimates:
To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided and future results could differ. The allowance for loan losses, the fair values of financial instruments and the fair value of loan servicing rights are particularly subject to change.
Cash Flows:
Cash and cash equivalents includes cash, demand deposits in other financial institutions and short-term investments with maturities of 90 days or less. Cash flows are reported net for customer loan and deposit transactions.
Securities:
Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income (loss). Trading securities are bought for sale in the near term and are carried at fair value, with changes in unrealized holding gains and losses included in income. Federal Home Loan Bank stock is carried at cost in other assets. Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity.
Interest income includes amortization of purchase premium or discount. Gains and losses on sales are based on the amortized cost of the security sold. Securities are written down to fair value when a decline in fair value is not temporary.
The Company does not have any material derivative instruments for presentation nor does the Company participate in any hedging activities.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Real Estate Mortgages Held for Sale:
Loans held for sale are reported at the lower of cost or market on an aggregate basis. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.
Loans:
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses.
Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt and the loan is placed on nonaccrual. All unpaid accrued interest is reversed and interest income is subsequently recorded only to the extent cash payments are received. Accrual status is resumed when all contractually due payments are brought current and future payments are reasonably assured. Consumer installment loans, except those loans that are secured by real estate, are not placed on a nonaccrual status since these loans are charged-off when they have been delinquent from 90 to 180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness. Advances under Mastercard and Visa programs, as well as advances under all other consumer line of credit programs, are charged-off when collection appears doubtful.
Allowance for Loan Losses:
The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, internal loan grade classifications, economic conditions, and other factors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision, as more information becomes available or as future events change. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as special mention, substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.
A loan is impaired when full payment under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Mortgage and commercial loans, when they have been delinquent from 90 to 180 days, are reviewed to determine if a charge-off is necessary, if the related collateral, if any, is not sufficient to offset the indebtedness.
Investments in Limited Partnerships:
Investments in limited partnerships represent the Company's investments in affordable housing projects for the primary purpose of available tax benefits. The Company is a limited partner in these investments and as such, the Company is not involved in the management or operation of such investments. These investments are accounted for using the equity method of accounting. Under the equity method of accounting, the Company records its share of the partnership's earnings or losses in its income statement and adjusts the carrying amount of the investments on the balance sheet. These investments are measured for impairment through the lower of cost or market approach. The investment recorded at December 31, 2003 and 2002 was $500,000 and $495,000.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Foreclosed Assets:
Assets acquired through or instead of loan foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed. At December 31, 2003 and 2002, the balance of repossessed assets and real estate owned was $584,000 and $138,000 and are included with other assets on the balance sheet.
Land, Premises and Equipment:
Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the useful lives of the assets. Premises assets have useful lives between 7 and 50 years. Equipment assets have useful lives between 3 and 10 years.
Loan Servicing Rights:
Loan servicing rights are recognized as assets for the allocated value of retained servicing rights on loans sold. Loan servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and secondarily, as to geographic and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions.
Bank Owned Life Insurance:
At December 31, 2003 and 2002, the Company owned $15.5 million and $13.4 million of life insurance policies on certain officers to replace group term life insurance for these individuals. Bank owned life insurance is recorded at its cash surrender value, or the amount that can be realized. Bank owned life insurance is included in other assets in the consolidated financial statements.
Goodwill and Other Intangible Assets:
Goodwill results from prior business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Upon adoption of new accounting guidance in 2002, the Company ceased amortizing goodwill. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. The effect on net income of ceasing goodwill amortization in 2002 was $274,000, net of tax.
Other intangible assets consist of core deposit intangibles arising from branch acquisitions and trust deposit relationships arising from a trust acquisition. Core deposit intangibles are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which is 12 years. Trust deposit relationships are initially measured at fair value and then amortized on an accelerated method over their estimated useful lives, which is 10 years.
Repurchase Agreements:
Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.
Long-term Assets:
Premises and equipment, core deposit and other intangible assets and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Benefit Plans:
A noncontributory defined benefit pension plan covered substantially all employees until the plan was frozen. Funding of the plan equals or exceeds the minimum funding requirement determined by the actuary. The projected unit credit cost method is used to determine expense. Benefits are based on years of service and compensation levels. Effective April 1, 2000, the defined benefit pension plan was frozen. The Company maintains a directors' deferred compensation plan. A participant can elect to receives a return based on the performance of the Company's stock for their contribution. The Company acquires shares on the open market and records such shares as treasury stock. Effective January 1, 2003, the directors' deferred compensation plan was amended to restrict the deferral to be in stock only and deferred directors' fees are included in equity. Prior to amending the plan, deferred directors' fees were included in other liabilities.
Stock Compensation:
At the inception of the Lakeland Financial Corporation Stock Option Plan, there were 600,000 shares of common stock reserved for grants of stock options to employees of Lakeland Financial Corporation, its subsidiaries and Board of Directors. As of December 31, 2003, 521,475 options had been granted and 57,765 were available for future grants. These are accounted for under APB No. 25. Employee compensation expense under the stock option plan is reported if options are granted below market price at grant date. The Company has not made any such grants. Pro forma disclosures of net income and earnings per share are shown using the fair value method to measure expense for options granted using an option pricing model to estimate fair value.
Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. Had compensation cost for stock options been recorded in the financial statements, net income and earnings per common share would have been the pro forma amounts indicated below. The pro forma effect may increase in the future if more options are granted.
Risk-free interest rate 5.26% 5.53% 5.54% Expected option life 5.00 years 5.00 years 5.00 years Expected price volatility 73.13% 76.37% 76.23% Dividend yield 2.85% 2.87% 2.86%
Income Taxes:
Annual consolidated federal and state income tax returns are filed by the Company. Income tax expense is recorded based on the amount of taxes due on its tax return plus deferred taxes computed based upon the expected future tax consequences of temporary differences between carrying amounts and tax basis of assets and liabilities, using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Off-Balance Sheet Financial Instruments:
Financial instruments include credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. The fair value of standby letters of credit is recorded as a liability during the commitment period in accordance with FASB Interpretation No. 45.
Earnings Per Common Share:
Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements. The common shares outstanding for the Stockholders' Equity section of the Balance Sheet for 2003 and 2002 reflect the acquisition of 46,481 and 46,974 shares, respectively of Lakeland Financial Corporation common stock that have been purchased under the directors' deferred compensation plan described above. Because these shares are held in trust for the participants, they are treated as outstanding when computing the weighted-average common shares outstanding for the calculation of both basic and diluted earnings per share.
Comprehensive Income:
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale during the year and changes in the minimum pension liability, which are also recognized as separate components of equity.
Loss Contingencies:
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Restrictions on Cash:
The Company was required to have $6.9 million and $3.3 million of cash on hand or on deposit with the Federal Reserve Bank to meet regulatory reserve and clearing requirements at year-end 2003 and 2002. These balances do not earn interest.
Dividend Restriction:
Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to its shareholders. These restrictions pose no practical limit on the ability of the Bank or Company to pay dividends at historical levels.
Fair Value of Financial Instruments:
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Industry Segments:
While the Company's chief decision-makers monitor the revenue streams of the various Company products and services, the identifiable segments operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment.
Adoption of New Accounting Standards:
During 2003, the Company adopted FASB Statement 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities, FASB Statement 132 (revised 2003), Employers' Disclosures about Pensions and Other Postretirement Benefits, FASB Interpretation 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, and FASB Interpretation 46, Consolidation of Variable Interest Entities. Adoption of Statements No. 149 and 150 did not materially affect the Company's operating results or financial condition.
Statement 132 (revised 2003) requires additional disclosures about the assets, obligations, cash flows of defined benefit pension and postretirement plans, as well as the expense recorded for such plans.
Interpretation 45 requires recognizing the fair value of guarantees made and information about maximum potential payments that might be required, as well as the collateral or other recourse obtainable. Interpretation 45 covers guarantees such as standby letters of credit, performance guarantees, and direct or indirect guarantees of the indebtedness of others, but not guarantees of funding.
Interpretation 46, as revised in December 2003, changes the accounting model for consolidation from one based on consideration of control through voting interests. Whether to consolidate an entity will now also consider whether that entity has sufficient equity at risk to enable it to operate without additional financial support, whether the equity owners in that entity lack the obligation to absorb expected losses or the right to receive residual returns of the entity, or whether voting rights in the entity are not proportional to the equity interest and substantially all the entity's activities are conducted for an investor with few voting rights. As further discussed in Note 11, trust entities that had previously been consolidated with the Company are now reported separately.
Newly Issued But Not Yet Effective Accounting Standards:
No new accounting standards have been issued that are not yet effective that would have a material impact on the Company's financial condition or results of operations.
Reclassifications:
Certain amounts appearing in the financial statements and notes thereto for prior periods have been reclassified to conform with the current presentation. The reclassifications had no effect on net income or stockholders' equity as previously reported.
NOTE 2 - SECURITIES
Information related to the fair value of securities available for sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) at December 31 is provided in the table below. Gross Gross Fair Unrealized Unrealized Value Gain Losses ------------ ------------ ------------ (in thousands) - ---- U.S. Government agencies $ 17,280 $ 51 $ (5) Mortgage-backed securities 211,142 885 (2,814) State and municipal securities 52,945 2,004 (197) ------------ ------------ ------------- Total . . . . . . . . . . . . . .$ 281,367 $ 2,940 $ (3,016) ============ ============ ============
- ---- U.S. Treasury securities $ 5,338 $ 195 $ 0 U.S. Government agencies 11,946 575 0 Mortgage-backed securities 222,036 5,600 (183) State and municipal securities 34,785 1,275 (24) ------------ ------------ ------------ Total . . . . . . . . . . . . . .$ 274,105 $ 7,645 $ (207) ============ ============ ============
Information regarding the fair value of available for sale debt securities by maturity as of December 31, 2003 is presented below. Maturity information is based on contractual maturity for all securities other than mortgage-backed securities. Actual maturities of securities may differ from contractual maturities because borrowers may have the right to prepay the obligation without prepayment penalty.
Fair Value ------------ (in thousands)
Due in one year or less $ 101 Due after one year through five years 12,664 Due after five years through ten years 9,403 Due after ten years 48,057 ------------ 70,225 Mortgage-backed securities 211,142 ------------ Total debt securities . . . . . . . . . . . . . . . . . . . . .$ 281,367 ============
Security proceeds, gross gains and gross losses for 2003, 2002 and 2001 were as follows:
2003 2002 2001 ----------- ----------- ----------- (in thousands) Sales and calls of securities available for sale Proceeds $ 30,154 $ 10,467 $ 20,805 Gross gains 508 77 310 Gross losses 8 22 190
NOTE 2 - SECURITIES (continued)
Securities with carrying values of $197.8 million and $206.0 million were pledged as of December 31, 2003 and 2002, as collateral for deposits of public funds, securities sold under agreements to repurchase, borrowings from the FHLB and for other purposes as permitted or required by law. At year-end 2003 and 2002, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders' equity.
Information regarding securities with unrealized losses as of December 31, 2003 is presented below. The table distributes the securities between those with unrealized losses for less than twelve months and those with unrealized losses over more than twelve months or more.
All of the following are considered, to determine whether or not the impairment of these securities is other-than-temporary. All of the securities are backed by the U.S. Government or its agencies or are A rated or better, in the case of non-local municipal securities. None of the securities have call provisions (with the exception of the municipal securities) and payments as originally agreed are being received. There are no concerns of credit losses and there is nothing to indicate that full principal will not be received. Management considers the unrealized losses to be market driven and no loss will be realized unless the securities are sold. The Company does not have a history of actively trading securities, but keeps the securities available for sale should liquidity or other needs develop that would warrant the sale of securities. While these securities are held in the available for sale portfolio, the current intent and ability is to hold them until maturity.
NOTE 3 - LOANS
Total loans outstanding as of year-end consisted of the following:
2003 2002 ------------ ------------ (in thousands)
Commercial and industrial loans $ 593,194 $ 556,800 Agri-business and agricultural loans 82,262 68,137 Real estate mortgage loans 40,118 44,644 Real estate construction loans 3,932 2,540 Installment loans and credit cards 151,376 150,555 ------------ ------------ Total loans . . . . . . . . . . . . . . . . . . .$ 870,882 $ 822,676 ============ ============
The Company is not committed to lend additional funds to debtors whose loans have been modified. The 2003 and 2002 impaired loan totals included $127,000 and $4.1 million which were also included in the total for nonaccrual loans. Total impaired loans decreased by $4.3 million to $3.0 million at December 31, 2003 from $7.3 million at December 31, 2002. The decreases in nonperforming loans and impaired loans resulted from payments on six commercial loans, including one commercial loan of $1.7 million. The loans delinquent 90 days or more total includes one commercial credit for $2.9 million and $3.2 million in 2003 and 2002. The renewal of this loan has been complicated as more than one bank is involved, and it remains past maturity. The loan first became delinquent in 2002 and the maturity has not been extended. While this loan is current as to principal and interest, there can be no assurance that it will remain current given the circumstances involved.
NOTE 5 - SECONDARY MORTGAGE MARKET ACTIVITIES
Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of these loans were $231.8 million and $168.7 million at December 31, 2003 and 2002. Net loan servicing income/(loss) was ($166,000), ($48,000) and $82,000 for 2003, 2002 and 2001. Information on loan servicing rights follows:
Loan servicing rights: 2003 2002 2001 ------------ ------------ ------------ (in thousands)
Beginning of year $ 1,677 $ 1,507 $ 1,419 Originations 1,094 622 395 Amortization (671) (452) (307) ------------ ------------ ------------ End of year . . . . . . . . . . . .$ 2,100 $ 1,677 $ 1,507 ============ ============ ============
Valuation allowance: 2003 2002 2001 ------------ ------------ ------------ (in thousands)
Beginning of year $ 722 $ 388 $ 0 Additions expensed 421 913 705 Reductions credited to expense (645) (579) (317) ------------ ------------ ------------ End of year . . . . . . . . . . . .$ 498 $ 722 $ 388 ============ ============ ============
NOTE 6 - LAND, PREMISES AND EQUIPMENT, NET
Land, premises and equipment and related accumulated depreciation were as follows at December 31:
2003 2002 ------------ ------------ (in thousands)
Land $ 8,456 $ 8,053 Premises 21,004 20,357 Equipment 14,830 12,622 ------------ ------------ Total cost . . . . . . . . . . . . . . . . . . . . 44,290 41,032 Less accumulated depreciation 18,133 16,264 ------------ ------------ Land, premises and equipment, net $ 26,157 $ 24,768 ============ ============
NOTE 7 - GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The change in the carrying amount of goodwill during the year was as follows:
2003 2002 ------------ ------------ (in thousands)
Beginning of year $ 4,970 $ 0 Reclassified from unidentifiable intangible assets 0 4,970 ------------ ------------ End of year $ 4,970 $ 4,970 ============ ============
NOTE 7 - GOODWILL AND OTHER INTANGIBLE ASSETS (continued)
Aggregate amortization expense was $154,000, $149,000 and $193,000 for 2003, 2002 and 2001.
Estimated amortization expense for each of the next five years:
Amount ------------ (in thousands) $ 214 2005 212 2006 209 2007 206 2008 206
NOTE 8 - DEPOSITS
The aggregate amount of time deposits, each with a minimum denomination of $100,000, was approximately $106.4 million and $225.0 million at December 31, 2003 and 2002.
At December 31, 2003, the scheduled maturities of time deposits were as follows:
Amount ------------ (in thousands) Maturing in 2004 $ 175,302 Maturing in 2005 71,067 Maturing in 2006 15,286 Maturing in 2007 28,526 Maturing in 2008 9,372 Thereafter 950 ------------ Total time deposits $ 300,503 ============
NOTE 9 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase ("repo accounts") represent collateralized borrowings with customers located primarily within the Company's service area. Repo accounts are not covered by federal deposit insurance and are secured by securities owned. Information on these liabilities and the related collateral for 2003 and 2002 is as follows:
The Company retains the right to substitute similar type securities, and has the right to withdraw all collateral applicable to repo accounts whenever the collateral values are in excess of the related repurchase liabilities. At December 31, 2003, there were no material amounts of securities at risk with any one customer. The Company maintains control of these securities through the use of third-party safekeeping arrangements.
NOTE 10 - BORROWINGS
All notes require monthly interest payments and were secured by residential real estate loans and securities with a carrying value of $86.6 million at December 31, 2003. At December 31, 2003, the Company owned $4.3 million of Federal Home Loan Bank (FHLB) stock, which also secures debts to the FHLB.
In addition to the long-term borrowings, the Company had $55 million and $26 million in fixed rate notes with the FHLB at December 31, 2003 and 2002. For the year-end 2003, these notes mature at various times between January 30, 2004 and July 20, 2004. These notes are classified as short-term borrowings in the financial statements. The Company is authorized to borrow up to $100 million from the FHLB.
Long-term borrowings mature over each of the next five years as follows:
(in thousands) ------------ 2004 $ 20,000 2005 10,000 2006 0 2007 0 2008 0
NOTE 11 - SUBORDINATED DEBENTURES AND TRUST PREFERRED SECURITIES
In September 1997, Lakeland Capital Trust completed a public offering of two million shares of cumulative trust preferred securities with a liquidation preference of $10 per security. The proceeds of the offering were loaned to the Company in exchange for subordinated debentures with terms similar to the preferred securities. On October 1, 2003, the subordinated debentures were redeemed and the preferred securities called. Loss on extinguishment of debt of $804,000 was recorded in connection with the call of the preferred securities.
Lakeland Statutory Trust II, a trust formed by the Company, issued $30.0 million of floating rate trust preferred securities on October 1, 2003 as part of a privately placed offering of such securities. The Company issued subordinated debentures to the trust in exchange for the proceeds of the trust. Subject to the Company having received prior approval of the Federal Reserve if then required, the Company may redeem the subordinated debentures, in whole or in part, but in all cases in a principal amount with integral multiples of $1,000, on any interest payment date on or after October 1, 2008 at 100% of the principal amount, plus accrued and unpaid interest. The subordinated debentures must be redeemed no later than 2033. These securities are considered as Tier I capital (with certain limitations applicable) under current regulatory guidelines. The floating rate of the trust preferred securities and subordinated debentures at December 31, 2003 was 4.205%. The holding company's investment in the common stock of the trust was $928,000 and is included in other assets.
Prior to 2003, Lakeland Capital Trust was consolidated in the Company's financial statements, with the trust preferred securities issued by the trust reported in liabilities as "guaranteed preferred beneficial interests" and the subordinated debentures eliminated in consolidation. The trust preferred securities issued by Lakeland Capital Trust have been redeemed and are no longer outstanding. The Company issued new securities through Lakeland Statutory Trust II in 2003. Under new accounting guidance, FASB Interpretation No. 46, as revised in December 2003, trusts for a trust preferred offering are no longer consolidated with the Company. Accordingly, the Company does not report the securities issued by Lakeland Statuttory Trust II as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company and held by the trust, as these are no longer eliminated in consolidation. Since the amount of the subordinated debentures equals the amount of trust preferred securities and common stock, the effect of no longer consolidating the trust changes certain balance sheet classifications, but not equity or net income. Accordingly, the amounts previously reported as "guaranteed preferred beneficial interest" in liabilities have been recaptioned "subordinated debentures" and continue to be presented in liabilities on the balance sheet.
NOTE 12 - EMPLOYEE BENEFIT PLANS
In April, 2000, the Lakeland Financial Corporation Pension Plan was frozen. As a result of this curtailment, a gain was recognized in the income statement for the second quarter of 2000. The Company also maintains a Supplemental Executive Retirement Plan (SERP) for select officers that was established as a funded, non-qualified deferred compensation plan.
NOTE 12 - EMPLOYEE BENEFIT PLANS (continued)
The expected long-term rate of return on plan assets is developed in consultation with the plan actuary. It is primarily based upon industry trends and consensus rates of return which are then adjusted to reflect the specific asset allocations and historical rates of return of the Company's plan assets.
The asset allocations at the measurement dates of September 30, 2003, and 2002, by asset category are as follows:
Pension Plan Assets SERP Plan Assets at September 30, at September 30, -------------------------- -------------------------- Asset Category 2003 2002 2003 2002 - -------------- ------------ ------------ ------------ ------------ Equity securities 74% 63% 59% 52% Debt Securities 23% 36% 36% 42% Other 3% 1% 5% 6% ------------ ------------ ------------ ------------ Total 100% 100% 100% 100% ============ =========== ============ ============
As of the measurement date, the investment objective was to realize a rate of return on the plan assets matching that of the actuarial assumption. The allowable asset allocation parameters were as follows: Equities: 50%-75% and Fixed Income: 25%-50%. The equity component is managed by an outside portfolio manager and consists of a diversified portfolio of common stocks. The fixed income component is managed internally by the Company's Trust Department and consists of Treasury securities and corporate bonds. The Company has an internal Pension Administration Committee consisting of the Human Resources Director, Chief Financial Officer, Manager of Retirement Plan Services, Senior Personal Trust Officer and Senior Trust Investment Officer. During 2004, the Committee will meet to review investment performance and to prepare a formal investment policy.
NOTE 12 - EMPLOYEE BENEFIT PLANS (continued)
Contributions
The Company expects to contribute $299,000 to its pension plan and $119,000 to its SERP plan in 2004.
Other Employee Benefit Plans
The Company maintains a 401(k) profit sharing plan for all employees meeting age and service requirements. The Company contributions are based upon the rate of return on stockholders' equity as of January 1st of each year. The expense recognized was $732,000, $620,000 and $551,000 in 2003, 2002 and 2001.
Under employment agreements with certain executives, certain events leading to separation from the Company could result in cash payments totaling $2.2 million as of December 31, 2003. On December 31, 2003, no amounts were accrued on these contingent obligations.
NOTE 13 - OTHER INCOME AND EXPENSE
NOTE 14 - INCOME TAXES
Income tax expense included $203,000, $20,000 and $41,000 applicable to security transactions for 2003, 2002 and 2001. The differences between financial statement tax expense and amounts computed by applying the statutory federal income tax rate of 35%, 35% and 34% for 2003, 2002, and 2001 to income before income taxes were as follows:
NOTE 14 - INCOME TAXES (continued)
In addition to the net deferred tax assets included above, the deferred income tax asset (liability) allocated to the unrealized net loss on securities available for sale included in equity was $91,000 and $(2.7) million for 2003 and 2002. The deferred income tax asset allocated to the minimum pension liability included in equity was $761,000 and $535,000 for 2003 and 2002.
NOTE 15 - RELATED PARTY TRANSACTIONS
Loans to principal officers, directors, and their affiliates as of December 31, 2003 and 2002 were as follows:
2003 2002 ------------ ------------ (in thousands) Beginning balance $ 39,931 $ 39,075 New loans and advances 68,044 58,186 Effect of changes in related parties 5,135 32 Repayments (68,705 (57,362) ------------ ------------ Ending balance . . . . . . . . . . . . . . . . . . .$ 44,405 $ 39,931 ============ ============
Deposits from principal officers, directors, and their affiliates at year-end 2003 and 2002 were $2.0 million and $5.0 million. In addition, the amount owed directors for fees under the deferred directors' plan as of December 31, 2003 and 2002 was $994,000 and $1.3 million. The related expense for the deferred directors' plan as of December 31, 2003, 2002 and 2001 was $235,000, $487,000 and $399,000.
NOTE 16 - STOCK OPTIONS
NOTE 17 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS
The Company and Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2003 and 2002, that the Company and Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2003, the most recent notification from the federal regulators categorized the Company and Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Company and Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Company's or Bank's category.
NOTE 17 - CAPITAL REQUIREMENTS AND RESTRICTIONS ON RETAINED EARNINGS (continued)
Indiana law prohibits the Bank from paying dividends in an amount greater than its undivided profits. The Bank is required to obtain the approval of the Department of Financial Institutions for the payment of any dividend if the total amount of all dividends declared by the Bank during the calendar year, including the proposed dividend, would exceed the sum of the retained net income for the year to date combined with its retained net income for the previous two years. Indiana law defines "retained net income" to mean the net income of a specified period, calculated under the consolidated report of income instructions, less the total amount of all dividends declared for the specified period. As of December 31, 2003, approximately $19.8 million was available to be paid as dividends to the Company by the Bank.
The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2003. Notwithstanding the availability of funds for dividends, however, the FDIC may prohibit the payment of any dividends by the Bank if the FDIC determines such payment would constitute an unsafe or unsound practice.
NOTE 18 - FAIR VALUES OF FINANCIAL INSTRUMENTS
The following table contains the estimated fair values and the related carrying values of the Company's financial instruments at December 31, 2003 and 2002. Items, which are not financial instruments, are not included.
For purposes of the above disclosures of estimated fair value, the following assumptions were used as of December 31, 2003 and 2002. The estimated fair value for cash, cash equivalents, accrued interest and Federal Home Loan Bank stock is considered to approximate cost. Real estate mortgages held for sale are based upon the actual contracted price for those loans sold but not yet delivered, or the current Federal Home Loan Mortgage Corporation price for normal delivery of mortgages with similar coupons and maturities at year-end. The estimated fair value of loans is based on estimates of the rate the Company would charge for similar loans at December 31, 2003 and 2002, applied for the time period until estimated repayment. The estimated fair value for demand and savings deposits is based on their carrying value. The estimated fair value for certificates of deposit and borrowings is based on estimates of the rate the Company would pay on such deposits or borrowings at December 31, 2003 and 2002, applied for the time period until maturity. The estimated fair value of variable rate short-term borrowed funds is considered to approximate carrying value. The estimated fair value of other financial instruments and off-balance sheet loan commitments approximate cost and are not considered significant to this presentation.
NOTE 18 - FAIR VALUES OF FINANCIAL INSTRUMENTS (continued)
While these estimates of fair value are based on management's judgment of the most appropriate factors, there is no assurance that, were the Company to have disposed of such items at December 31, 2003 and 2002, the estimated fair values would necessarily have been achieved at that date, since market values may differ depending on various circumstances. The estimated fair values at December 31, 2003 and 2002 should not necessarily be considered to apply at subsequent dates.
NOTE 19 - COMMITMENTS, OFF-BALANCE SHEET RISKS AND CONTINGENCIES
During the normal course of business, the Company becomes a party to financial instruments with off-balance sheet risk in order to meet the financing needs of its customers. These financial instruments include commitments to make loans and open-ended revolving lines of credit. Amounts as of December 31, 2003 and 2002, were as follows:
At December 31, 2003 and 2002, the range of interest rates for commercial loan commitments with a fixed rate was 2.00% to 10.75% and 2.00% to 11.00%. The range of interest rates for commercial loan commitments with variable rates was 2.67% to 9.00% and 3.00% to 10.25% at December 31, 2003 and 2002. The index on variable rate commercial loan commitments is principally the Company's base rate, which is the national prime rate. The range of interest rates for mortgage loan commitments with a fixed rate was 4.88% to 7.25% at December 31, 2003 and 2002. The range of interest rates for mortgage loan commitments with a variable rate was 5.00% to 7.00% and 6.00% to 6.50% at December 31, 2003 and 2002. At December 31, 2003 and 2002, the range of interest rates for fixed rate credit card commitments was 14.95% to 17.95%. At December 31, 2003 and 2002 the rate on variable credit card commitments was 7.00% and 7.25%. The range of interest rates for open-ended revolving line commitments with a variable rate was 2.99% to 15.00% and 3.99% to 15.00% at December 31, 2003 and 2002.
Commitments, excluding open-ended revolving lines, generally have fixed expiration dates of one year or less. Open-ended revolving lines are monitored for proper performance and compliance on a monthly basis. Since many commitments expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Company follows the same credit policy (including requiring collateral, if deemed appropriate) to make such commitments as is followed for those loans that are recorded in its financial statements.
The Company's exposure to credit losses in the event of nonperformance is represented by the contractual amount of the commitments. Management does not expect any significant losses as a result of these commitments.
NOTE 20 - PARENT COMPANY STATEMENTS
NOTE 21 - EARNINGS PER SHARE
NOTE 22 - SELECTED QUARTERLY DATA (UNAUDITED) (in thousands except per share data)
NOTE 22 - SELECTED QUARTERLY DATA (UNAUDITED) (in thousands except per share data) (continued)
NOTE 23 - BRANCH DIVESTITURES
On September 21, 2001, the Company sold its Greentown, Logansport, Peru, Roann and Wabash, Indiana offices. The Company paid $39.8 million to settle the net liabilities assumed by the buyer and recorded a gain of $753,000.
NOTE 24 - TRUST ACQUISITION
On December 1, 2003, the Company acquired the Fort Wayne, Indiana office of Indiana Capital Management Bank & Trust. The Company paid $600,000 to settle the net assets acquired. Summary information regarding the effect of the sale on the balance sheet is presented below. In addition, the Company received $60.0 million in trust assets that are not included in these financial statements. Amount ------------ Assets: (in thousands) Equipment $ 30 Intangible assets 572 Liabilities: Other liabilities $ 2
REPORT OF INDEPENDENT AUDITORS
Stockholders and Board of Directors Lakeland Financial Corporation Warsaw, Indiana
We have audited the accompanying consolidated balance sheets of Lakeland Financial Corporation ("Company") and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Lakeland Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.
Crowe Chizek and Company LLC South Bend, Indiana January 9, 2004
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Company's consolidated financial statements and related information. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements reasonably present the Company's financial position and results of operations and were prepared in conformity with accounting principles generally accepted in the United States of America. Management also has included in the Company's financial statements amounts that are based on estimates and judgments, which it believes, are reasonable under the circumstances.
The Company maintains a system of internal controls designed to provide reasonable assurance that all assets are safeguarded, financial records are reliable for preparing consolidated financial statements and the Company complies with laws and regulations relating to safety and soundness which are designated by the FDIC and other appropriate federal banking agencies. The selection and training of qualified personnel and the establishment and communication of accounting and administrative policies and procedures are elements of this control system. The effectiveness of the internal control system is monitored by a program of internal audit and by independent certified public accountants (independent auditors). Management recognizes that the cost of a system of internal controls should not exceed the benefits derived and that there are inherent limitations to be considered in the potential effectiveness of any system. Management believes the Company's system provides the appropriate balance between costs of controls and the related benefits.
The independent auditors have audited the Company's consolidated financial statements in accordance with auditing standards generally accepted in the United States of America and provide an objective, independent review of the fairness of the reported operating results and financial position. The board of directors of the Company has an audit review committee composed of six non-management directors. The committee meets periodically with the internal auditors and the independent auditors.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a -15(e) promulgated under the Securities and Exchange Act of 1934, as amended) as of December 31, 2003. Based on that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information appearing in the definitive Proxy Statement, dated as of March 5, 2004, is incorporated herein by reference in response to this item.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information appearing in the definitive Proxy Statement, dated as of March 5, 2004, is incorporated herein by reference in response to this item. The sections in the Proxy Statement marked "Report of the Compensation Committee on Executive Compensation", "Stock Price Performance" and "Audit Committee Report" are furnished for the information of the Commission and are not deemed to be "filed" as part of the Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information appearing in the definitive Proxy Statement, dated as of March 5, 2004, is incorporated herein by reference in response to this item.
Equity Compensation Plan Information
The table below sets forth the following information as of December 31, 2003 for (i) all compensation plans previously approved by the Company's shareholders and (ii) all compensation plans not previously approved by the Company's shareholders: (a) the number of securities to be issued upon the exercise of outstanding options, warrants and rights;
(b) the weighted-average exercise price of such outstanding options, warrants and rights;
(c) other than securities to be issued upon the exercise of such outstanding options, warrants and rights, the number of securities remaining available for future issuance under the plans.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information appearing in the definitive Proxy Statement, dated as of March 5, 2004, is incorporated herein by reference in response to this item.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information appearing in the definitive proxy statement, dated as of March 5, 2004, is incorporated herein by reference in response to this item.
(b) Reports on Form 8-K
A report on Form 8-K was filed on October 15, 2003 under Item 12 which reported the Company's third quarter financial information in the form of a press release.
A report on Form 8-K was filed on January 15, 2004 under Item 12 which reported the Company's fourth quarter and fiscal year financial information in the form of a press release.
SIGNATURES
Pursuant to the requirements of Section 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LAKELAND FINANCIAL CORPORATION
Date: February 25, 2004 By /s/ Michael L. Kubacki Michael L. Kubacki, Chairman
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Name Title Date
/s/ Michael L. Kubacki Michael L. Kubacki Principal Executive Officer February 25, 2004 and Director
/s/ David M. Findlay David M. Findlay Principal Financial Officer February 25, 2004
/s/ Teresa A. Bartman Teresa A. Bartman Principal Accounting Officer February 25, 2004
Robert E. Bartels, Jr Director February 25, 2004
/s/ L. Craig Fulmer L. Craig Fulmer Director February 25, 2004
/s/ Allan J. Ludwig Allan J. Ludwig Director February 25, 2004
/s/ Charles E. Niemier Charles E. Niemier Director February 25, 2004
/s/ Emily E. Pichon Emily E. Pichon Director February 25, 2004
/s/ Richard L. Pletcher Richard L. Pletcher Director February 25, 2004
Steven D. Ross Director February 25, 2004
Donald B. Steininger Director February 25, 2004
Terry L. Tucker Director February 25, 2004
M. Scott Welch Director February 25, 2004
Exhibit 21
Subsidiaries
1. Lake City Bank, Warsaw, Indiana, a banking corporation organized under the laws of the State of Indiana.
2. Lakeland Statutory Trust II, a statutory business trust formed under Connecticut law.
3. LCB Investments Limited, a subsidiary of Lake City Bank formed under the laws of Bermuda to manage a portion of the Bank's investment portfolio.