UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO
-------- --------
Commission File Number: 000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
DELAWARE 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 W. Pine Street, Lodi, California 95240
(Address of principal Executive offices) (Zip Code)
Registrant's telephone number, including area code (209) 367-2300
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by checkmark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act: (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Number of shares of common stock of the registrant: Par value $0.01, authorized
2,000,000 shares; issued and outstanding 811,933 as of November 1, 2006.
FARMERS & MERCHANTS BANCORP
FORM 10-Q
TABLE OF CONTENTS
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PART I. - FINANCIAL INFORMATION PAGE
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ITEM 1 - FINANCIAL STATEMENTS
Consolidated Balance Sheets as of September 30, 2006 (Unaudited),
December 31, 2005 and September 30, 2005 (Unaudited). 3
Consolidated Statements of Income (Unaudited) for the Three Months
and Nine Months Ended September 30, 2006 and 2005. 4
Consolidated Statements of Comprehensive Income (Unaudited) for the
Three Months and Nine Months Ended September 30, 2006 and 2005. 5
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
for the Nine Months Ended September 30, 2006 and 2005. 6
Consolidated Statements of Cash Flows (Unaudited) for the Nine
Months Ended September 30, 2006 and 2005. 7
Notes to the Unaudited Consolidated Financial Statements 8
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 13
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 28
ITEM 4 - CONTROLS AND PROCEDURES 31
PART II. -OTHER INFORMATION
-----------------
ITEM 1 - LEGAL PROCEEDINGS 32
ITEM 1A - RISK FACTORS 32
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 32
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES 32
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 32
ITEM 5 - OTHER INFORMATION 32
ITEM 6 - EXHIBITS 32
SIGNATURES 33
INDEX TO EXHIBITS 33
2
PART I. - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
FARMERS & MERCHANTS BANCORP
CONSOLIDATED BALANCE SHEETS
=============================================================================================
(in thousands) Sept. 30, December 31, Sept. 30,
2006 2005 2005
ASSETS (Unaudited) (Unaudited)
---------------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due From Banks $ 41,609 $ 50,669 $ 36,871
Federal Funds Sold - - -
---------------------------------------------------------------------------------------------
Total Cash and Cash Equivalents 41,609 50,669 36,871
Investment Securities:
Available-for-Sale 150,994 158,029 143,884
Held-to-Maturity 113,045 109,911 110,540
---------------------------------------------------------------------------------------------
Total Investment Securities 264,039 267,940 254,424
---------------------------------------------------------------------------------------------
Loans: 1,035,200 973,257 944,579
Less: Allowance for Loan Losses 18,300 17,860 17,905
---------------------------------------------------------------------------------------------
Loans, Net 1,016,900 955,397 926,674
---------------------------------------------------------------------------------------------
Land, Buildings & Equipment 19,731 17,522 16,311
Bank Owned Life Insurance 38,026 36,799 36,404
Interest Receivable and Other Assets 35,508 24,662 22,670
---------------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,415,813 $ 1,352,989 $ 1,293,354
=============================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
---------------------------------------------------------------------------------------------
Deposits:
Demand $ 269,519 $ 325,745 $ 267,765
Interest Bearing Transaction 125,488 138,321 119,918
Savings 272,127 283,226 289,662
Time Deposits 447,258 356,048 369,271
---------------------------------------------------------------------------------------------
Total Deposits 1,114,392 1,103,340 1,046,616
---------------------------------------------------------------------------------------------
Fed Funds Purchased - 650 19,700
FHLB Borrowings 138,844 98,847 75,857
Subordinated Debentures 10,310 10,310 10,310
Interest Payable and Other Liabilities 21,946 16,194 17,827
---------------------------------------------------------------------------------------------
Total Liabilities 1,285,492 1,229,341 1,170,310
---------------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common Stock 8 8 8
Additional Paid-In Capital 90,334 95,862 96,808
Retained Earnings 41,759 29,463 28,509
Accumulated Other Comprehensive Loss (1,780) (1,685) (2,281)
---------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 130,321 123,648 123,044
---------------------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $ 1,415,813 $ 1,352,989 $ 1,293,354
=============================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
3
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
===========================================================================================================
(in thousands except per share data) Three Months Nine Months
Ended Sept. 30, Ended, Sept. 30
2006 2005 2006 2005
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INTEREST INCOME
Interest & Fees on Loans $ 20,015 $ 16,061 $ 56,595 $ 44,631
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 11 41 48 97
Interest on Investment Securities:
Taxable 2,099 1,769 6,232 5,498
Tax-Exempt 825 834 2,447 2,389
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Total Interest Income 22,950 18,705 65,322 52,615
-----------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 5,048 2,689 12,515 6,991
Borrowed Funds 1,590 992 4,255 2,441
Subordinated Debentures 218 166 613 463
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Total Interest Expense 6,856 3,847 17,383 9,895
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NET INTEREST INCOME 16,094 14,858 47,939 42,720
Provision for Loan Losses - - 275 -
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NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES 16,094 14,858 47,664 42,720
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NON-INTEREST INCOME
Service Charges on Deposit Accounts 1,754 1,128 4,326 3,273
Net Loss on Sale of Investment Securities (664) (307) (1,083) (163)
Credit Card Merchant Fees 552 546 1,626 1,526
Increase in Cash Surrender Value of Life Insurance 425 403 1,228 1,169
ATM Fees 307 277 892 714
Other 740 937 2,228 2,390
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Total Non-Interest Income 3,114 2,984 9,217 8,909
-----------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries & Employee Benefits 6,919 7,027 21,527 20,437
Occupancy 564 495 1,801 1,505
Equipment 817 772 2,463 1,733
Credit Card Merchant Expense 416 395 1,203 1,088
Marketing 311 232 688 865
Other 1,750 1,531 5,005 4,480
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Total Non-Interest Expense 10,777 10,452 32,687 30,108
-----------------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 8,431 7,390 24,194 21,521
Provision for Income Taxes 3,098 2,643 8,830 7,754
-----------------------------------------------------------------------------------------------------------
NET INCOME $ 5,333 $ 4,747 $ 15,364 $ 13,767
===========================================================================================================
EARNINGS PER SHARE $ 6.54 $ 5.74 $ 18.77 $ 16.59
===========================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
4
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
==================================================================================================================================
(in thousands) Three Months Nine Months
Ended Sept. 30, Ended Sept. 30,
2006 2005 2006 2005
----------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 5,333 $ 4,747 $ 15,364 $ 13,767
OTHER COMPREHENSIVE (LOSS) INCOME -
UNREALIZED (LOSSES) GAINS ON DERIVATIVE INSTRUMENTS:
Unrealized holding (losses) gains arising during the period, net
of income tax effects of $0 and $1 for the quarters ended
September 30, 2006 and 2005, respectively, and $0 and $0
for the nine months ended September 30, 2006 and 2005, respectively. - (1) - -
Less: Reclassification adjustment for realized losses included in net
income, net of related income tax effects of $(3) and $(3) for the
quarters ended September 30, 2006 and 2005, respectively, and $(2) and
$(9) for the nine months ended September 30, 2006 and 2005, respectively. (5) (4) (3) (13)
UNREALIZED GAINS (LOSSES) ON SECURITIES:
Unrealized holding gains (losses) arising during the period, net of
income tax provision (benefit) of $992 and $(435) for the quarters ended
September 30, 2006 and 2005, respectively, and of $(521) and $(968)
for the nine months ended September 30, 2006 and 2005, respectively. 1,365 (597) (720) (1,332)
Less: Reclassification adjustment for realized losses included
in net income, net of related income tax effects of $278 and $129
for the quarters ended September 30, 2006 and 2005, respectively, and of
$455 and $69 for the nine months ended September 30, 2006 and 2005,
respectively. 386 178 628 94
----------------------------------------------------------------------------------------------------------------------------------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 1,746 (424) (95) (1,251)
----------------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME $ 7,079 $ 4,323 $ 15,269 $ 12,516
==================================================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
5
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
===============================================================================================================================
(in thousands except share data) ACCUMULATED
COMMON ADDITIONAL OTHER TOTAL
SHARES COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
OUTSTANDING STOCK CAPITAL EARNINGS LOSS EQUITY
-------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2004 792,722 $ 8 $ 82,237 $ 35,332 $ (1,030) $ 116,547
===============================================================================================================================
Net Income - - 13,767 - 13,767
Cash Dividends Declared on -
Common Stock - - (2,659) - (2,659)
5% Stock Dividend 38,995 - 17,641 (17,641) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (290) - (290)
Repurchase of Stock (6,143) - (3,070) - - (3,070)
Change in Unrealized Loss on
Derivative Instruments (12) (12)
Change in Net Unrealized Loss
on Securities Available for Sale - - - (1,239) (1,239)
-------------------------------------------------------------------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 2005 825,574 $ 8 $ 96,808 $ 28,509 $ (2,281) $ 123,044
===============================================================================================================================
-------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2005 823,651 $ 8 $ 95,862 $ 29,463 $ (1,685) $ 123,648
===============================================================================================================================
Net Income - - 15,364 - 15,364
Cash Dividends Declared on -
Common Stock - - (3,068) - (3,068)
Repurchase of Stock (10,918) - (5,528) - - (5,528)
Change in Unrealized Loss on
Derivative Instruments (3) (3)
Change in Net Unrealized Loss
on Securities Available for Sale - - - (92) (92)
-------------------------------------------------------------------------------------------------------------------------------
BALANCE, SEPTEMBER 30, 2006 812,733 $ 8 $ 90,334 $ 41,759 $ (1,780) $ 130,321
===============================================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
6
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Nine Months Ended
============================================================================================================
(in thousands) Sept. 30, Sept. 30,
2006 2005
------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net Income $ 15,364 $ 13,767
Adjustments to Reconcile Net Income to Net
Cash Provided by Operating Activities:
Provision for Loan Losses 275 -
Depreciation and Amortization 1,387 1,168
Net (Accretion) Amortization of Investment Security Discounts & Premium (73) 482
Net Loss on Sale of Investment Securities 1,083 163
Net Gain on Sale of Property & Equipment (3) (1)
Net Change in Operating Assets & Liabilities:
Net Increase in Interest Receivable and Other Assets (12,010) (3,791)
Net Increase in Interest Payable and Other Liabilities 5,752 1,388
------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 11,775 13,176
INVESTING ACTIVITIES:
Securities Available-for-Sale:
Purchased (41,826) (15,550)
Sold, Matured or Called 47,733 54,565
Securities Held-to-Maturity:
Purchased (7,348) (27,703)
Matured or Called 4,174 7,058
Net Loans Originated or Acquired (62,519) (78,030)
Principal Collected on Loans Previously Charged Off 741 537
Net Additions to Premises and Equipment (3,598) (2,508)
Proceeds from Sale of Property & Equipment 5 1
------------------------------------------------------------------------------------------------------------
Net Cash Used by Investing Activities (62,638) (61,630)
FINANCING ACTIVITIES:
Net Decrease in Demand, Interest-Bearing Transaction,
and Savings Accounts (80,158) (5,892)
Increase in Time Deposits 91,210 50,398
Net (Decrease) Increase in Federal Funds Purchased (650) 19,700
Net Increase (Decrease) in Federal Home Loan Bank Advances 39,997 (5,032)
Cash Dividends (3,068) (2,949)
Stock Repurchases (5,528) (3,070)
------------------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 41,803 53,155
(Decrease) Increase in Cash and Cash Equivalents (9,060) 4,701
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 50,669 32,170
------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AS OF SEPT. 30, 2006 AND SEPT. 30, 2005 $ 41,609 $ 36,871
============================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
7
FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. SIGNIFICANT ACCOUNTING POLICIES
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was established
in 1916. The Bank's wholly owned subsidiaries include Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Farmers & Merchants
Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts
as trustee on deeds of trust originated by the Bank.
The Company's other subsidiaries include F & M Bancorp, Inc. and FMCB Statutory
Trust I. F & M Bancorp, Inc. was created in March 2002 to protect the name F &
M Bank. During 2002, the Company completed a fictitious name filing in
California to begin using the streamlined name, "F & M Bank" as part of a larger
effort to enhance the Company's image and build brand name recognition. In
December 2003, the Company formed a wholly owned subsidiary, FMCB Statutory
Trust I. FMCB Statutory Trust I is a non-consolidated subsidiary per generally
accepted accounting principles (GAAP), and was formed for the sole purpose of
issuing Trust Preferred Securities. The accounting and reporting policies of the
Company conform with accounting principles generally accepted in the United
States of America and prevailing practice within the banking industry. The
following is a summary of the significant accounting and reporting policies used
in preparing the consolidated financial statements.
BASIS OF PRESENTATION
The accompanying consolidated financial statements of the Company have been
prepared in accordance with accounting principles generally accepted in the
United States of America for financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all
adjustments (which consist solely of normal recurring accruals) considered
necessary for a fair presentation of the results for the interim periods
presented have been included. These interim consolidated financial statements
should be read in conjunction with the financial statements and related notes
contained in the Company's 2005 Annual Report to Shareholders on Form 10-K.
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Significant inter-company
transactions have been eliminated in consolidation. The results of operations
for the nine-month period ended September 30, 2006 may not necessarily be
indicative of the operating results for the full year 2006.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
8
CASH AND CASH EQUIVALENTS
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
INVESTMENT SECURITIES
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a level yield of
interest over the estimated remaining period until maturity. Losses, reflecting
a decline in value judged by the Company to be other than temporary, are
recognized in the period in which they occur.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. These securities are reported at fair value with aggregate unrealized
gains or losses excluded from income and included as a separate component of
shareholders' equity, net of related income taxes. Fair values are based on
quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
LOANS
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income; thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate, or the observable or estimated market price of the loan or on the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on non-accrual status with income reported accordingly. Cash payments are
first applied as a reduction of the principal balance until collection of the
remaining principal and interest can be reasonably assured. Thereafter, interest
income is recognized as it is collected in cash.
9
ALLOWANCE FOR LOAN LOSSES
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is reduced
by charge-offs and increased by provisions charged to operating expense and by
recoveries on loans previously charged-off. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly basis,
management reviews the credit quality of the loan portfolio and considers many
factors in determining the adequacy of the allowance at the balance sheet date.
The factors evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, current levels of problem loans and delinquencies, credit quality
trends, collateral values, loan volumes and concentrations, seasoning of the
loan portfolio, specific industry conditions, recent loss experience, duration
of the current business cycle, bank regulatory examination results and findings
of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures." These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4
to the Consolidated Financial Statements in the Company's 2005 Annual Report to
Shareholders.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become probable.
PREMISES AND EQUIPMENT
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
OTHER REAL ESTATE
Other real estate, which is included in other assets, is comprised of properties
no longer utilized for business operations and property acquired through
foreclosure in satisfaction of indebtedness. These properties are recorded at
fair value less estimated selling costs upon acquisition. Revised estimates to
the fair value less cost to sell are reported as adjustments to the carrying
amount of the asset, provided that such adjusted value is not in excess of the
carrying amount at acquisition. Initial losses on properties acquired through
full or partial satisfaction of debt are treated as credit losses and charged to
the Allowance for Loan Losses at the time of acquisition. Subsequent declines in
value from the recorded amounts, routine holding costs, and gains or losses upon
disposition, if any, are included in non-interest income or expense as incurred.
INCOME TAXES
The Company uses the liability method of accounting for income taxes. This
method results in the recognition of deferred tax assets and liabilities that
are reflected at currently enacted income tax rates applicable to the period in
which the deferred tax assets or liabilities are expected to be realized or
10
settled. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes. The deferred
provision for income taxes is the result of the net change in the deferred tax
asset and deferred tax liability balances during the year. This amount combined
with the current taxes payable or refundable results in the income tax expense
for the current year.
DIVIDENDS AND EARNINGS PER SHARE
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded. No
cash dividends were declared during the third quarter of 2006.
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding for the period. The weighted average
number of shares outstanding for the three and nine month periods ended
September 30, 2006 were 814,887 and 818,719. The weighted average number of
shares outstanding for the three and nine month periods ended September 30, 2005
were 827,012 and 829,976. Prior periods have been restated for stock dividends
paid in 2005. No stock dividends have been paid in 2006.
SEGMENT REPORTING
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related Information" requires that public companies report
certain information about operating segments. It also requires that public
companies report certain information about their products and services, the
geographic areas in which they operate, and their major customers. The Company
is a holding company for a community bank which offers a wide array of products
and services to its customers. Pursuant to its banking strategy, emphasis is
placed on building relationships with its customers, as opposed to building
specific lines of business. As a result, the Company is not organized around
discernable lines of business and prefers to work as an integrated unit to
customize solutions for its customers, with business line emphasis and product
offerings changing over time as needs and demands change. Therefore, only one
segment is reported.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative
Instruments and Certain Hedging Activities" as amended by the Statement of
Financial Accounting Standards, No. 138, establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. All derivatives,
whether designated in hedging relationships or not, are required to be recorded
on the balance sheet at fair value. Changes in the fair value of those
derivatives are accounted for depending on the intended use of the derivative
and the resulting designation under specified criteria. If the derivative is
designated as a fair value hedge, the changes in the fair value of the
derivative and of the hedged item attributable to the hedged risk are recognized
in earnings. If the derivative is designated as a cash flow hedge, designed to
minimize interest rate risk, the effective portions of the change in the fair
value of the derivative are recorded in other comprehensive income (loss), net
of related income taxes. Ineffective portions of changes in the fair value of
cash flow hedges are recognized in earnings.
From time to time the Company utilizes derivative financial instruments such as
interest rate caps, floors, swaps and collars. These instruments are purchased
and/or sold to reduce the Company's exposure to changing interest rates. The
Company marks to market the value of its derivative financial instruments and
reflects gain or loss in earnings in the period of change or in other
comprehensive income (loss). The Company was not utilizing any derivative
instruments during the nine month period ended September 30, 2006.
11
COMPREHENSIVE INCOME
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income (loss) includes
net income and changes in fair value of its available-for-sale investment
securities, minimum pension liability adjustments and cash flow hedges.
2. RECENT ACCOUNTING DEVELOPMENTS
In June 2006, the FASB issued Financial Accounting Standards Interpretation No.
48 (FIN 48), "Accounting for Uncertainty in Income Taxes." FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with FASB Statement No. 109, "Accounting for
Income Taxes." FIN 48 prescribes a recognition threshold and measurement
attributable for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosures and transitions. FIN 48 is effective for fiscal
years beginning after December 15, 2006. Management is in the process of
evaluating the impact the adoption of FIN 48 will have on the results of
operations.
In September 2006, the FASB issued Statement No. 157 (SFAS 157), "Fair Value
Measurements." SFAS 157 defines fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurements. SFAS
157 applies whenever other standards require (or permit) assets or liabilities
to be measured at fair value but does not expand the use of fair value in any
new circumstances. In this standard, the FASB clarifies the principle that fair
value should be based on the assumptions market participants would use when
pricing the asset or liability. In support of this principle, SFAS 157
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. The provisions of SFAS 157 are effective for
financial statements issued for fiscal years beginning after November 15, 2007
and interim periods within those fiscal years. Management is in the process of
evaluating the impact the adoption of SFAS 157 will have on the results of
operations.
In September 2006, the FASB ratified the consensuses reached by the Emerging
Issues Task Force (the Task Force) on Issue No. 06-5 (EITF 06-5) "Accounting for
the Purchases of Life Insurance - Determining the Amount that Could be Realized
in Accordance with FASB Technical Bulletin No.85-4" (FTB 85-4). FTB 85-4
indicates that the amount of the asset included in the balance sheet for life
insurance contracts within its scope should be "the amount that could be
realized under the insurance contract as of the date of the statement of
financial position." Questions arose in applying the guidance in FTB 85-4 to
whether "the amount that could be realized" should consider 1) any additional
amounts included in the contractual terms of the insurance policy other than the
cash surrender value and 2) the contractual ability to surrender all of the
individual-life policies (or certificates in a group policy) at the same time.
EITF 06-5 determined that "the amount that could be realized" should 1) consider
any additional amounts included in the contractual terms of the policy and 2)
assume the surrender of an individual-life by individual-life policy (or
certificate by certificate in a group policy. Any amount that is ultimately
realized by the policy holder upon the assumed surrender of the final policy (or
final certificate in a group policy) shall be included in the "amount that could
be realized." An entity should apply the provisions of EITF 06-5 through either
a change in accounting principle through a cumulative-effect adjustment to
retained earnings as of the beginning of the year of adoption or a change in
accounting principle through retrospective application to all prior periods.
The provisions of EITF 06-5
12
are effective for fiscal years beginning after December 15, 2006. Management is
in the process of evaluating the impact the adoption of EITF 06-5 will have on
the results of operations.
In September 2006, the FASB ratified the consensuses reached by the Task Force
on Issue No. 06-4 (EITF 06-4) "Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements." A question arose when an employer enters into an endorsement
split-dollar life insurance arrangement related to whether the employer should
recognize a liability for the future benefits or premiums to be provided to the
employee. EITF 06-4 indicates that an employer should recognize a liability for
future benefits and that a liability for the benefit obligation has not been
settled through the purchase of an endorsement type policy. An entity should
apply the provisions of EITF 06-4 either through a change in accounting
principle through a cumulative-effect adjustment to retained earnings as of the
beginning of the year of adoption or a change in accounting principle through
retrospective application to all prior periods. The provisions of EITF 06-4 are
effective for fiscal years beginning after December 15, 2007. Management is in
the process of evaluating the impact the adoption of EITF 06-4 will have on the
results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108 ("SAB 108"),
"Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements", providing guidance on
quantifying financial statement misstatement and implementation (e.g.,
restatement or cumulative effect to assets, liabilities and retained earnings)
when first applying this guidance. SAB 108 is effective for fiscal years ending
after November 15, 2006. The Company does not believe the guidance provided by
SAB 108 will have a material effect on the Company's financial condition or
results of operations.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following is management's discussion and analysis of the major factors that
influenced our financial performance for the three and nine months ended
September 30, 2006. This analysis should be read in conjunction with our 2005
Annual Report, filed as exhibit 13 on Form 10-K, and with the unaudited
financial statements and notes as set forth in this report.
FORWARD-LOOKING STATEMENTS
This quarterly report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of
13
further acts or threats of terrorism; and (viii) other factors discussed in the
Company's Form 10-K filing for the year-ended December 31, 2005 with the
Securities and Exchange Commission.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
INTRODUCTION
Farmers & Merchants Bancorp, or the Company, is a bank holding company formed
March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California,
or the Bank, is a California, state-chartered bank formed in 1916. The Bank
serves the northern Central Valley of California with 20 banking offices. The
service area includes Sacramento, San Joaquin, Stanislaus and Merced Counties
with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto,
Turlock and Hilmar.
Substantially all of the Company's business activities are conducted within its
market area.
As a bank holding company, the Company is subject to regulation and examination
by the Board of Governors of the Federal Reserve System ("FRB"). Since the Bank
is a California, state-chartered, non-FED member bank, it is subject to the
regulation and examination of the California Department of Financial
Institutions and the Federal Deposit Insurance Corporation.
OVERVIEW
The Company's primary service area encompasses the northern Central Valley of
California, a region that is impacted by the seasonal needs of the agricultural
industry. Accordingly, discussion of the Company's Financial Condition and
Results of Operations is influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in fall and winter as crops are harvested and
sold).
For the three and nine months ended September 30, 2006, Farmers & Merchants
Bancorp reported net income of $5,333,000 and $15,364,000, earnings per share of
$6.54 and $18.77 and return on average assets of 1.54% and 1.51%, respectively.
Return on average shareholders' equity was 16.81% and 16.23% for the three and
nine months ended September 30, 2006.
For the three and nine months ended September 30, 2005, Farmers & Merchants
Bancorp reported net income of $4,747,000 and $13,767,000, earnings per share of
$5.74 and $16.59 and return on average assets of 1.50% and 1.47%, respectively.
Return on average shareholders' equity was 15.73% and 15.31% for the three and
nine months ended September 30, 2005.
The Company's improved earnings performance in the first nine months of 2006
when compared to the same period last year was due to a combination of (1)
growth in earning assets; and (2) improvement in the net interest margin due to
rising interest rates.
The following is a summary of the financial results for the nine-month period
ended September 30, 2006 compared to September 30, 2005.
- Net income increased 11.6% to $15.4 million from $13.8 million.
14
- Earnings per share increased 13.1% to $18.77 from $16.59.
- Net interest income increased 12.2% to $47.9 million from $42.7 million.
- Net interest margin on a tax-equivalent basis increased 16 basis points
from 5.07% to 5.23%.
- Total assets increased 9.5% to $1.4 billion.
- Gross loans increased 9.6% to $1.0 billion.
- Total deposits increased 6.5% to $1.1 billion.
RESULTS OF OPERATIONS
NET INTEREST INCOME / NET INTEREST MARGIN
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the three and nine month periods ending
September 30, 2006 and 2005.
The average yields on earning assets and average rates paid on interest-bearing
liabilities have been computed on an annualized basis for purposes of
comparability with full year data. Average balance amounts for assets and
liabilities are the computed average of daily balances.
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on
tax-exempt investments and municipal loans is adjusted to an amount comparable
to interest subject to normal income taxes. This adjustment is referred to as
"taxable equivalent" and is noted wherever applicable.
The Volume and Rate Analysis of Net Interest Income summarizes the changes in
interest income and interest expense based on changes in average asset and
liability balances (volume) and changes in average rates (rate). For each
category of interest-earning assets and interest-bearing liabilities,
information is provided with respect to changes attributable to: (1) changes in
volume (change in volume multiplied by initial rate); (2) changes in rate
(change in rate multiplied by initial volume); and (3) changes in rate/volume
(allocated in proportion to the respective volume and rate components).
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some
maturity mismatch is inherent in the asset and liability mix. (See Item 3.
"Quantitative and Qualitative Disclosures about Market Risk: Market Risk -
Interest Rate Risk").
15
FARMERS & MERCHANTS BANCORP
QUARTERLY AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Three Months Ended Sept 30, Three Months Ended Sept 30,
2006 2005
ASSETS Balance Interest Rate Balance Interest Rate
-----------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 772 $ 11 5.65% $ 4,817 $ 41 3.38%
Investment Securities Available-for-Sale
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 30,834 315 4.09% 57,496 548 3.81%
Municipals - Taxable 0 0 0.00% 0 0 0.00%
Municipals - Non-Taxable 15,417 251 6.51% 15,699 223 5.68%
Mortgage Backed Securities 104,379 1,258 4.82% 75,354 729 3.87%
Other 7,516 103 5.48% 3,548 64 7.22%
-----------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Available-for-Sale 158,146 1,927 4.87% 152,097 1,564 4.11%
-----------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 30,580 317 4.15% 30,701 308 4.01%
Municipals - Taxable 0 0 0.00% 0 0 0.00%
Municipals - Non-Taxable 66,910 997 5.96% 67,403 945 5.61%
Mortgage Backed Securities 9,474 90 3.80% 11,932 112 3.75%
Other 2,119 16 3.02% 277 7 10.11%
-----------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Held-to-Maturity 109,083 1,420 5.21% 110,313 1,372 4.97%
-----------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 575,798 10,600 7.30% 506,791 8,689 6.80%
Home Equity 67,695 1,392 8.16% 65,976 1,100 6.61%
Agricultural 172,982 3,769 8.64% 152,599 2,747 7.14%
Commercial 178,849 3,825 8.48% 169,625 3,089 7.22%
Consumer 13,580 285 8.33% 12,905 301 9.25%
Credit Card 5,553 133 9.50% 5,095 124 9.66%
Municipal 1,460 11 2.99% 1,002 11 4.36%
-----------------------------------------------------------------------------------------------------------------------------
Total Loans 1,015,917 20,015 7.82% 913,993 16,061 6.97%
-----------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,283,918 $ 23,373 7.22% 1,181,220 $ 19,038 6.39%
========================= =========================
Unrealized Gain/(Loss) on Securities
Available-for-Sale (4,856) (2,053)
Allowance for Loan Losses (18,421) (17,933)
Cash and Due From Banks 37,797 35,904
All Other Assets 83,887 72,959
---------------------------------------------------------- -----------
TOTAL ASSETS $1,382,325 $1,270,097
========================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 126,585 $ 22 0.07% $ 116,849 $ 20 0.07%
Savings 274,822 665 0.96% 291,876 324 0.44%
Time Deposits 434,155 4,361 3.99% 358,160 2,345 2.60%
-----------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 835,562 5,048 2.40% 766,885 2,689 1.39%
Other Borrowed Funds 120,045 1,590 5.25% 89,120 992 4.42%
Subordinated Debentures 10,310 218 8.39% 10,310 166 6.39%
-----------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 965,917 $ 6,856 2.82% 866,315 $ 3,847 1.76%
========================= =========================
Interest Rate Spread 4.41% 4.63%
Demand Deposits (Non-Interest Bearing) 270,111 266,351
All Other Liabilities 19,395 16,722
--------------------------------------------------------- ----------
TOTAL LIABILITIES 1,255,423 1,149,388
Shareholders' Equity 126,902 120,709
---------------------------------------------------------- ----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,382,325 $1,270,097
========================================================== ===========
Impact of Non-Interest Bearing
Deposits and Other Liabilities 0.70% 0.47%
Net Interest Income and Margin
on Total Earning Assets 16,517 5.10% 15,191 5.10%
Tax Equivalent Adjustment (423) (333)
-----------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 16,094 4.97% $ 14,858 4.99%
=============================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan interest income
includes fee income and unearned discount in the amount of $596,000 and $877,000 for the quarters ended September 30, 2006
and 2005, respectively. Yields on securities available-for-sale are based on historical cost.
16
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Nine Months Ended Sept. 30, Nine Months Ended Sept. 30,
2006 2005
ASSETS Balance Interest Rate Balance Interest Rate
--------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 1,334 $ 48 4.81% $ 4,474 $ 97 2.90%
Investment Securities Available-for-Sale
U.S. Agencies 30,846 939 4.06% 62,360 1,739 3.72%
Municipals - Taxable - - 0.00% 108 5 6.17%
Municipals - Non-Taxable 15,652 745 6.34% 16,175 741 6.11%
Mortgage Backed Securities 106,765 3,746 4.68% 79,820 2,341 3.91%
Other 5,509 260 6.29% 4,517 180 5.31%
--------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Available-for-Sale 158,772 5,690 4.78% 162,980 5,006 4.10%
--------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 30,607 952 4.15% 27,443 859 4.17%
Municipals - Non-Taxable 66,389 2,953 5.93% 64,114 2,882 5.99%
Mortgage Backed Securities 10,059 288 3.82% 12,556 358 3.80%
Other 2,122 47 2.95% 286 15 6.99%
--------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Held-to-Maturity 109,177 4,240 5.18% 104,399 4,114 5.25%
--------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 558,734 29,953 7.17% 501,071 24,929 6.65%
Home Equity 67,002 3,973 7.93% 64,426 2,961 6.14%
Agricultural 163,362 10,161 8.32% 139,178 6,999 6.72%
Commercial 179,773 11,199 8.33% 164,668 8,518 6.92%
Consumer 13,476 877 8.70% 12,647 822 8.69%
Credit Card 5,435 400 9.84% 4,992 369 9.88%
Municipal 1,175 32 3.64% 988 33 4.47%
--------------------------------------------------------------------------------------------------------------------------
Total Loans 988,957 56,595 7.65% 887,970 44,631 6.72%
--------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,258,240 $ 66,572 7.07% 1,159,823 $ 53,848 6.21%
======================== =======================
Unrealized Gain/(Loss) on Securities
Available-for-Sale (4,034) (1,496)
Allowance for Loan Losses (18,300) (17,881)
Cash and Due From Banks 37,518 34,268
All Other Assets 80,373 70,682
---------------------------------------------------------- -----------
TOTAL ASSETS $1,353,797 $1,245,396
========================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 128,382 $ 67 0.07% $ 114,493 $ 58 0.07%
Savings 278,262 1,512 0.73% 299,336 977 0.44%
Time Deposits 405,998 10,936 3.60% 352,939 5,956 2.26%
--------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 812,642 12,515 2.06% 766,768 6,991 1.22%
Other Borrowed Funds 111,024 4,255 5.12% 73,003 2,441 4.47%
Subordinated Debentures 10,310 613 7.95% 10,310 463 6.00%
--------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 933,976 $ 17,383 2.49% 850,081 $ 9,895 1.56%
======================== =======================
Interest Rate Spread 4.59% 4.65%
Demand Deposits (Non-Interest Bearing) 277,025 260,482
All Other Liabilities 16,588 14,966
---------------------------------------------------------- -----------
TOTAL LIABILITIES 1,227,589 1,125,529
Shareholders' Equity 126,208 119,867
---------------------------------------------------------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,353,797 $1,245,396
========================================================== ===========
Impact of Non-Interest Bearing
Deposits and Other Liabilities 0.64% 0.42%
Net Interest Income and Margin
on Total Earning Assets 49,189 5.23% 43,953 5.07%
Tax Equivalent Adjustment (1,250) (1,233)
--------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 47,939 5.09% $ 42,720 4.92%
==========================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan interest income includes
fee income and unearned discount in the amount of $2.1 million and $2.6 million for the nine months ended September 30, 2006
and 2005, respectively. Yields on securities available-for-sale are based on historical cost.
17
FARMERS & MERCHANTS BANCORP
VOLUME AND RATE ANALYSIS OF NET INTEREST REVENUE
(Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Nine Months Ended
Sept. 30, 2006 Compared to Sept. 30, 2005 Sept. 30, 2006 Compared to Sept. 30, 2005
INTEREST EARNING ASSETS Volume Rate Net Chg. Volume Rate Net Chg.
------------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ (47) $ 17 $ (30) $ (91) $ 42 $ (49)
Investment Securities Available for Sale
U.S. Treasuries 0 0 0 0 0 0
U.S. Agencies (270) 37 (233) (947) 147 (800)
Municipals - Taxable 0 0 0 (2) (3) (5)
Municipals - Non-Taxable (4) 32 28 (24) 28 4
Mortgage Backed Securities 323 206 529 888 517 1,405
Other 58 (19) 39 44 36 80
------------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Available for Sale 107 256 363 (41) 725 684
------------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Treasuries 0 0 0 0 0 0
U.S. Agencies (1) 10 9 98 (5) 93
Municipals - Taxable 0 0 0 0 0 0
Municipals - Non-Taxable (7) 59 52 101 (30) 71
Mortgage Backed Securities (23) 1 (22) (71) 1 (70)
Other 17 (8) 9 45 (13) 32
------------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities
Held to Maturity (14) 62 48 173 (47) 126
------------------------------------------------------------------------------------------------------------------------------------
Loans:
Real Estate 1,239 672 1,911 3,002 2,022 5,024
Home Equity 29 263 292 123 889 1,012
Agricultural 397 625 1,022 1,339 1,823 3,162
Commercial 175 561 736 831 1,850 2,681
Consumer 15 (31) (16) 54 1 55
Credit Card 11 (2) 9 33 (2) 31
Other 4 (4) 0 5 (7) (2)
------------------------------------------------------------------------------------------------------------------------------------
Total Loans 1,870 2,084 3,954 5,387 6,576 11,963
------------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,916 2,419 4,335 5,428 7,296 12,724
------------------------------------------------------------------------------------------------------------------------------------
INTEREST BEARING LIABILITIES
Interest Bearing
Deposits:
Transaction 2 0 2 7 2 9
Savings (20) 361 341 (74) 609 535
Time Deposits 574 1,442 2,016 1,003 3,977 4,980
------------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 556 1,803 2,359 936 4,588 5,524
Other Borrowed Funds 386 212 598 1,417 397 1,814
Subordinated Debentures 0 52 52 0 150 150
------------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 942 2,067 3,009 2,353 5,135 7,488
------------------------------------------------------------------------------------------------------------------------------------
TOTAL CHANGE $ 974 $ 352 $ 1,326 $ 3,075 $ 2,161 $ 5,236
====================================================================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the
total "net change". The above figures have been rounded to the nearest whole number.
18
3RD QUARTER 2006 VS. 3RD QUARTER 2005
Net interest income for the third quarter of 2006 increased 8.3% to $16.1
million, compared to $14.8 million for the third quarter of 2005. On a fully
taxable equivalent basis, net interest income increased 8.7% and totaled $16.5
million for the third quarter of 2006, compared to $15.2 million for the third
quarter of 2005.
The primary reason for the increase in net interest income during the third
quarter of 2006 when compared to the same period last year was a 8.7% growth in
average earning assets and an improvement in the mix of average earning assets
(as reflected by an increase in average loans as a percentage of average earning
assets).
For the three months ended September 30, 2006 the Company's net interest margin
on a fully taxable equivalent basis was 5.10%, the same as it was for the three
months ended September 30, 2005. This represents the first quarter since the
Federal Reserve Bank began raising rates in July, 2004 that the Company's net
interest margin did not increase when compared to the same period in the prior
year. Despite the fact that market interest rates were higher overall during
the 3rd quarter of 2006 than in 2005, rates on average interest bearing
liabilities increased more than yields on earning assets over this period,
offsetting any improvement in the Company's net interest margin from volume and
mix factors (as discussed above).
Current trends in the pricing of both loans and deposits will, in management's
opinion, continue to place pressures on the Company's net interest margin in
future quarters. For further discussion see Market Risk - Interest Rate Risk
under Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Loans, generally the Company's highest earning asset, increased $90.6 million as
of September 30, 2006 compared to September 30, 2005. On an average balance
basis, loans increased by $101.9 million for the three months ended September
30, 2006 compared to the three months ended September 30, 2005. The yield on
the loan portfolio increased 85 basis points to 7.82% for the three months ended
September 30, 2006 compared to 6.97% for the three months ended September 30,
2005. This increase in yield and volume resulted in interest revenue from loans
increasing 24.6% to $20.0 million for the third quarter of 2006 compared to
$16.1 million for the third quarter of 2005.
The investment portfolio is the other main component of the Company's earning
assets. Management believes the Company's investment policy is conservative.
The Company invests primarily in mortgage-backed securities, U.S. Government
Agencies, and high-grade municipals. Since the risk factor for these types of
investments is significantly lower than that of loans, the yield earned on
investments is generally less than that of loans.
Average investment securities were $267.2 million for the third quarter of 2006
compared to $262.4 million for the third quarter of 2005. The average yield, on
a taxable equivalent basis (TE), in the investment portfolio was 5.01% for the
third quarter of 2006 compared to 4.48% for the third quarter of 2005. The
increase in the yield on investment securities combined with the small increase
in volume resulted in an increase in interest income of $411,000, or 14.0%, for
the three months ended September 30, 2006. Net interest income on the Schedule
of Year-to-Date Average Balances and Interest Rates is shown on a taxable
equivalent basis (TE), which is higher than net interest income on the
Consolidated Statements of Income because of adjustments that relate to income
on certain securities that are exempt from federal income taxes.
19
Compared to the third quarter of 2005, the Company has grown average
interest-bearing sources of funds by $99.6 million or 11.5%. Interest bearing
deposits grew $68.7 million while all other interest bearing sources of funds
(including FHLB Advances) increased by $30.9 million (see Deposits and Federal
Home Loan Bank Advances and Other Borrowings). Overall, the average interest
rate on interest-bearing sources of funds was 2.82% for the three months ended
September 30, 2006 and 1.76% for the three months ended September 30, 2005. The
increase in the volume and rate on interest-bearing sources of funds resulted in
an increase in interest expense of $3.0 million, or 78.2%, for the three months
ended September 30, 2006 over the same period in 2005.
NINE MONTHS ENDING SEPTEMBER 30, 2006 VS. NINE MONTHS ENDING SEPTEMBER 30, 2005
During the first nine months of 2006, net interest income increased 12.2% to
$47.9 million, compared to $42.7 million at September 30, 2005. On a fully
taxable equivalent basis, net interest income increased 11.9% and totaled $49.2
million for the nine months ended September 30, 2006, compared to $43.9 million
for the same period in 2005.
As reported in previous quarters, one of the reasons for the increase in net
interest income during the first nine months of 2006 when compared to the same
period last year was an improvement in the volume and mix of average earning
assets (as reflected by an increase in average loans as a percentage of average
earning assets). Moreover, as a result of the Federal Reserve Bank having
increased short-term market interest rates by 425 basis points since June 2004,
the Company's net interest income has also benefited substantially from an
increase in the yield on average earning assets.
For the nine months ended September 30, 2006, the Company's net interest margin
was 5.23% compared to 5.07% for the same period in 2005. The Company's yield on
earning assets has improved over the last twelve months as a result of increases
in short-term market interest rates. For further discussion see Market Risk -
Interest Rate Risk under Item 3. Quantitative and Qualitative Disclosures About
Market Risk.
Although the Company's net interest margin has improved year-to-date over the
same period in the prior year, current trends in the pricing of both loans and
deposits (see "3rd Quarter 2006 vs. 3rd Quarter 2005") have placed pressures on
the Company's net interest margin in recent quarters, and will, in management's
opinion, continue to place pressures on the net interest margin in future
quarters.
Loans, on an average balance basis, increased by $101.0 million for the nine
months ended September 30, 2006 compared to the nine months ended September 30,
2005. The yield on the loan portfolio increased 93 basis points to 7.65% for
the nine months ended September 30, 2006 compared to 6.72% for the nine months
ended September 30, 2005. This increase in yield and volume resulted in
interest revenue from loans increasing 26.8% or $12.0 million for the first nine
months of 2006.
Average investment securities were $267.9 million for the nine months ended
September 30, 2006 compared to $267.4 million for the same period in 2005. The
average yield (TE) for the nine months ended September 30, 2006 was 4.94%
compared to 4.55% for the nine months ended September 30, 2005, partially due to
an increase in higher yielding mortgage backed securities. The increase in the
yield on investment securities combined with the small increase in volume
resulted in an increase in interest income of $809,000, or 8.9% for the nine
months ended September 30, 2006.
Compared to the first nine months of 2005, the Company has grown average
interest-bearing sources of funds by $83.9 million or 9.9%. Interest bearing
deposits grew $45.9 million while all other interest bearing sources of funds
(including FHLB Advances) increased by $38.0 million (see Deposits and
20
Federal Home Loan Bank Advances and Other Borrowings). Overall, the average
interest rate on interest-bearing sources of funds was 2.49% for the nine months
ended September 30, 2006 and 1.56% for the nine months ended September 30, 2005.
The increase in the volume and rate on interest-bearing sources of funds
resulted in an increase in interest expense of $7.5 million, or 75.7%, for the
nine months ended September 30, 2006 compared to the same period in 2005.
ALLOWANCE AND PROVISION FOR LOAN LOSSES
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the loan portfolio. The allowance for loan losses is maintained at
a level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy
of the allowance for loan losses, management takes into consideration
examinations by the Company's supervisory authorities, results of internal
credit reviews, financial condition of borrowers, loan concentrations, prior
loan loss experience, and general economic conditions. The allowance is based
on estimates and ultimate losses may vary from the current estimates.
Management reviews these estimates periodically and, when adjustments are
necessary, they are reported in the period in which they become known.
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approval standards, dollar limits on loans to one borrower and
by restricting loans made primarily to its principal market area where
management believes it is better able to assess the applicable risk.
Additionally, management has established guidelines to ensure the
diversification of the Company's credit portfolio such that even within key
portfolio sectors such as real estate or agriculture, the portfolio is
diversified across factors such as location, building type, crop type, etc.
Management reports regularly to the Board of Directors regarding trends and
conditions in the loan portfolio and regularly conducts credit reviews of
individual loans. Loans that are performing but have shown some signs of
weakness are subjected to more stringent reporting and oversight.
The provision for loan losses totaled $275,000 for the first nine months of
2006. There was no provision for the first nine months of 2005. Changes in the
provision between the first nine months of 2006 and 2005 were the result of
management's evaluation of the adequacy of the allowance for loan losses
relative to factors such as the credit quality of the loan portfolio, loan
growth, current loan losses and the prevailing economic climate and its effect
on borrowers' ability to repay loans in accordance with the terms of the notes
(see "Note 1. Critical Accounting Policies and Estimates - Allowance for Loan
Losses" and "Item 3. Quantitative and Qualitative Disclosures About Market
Risk-Credit Risk").
The allowance for loan losses was $18.3 million or 1.8% of the total loan
balance and $17.9 million or 1.9% of the total loan balance at September 30,
2006 and September 30, 2005, respectively. As of December 31, 2005, the
allowance for loan losses was $17.9 million, which represented 1.8% of the total
loan balance. After reviewing all factors above, management concluded that the
allowance for loan losses as of September 30, 2006 was adequate. See the table
below for allowance for loan loss activity for the periods indicated.
21
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands) 2006 2005 2006 2005
-----------------------------------------------------------------------------------------------------------
Balance at Beginning of Period $ 18,531 $ 17,943 $ 17,860 $ 17,727
Provision Charged to Expense - - 275 -
Recoveries of Loans Previously Charged Off 70 41 735 537
Loans Charged Off (301) (79) (570) (359)
===========================================================================================================
Balance at End of Period $ 18,300 $ 17,905 $ 18,300 $ 17,905
===========================================================================================================
NON-INTEREST INCOME
Non-interest income includes: (1) service charges and fees from deposit
accounts; (2) net gains and losses from the sale of investment securities; (3)
credit card merchant fees; (4) ATM fees; (5) increases in the cash surrender
value of bank owned life insurance; and (6) fees from other miscellaneous
business services. Overall, non-interest income increased $130,000 or 4.4% for
the three months ended September 30, 2006 compared to the same period of 2005.
The primary reason for this increase was fees related to the Company's Overdraft
Privilege Service which was offered to eligible customers with deposit accounts
in good standing beginning May 1, 2006. These fees increased $644,000 for the
three months ending September 30, 2006 compared to the same period in 2005.
Offsetting this increase in fees were losses on sale of investment securities
which increased 116.3% or $357,000 (See "Investment Securities").
Non-interest income increased $308,000 or 3.5% for the nine months ended
September 30, 2006 compared to the same period of 2005. The primary reasons for
this change were: (1) an increase of $1.2 million in fees related to the
Company's Overdraft Privilege Service; (2) an increase of $178,000 in ATM fees;
offset by (3) a $1.1 million increase in losses on the sale of
available-for-sale investment securities (See "Investment Securities").
NON-INTEREST EXPENSE
Non-interest expense for the Company includes expenses for salaries and employee
benefits, occupancy, equipment, supplies, legal fees, professional services,
data processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.
Non-interest expense increased $325,000 or 3.1% over the third quarter of 2005,
primarily as a result of an $110,000 increase in operating losses related to our
Overdraft Privilege Service which was offered to eligible customers with deposit
accounts in good standing beginning May 1, 2006. The increase in fees (See
"Non-Interest Income") related to this program has also resulted in an increase
in operating charges related to those fees. The other major factors impacting
non-interest expense were an increase in direct mail expenses related to certain
deposit products in the amount of $185,000 and a $98,000 early payoff penalty on
Federal Home Loan Bank Advances (See "Federal Home Loan Bank Advances and Other
Borrowings"). Offsetting these increases was a decrease of $108,000 in salaries
& employee benefits due to reduced contributions to the Company's employee
incentive bonus plans to align with our year-end projections.
Non-interest expense for the nine months ended September 30, 2006 increased $2.6
million or 8.6% over the same period in 2005, primarily as a result of a $1.1
million increase in salaries and employee benefits on a year-to-date basis.
Salaries and employee benefits increased over the prior year due to officer
raises that took place in November 2005 and increased contributions to the
Company's employee incentive
22
plans. Additionally, remodeling and expansion of the Bank's branch network has
impacted non-interest expense along with expanded software maintenance
contracts.
PROVISION FOR INCOME TAXES
The provision for income taxes increased 17.2% to $3.1 million for the third
quarter of 2006. The Company's effective tax rate increased for the third
quarter of 2006 and was 36.7% compared to 35.8% for the same period in 2005.
This increase in the effective tax rate was due to a decrease in the mix of
tax-exempt income from municipal securities and cash surrender value of life
insurance policies.
The provision for income taxes increased 13.9% to $8.8 million for the first
nine months of 2006. The Company's effective tax rate increased for the first
nine months of 2006 and was 36.5% compared to 36.0% for the same period in 2005.
FINANCIAL CONDITION
This section presents a comparison of the Company's financial condition for the
nine month period ending September 30, 2006 and the same period in 2005. As
previously discussed (see "Overview") the seasonality of the Company's business
due to its agricultural customer base makes a comparison of the September 30th
financial condition to the preceding December 31st not meaningful.
INVESTMENT SECURITIES
The investment portfolio provides the Company with an income alternative to
loans as well as a tool to better manage its liquidity and interest rate risk.
As of September 30, 2006 the investment portfolio represented 18.6% of the
Company's total assets. Total investment securities increased $9.6 million from
a year ago and now total $264.0 million. During the first nine months of 2006,
the Company sold $27.6 million in available-for-sale investment securities at a
loss of $1.1 million. These securities had a remaining life under three years
and yields below current market rates. Funds not invested in loans were
reinvested in higher yielding, somewhat longer-term (5-7 years) securities which
should serve to strengthen the Company's future net interest margin, reduce the
Company's asset sensitivity, and better protect against future declines in
market interest rates.
Not included in the investment portfolio are overnight investments in Federal
Funds Sold. For the nine months ended September 30, 2006, average Federal Funds
Sold was $1.3 million compared to $4.5 million at September 30, 2005.
The Company classifies its investments as held-to-maturity, trading or
available-for-sale. Securities are classified as held-to-maturity and are
carried at amortized cost when the Company has the intent and ability to hold
the securities to maturity. Trading securities are securities acquired for
short-term appreciation and are carried at fair value, with unrealized gains and
losses recorded in non-interest income. As of September 30, 2006 and 2005 there
were no securities in the trading portfolio. Securities classified as
available-for-sale include securities which may be sold to effectively manage
interest rate risk exposure, prepayment risk, satisfy liquidity demands and
other factors. These securities are reported at fair value with aggregate,
unrealized gains or losses excluded from income and included as a separate
component of shareholders' equity, net of related income taxes.
Losses in the investment portfolio, reflecting a decline in value judged by the
Company to be other than temporary, are recognized in the period in which they
occur. As of September 30, 2006, the Company held 200 investments of which 64
were in a loss position for 12 months or more. Management periodically evaluates
each investment security for other than temporary impairment relying primarily
on
23
industry analyst reports and observations of market conditions and interest rate
fluctuations. Based on the evaluation as of September 30, 2006, management
determined that there were no securities that qualified as "Other Than
Temporarily Impaired."
LOANS
The Company's loan portfolio at September 30, 2006 increased $90.6 million, or
9.5%, from September 30, 2005. The increase was due to strong loan demand in
the Company's market area, along with an aggressive calling program on selected
loan prospects. Additionally, on an average balance basis loans have increased
$101.0 million or 11.4% from the prior year. Real Estate Loans, primarily those
secured by production agricultural properties, have increased 16.1% from the
prior year. The following table sets forth the distribution of the loan
portfolio by type as of the dates indicated.
Loan Portfolio As Of:
---------------------
(in thousands) September 30, 2006 Dec. 31, 2005 September 30, 2005
-------------------------------------------------------------------------------------------
Real Estate $ 511,335 $ 432,378 $ 440,600
Real Estate Construction 79,295 110,235 78,269
Home Equity 68,758 69,013 67,729
Agricultural 173,505 170,657 157,661
Commercial 184,268 174,530 184,088
Consumer 20,513 18,958 18,692
-------------------------------------------------------------------------------------------
Gross Loans 1,037,674 975,771 947,039
Less:
Unearned Income 2,474 2,514 2,460
Allowance for Loan Losses 18,300 17,860 17,905
-------------------------------------------------------------------------------------------
Net Loans $ 1,016,900 $ 955,397 $ 926,674
===========================================================================================
NON-PERFORMING ASSETS
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of
September 30, 2006 were $80,000 compared to $259,000 at September 30, 2005.
Accrued interest reversed from income on loans placed on a non-accrual status
totaled $14,000 at September 30, 2006 compared to $9,000 at September 30, 2005.
The Company has reported no other real estate owned from September 30, 2005
through September 30, 2006.
Non-Performing Assets
---------------------
(in thousands) September 30, 2006 Dec. 31, 2005 September 30, 2005
--------------------------------------------------------------------------------------------------
Non-Performing Loans $ 80 $ 694 $ 259
Other Real Estate Owned - - -
==================================================================================================
Total $ 80 $ 694 $ 259
==================================================================================================
--------------------------------------------------------------------------------------------------
Non-Performing Assets
as a % of Total Loans 0.01% 0.07% 0.03%
--------------------------------------------------------------------------------------------------
Allowance for Loan Losses as a
% of Non-Performing Loans 22,857.9% 2,573.5% 6,913.1%
--------------------------------------------------------------------------------------------------
24
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of September 30, 2006 for which known credit
problems of the borrower would cause serious doubts as to the ability of these
borrowers to comply with their present loan repayment terms, or any known events
that would result in the loan being designated as non-performing at some future
date. The Company's management cannot, however, predict the extent to which the
following or other factors may affect a borrower's ability to pay: (1)
deterioration in general economic conditions, real estate values or agricultural
commodity prices; (2) increases in interest rates; or (3) changes in the overall
financial condition or business of a borrower.
DEPOSITS
One of the key sources of funds to support earning assets (loans and
investments) is the generation of deposits from the Company's customer base.
The ability to grow the customer base and subsequently deposits is a significant
element in the performance of the Company.
At September 30, 2006, deposits totaled $1.1 billion. This represents an
increase of 6.5% or $67.8 million from September 30, 2005. Core deposits
(exclusive of Public Time Deposits) increased 5.3% over the same period. Public
Time Deposits have increased $15.6 million since September 30, 2005.
Demand, interest bearing transaction and time deposit accounts increased $85.3
million or 11.3% from September 30, 2005. The Company's calling efforts for
prospective customers includes acquiring both loan and deposit relationships
which result in new demand, interest bearing transaction accounts and time
deposits. Savings deposits (which include money market accounts) decreased $17.5
million or 6.1% from September 30, 2005. Savings deposits have declined as
customers have transferred their funds to higher yielding time deposit accounts
with the Bank.
FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS
Advances from the Federal Home Loan Bank are another key source of funds to
support earning assets (see "Item 3. Quantitative and Qualitative Disclosures
about Market Risk and Liquidity Risk"). These advances are also used to manage
the Company's interest rate risk exposure, and as opportunities exist, to borrow
and invest the proceeds at a positive spread through the investment portfolio.
FHLB Advances as of September 30, 2006 were $138.8 million compared to $75.8
million of FHLB Advances as of September 30, 2005. This increase of $62.9
million in borrowings occurred as a result of the Company's growth in average
earning assets exceeding its growth in average deposits by $36.0 million over
the last twelve months. During the third quarter of 2006 the Company prepaid $25
million of long-term advances with a remaining maturity of 18 months. These
advances carried an interest rate of 5.35%. A prepayment penalty of $98,000 was
paid. This action was part of the Company's overall strategy to reduce its asset
sensitivity and protect against future decreases in market interest rates.
LONG-TERM SUBORDINATED DEBENTURES
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. Although this amount is reflected as subordinated debt on
the Company's balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital (see "Capital"). These
securities accrue interest at a variable rate based upon 3-month Libor plus
2.85%. Interest rates reset quarterly and were 8.24% as of September 30, 2006,
7.35% at December 31, 2005 and 6.74% at September 30, 2005.
CAPITAL
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support
25
business growth and to insure depositor protection. Shareholders' Equity
totaled $130.3 million at September 30, 2006 and $123.0 million at September 30,
2005.
The Company and the Bank are subject to capital adequacy requirements
administered by the federal banking agencies. Under these requirements and the
regulatory framework for prompt corrective action, the Company and the Bank must
meet specific capital guidelines that involve quantitative measures of the
Company's and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company's and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors. 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 Company's and the Bank's
financial statements. Management believes, as of September 30, 2006, that the
Company and the Bank meet all capital adequacy requirements to which they are
subject.
In its most recent notification from the Federal Deposit Insurance Corporation
the Bank was categorized as "well capitalized" under the regulatory framework
for prompt corrective action. To be categorized as "well capitalized", the Bank
must maintain minimum Total risk-based, Tier 1 risk-based, Tier 1 leverage
ratios as set forth in the table below. There are no conditions or events since
that notification that management believes have changed the institution's
categories.
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
-------------------------------------------------------------------------------------------------------------------------
THE COMPANY: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
-------------------------------------------------------------------------------------------------------------------------
As of September 30, 2006
Total Capital to Risk Weighted Assets $ 158,101 12.21% $ 103,627 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets 141,881 10.95% 51,814 4.0% N/A N/A
Tier I Capital to Average Assets 141,881 10.34% 54,872 4.0% N/A N/A
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
------------------------------------------------------------------------------------------------------------------------
THE BANK: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
------------------------------------------------------------------------------------------------------------------------
As of September 30, 2006
Total Capital to Risk Weighted Assets 151,263 11.75% 103,009 8.0% 128,761 10.0%
Tier I Capital to Risk Weighted Assets 135,139 10.50% 51,504 4.0% 77,257 6.0%
Tier I Capital to Average Assets 135,139 9.88% 54,708 4.0% 68,385 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December 2003 the Company issued
$10 million of trust preferred securities. On March 1, 2005 the Federal Reserve
Board issued its final rule effective April 11, 2005, concerning the regulatory
capital treatment of trust preferred securities ("TPS") by bank holding
companies ("BHCs"). Under the final rule BHCs may include TPS in Tier 1 capital
in an amount equal to 25% of the sum of core capital net of goodwill. The
quantitative limitation concerning goodwill will not be effective until March
31, 2009. Any portion of trust preferred securities not qualifying as Tier 1
capital would qualify as Tier 2 capital subject to certain limitations. The
Company has received notification from the Federal Reserve Bank of San Francisco
that all of the Company's trust preferred securities currently qualify as Tier 1
capital.
26
In accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continued
to have more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as "well capitalized." On April 4,
2006, the Board unanimously approved expanding the Repurchase Program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired
(see the Company's 2005 Form 10-K, Part II, Item 5. Market for Registrant's
Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Securities).
During the third quarter of 2006, the Company repurchased 4,776 shares at an
average share price of $510 per share. Since the second share repurchase program
was approved in 2004, the Company has repurchased over 24,000 shares for total
consideration of $11.6 million.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This "Management's Discussion and Analysis of Financial Condition and Results of
Operations," is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company's financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. These judgments govern areas such
as the allowance for loan losses, the fair value of financial instruments,
accounting for income taxes and pension accounting.
For a full discussion of the Company's critical accounting policies and
estimates see "Management's Discussion and Analysis" in the Company's Annual
Report to Shareholders for the year ended December 31, 2005.
OFF-BALANCE SHEET ARRANGEMENTS
Off-balance sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a material variable interest held by the Company in an
unconsolidated entity that provides financing, liquidity, market risk or credit
risk support to the Company, or engages in leasing, hedging or research and
development services with the Company.
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. As of September 30, 2006, the Company had
entered into commitments with certain customers amounting to $443.6 million
compared to $447.7 million at December 31, 2005 and $411.3 million at September
30, 2005. Letters of credit at September 30, 2006, December 31, 2005 and
September 30, 2005, were $8.5 million, $11.5 million and $15.2 million,
respectively. These commitments are not reflected in the accompanying
consolidated financial statements and do not significantly impact operating
results.
27
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company. Specifically, credit risk, interest rate risk, liquidity risk,
compliance risk, strategic risk, reputation risk and price risk can all affect
the market risk of the Company. These specific risk factors are not mutually
exclusive. It is recognized that any product or service offered by the Company
may expose the Company to one or more of these risk factors.
CREDIT RISK
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed.
Credit risk is found in all activities where success depends on counterparty,
issuer or borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Company's policy statements. In
addition, certain securities carry insurance to enhance credit quality of the
bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Company.
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan as amended by SFAS No. 118, Accounting by Creditors for Impairment of a
Loan - Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectible in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system, specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Consistent with FAS 114, management performs a detailed analysis of these loans,
including, but not limited to, cash flows, appraisals of the collateral,
conditions of the marketplace for liquidating the collateral and assessment of
the guarantors. Management then determines the inherent
28
loss potential and allocates a portion of the allowance for losses as a specific
allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies." In this second phase, groups of loans
are reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
- then-existing general economic and business conditions affecting the key
lending areas of the Company;
- credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
- collateral values;
- loan volumes and concentrations;
- seasoning of the loan portfolio;
- specific industry conditions within portfolio segments;
- recent loss experience within portfolio segments;
- duration of the current business cycle;
- bank regulatory examination results; and
- findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance
for loan losses. The Company's allowance for loan losses is maintained at a
level considered by management to be adequate to provide for estimated losses
inherent in the existing portfolio.
Management believes that the allowance for loan losses at September 30, 2006 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan charge-offs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
29
MARKET RISK - INTEREST RATE RISK
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company does not attempt to predict
interest rates and positions the balance sheet in a manner which seeks to
minimize, to the extent possible, the effects of changing interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products which reduces the market volatility of those
instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative Gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over
a rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 200 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
September 30, 2006, the Company's estimated net interest income sensitivity to
changes in interest rates, as a percent of net interest income was a decrease in
net interest income of 0.23% if rates increase by 200 basis points and a
decrease in net interest income of 1.53% if rates decline 200 basis points.
Comparatively, at December 31, 2005, the Company's estimated net interest income
sensitivity was an increase in net interest income of 0.54% if rates increase by
200 basis points and a decrease in net interest income of 3.11% if rates
decrease 200 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape; prepayments on loans and securities; pricing strategies on loans and
deposits; replacement of asset and liability cashflows; and other assumptions.
While the assumptions used are based on current
30
economic and local market conditions, there is no assurance as to the predictive
nature of these conditions including how customer preferences or competitor
influences might change.
LIQUIDITY RISK
Liquidity risk is the risk to earnings or capital resulting from the Company's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Company's ability to liquidate assets or acquire
funds quickly and with minimum loss of value. The Company endeavors to maintain
a cash flow adequate to fund operations, handle fluctuations in deposit levels,
respond to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. At September 30, 2006, the Company
maintained Federal Funds credit lines of $75 million with banks subject to the
customary terms and conditions for such arrangements and $150 million in
repurchase lines with major brokers. In addition, the Company has additional
borrowing capacity of $140.9 million from the Federal Home Loan Bank.
At September 30, 2006, the Company had available sources of liquidity, which
included cash and cash equivalents and unpledged investment securities of
approximately $92.5 million, which represents 6.5% of total assets.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures designed to ensure that
information is recorded and reported in all filings of financial reports. Such
information is reported to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer to allow timely and accurate
disclosure based on the definition of "disclosure controls and procedures" in
Rule 13a-15(e). In designing these controls and procedures, management
recognizes that they can only provide reasonable assurance of achieving the
desired control objectives. Management also evaluates the cost-benefit
relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company carried out an
evaluation of the effectiveness of Company's disclosure controls and procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. The
evaluation was based, in part, upon reports and affidavits provided by a number
of executives. Based on the foregoing, the Company's Chief Executive Officer and
the 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 over
financial reporting or in other factors that could significantly affect the
internal controls over financial reporting during the third quarter of 2006.
31
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
-------------------------
Certain lawsuits and claims arising in the ordinary course of business have been
filed or are pending against the Company or its subsidiaries. Based upon
information available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.
There are no material proceedings adverse to the Company to which any director,
officer or affiliate of the Company is a party.
ITEM 1A. RISK FACTORS
---------------------
See Item 1A. Risk Factors in the Company's 2005 Form 10-K. In management's
opinion there have been no material changes in risk factors since the filing of
the 2005 Form 10-K.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
-------------------------------------------------------------------
The following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the third quarter of 2006.
NUMBER OF SHARES APPROXIMATE DOLLAR
PURCHASED AS PART OF VALUE OF SHARES THAT
AVERAGE A PUBLICLY MAY YET BE PURCHASED
NUMBER OF PRICE PER ANNOUNCED PLAN OR UNDER THE PLAN OR
THIRD QUARTER 2006 SHARES SHARE PROGRAM PROGRAM
-------------------------------------------------------------------------------------------------------------------------
07/01/2006 - 07/31/2006 0 $ 0 0 $ 13,661,580
08/01/2006 - 08/31/2006 4,376 510 4,376 11,429,820
09/01/2006 - 09/30/2006 400 510 400 11,225,820
-------------------------------------------------------------------------------------------------------------------------
Total 4,776 510 4,776 11,225,820
All of the above shares were purchased pursuant to the publicly announced
repurchase program.
The common stock of Farmers & Merchants Bancorp is not widely held or listed on
any exchange. However, trades may be reported on the OTC Bulletin Board under
the symbol "FMCB.OB." Additionally, management is aware that there are private
transactions in the Company's common stock.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
---------------------------------------
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
-----------------------------------------------------------
None
ITEM 5. OTHER INFORMATION
-------------------------
None
ITEM 6. EXHIBITS
----------------
See Exhibit Index on Page 34.
32
SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FARMERS & MERCHANTS BANCORP
Date: November 3, 2006 /s/ Kent A. Steinwert
---------------------------------
Kent A. Steinwert
President and
Chief Executive Officer
(Principal Executive Officer)
Date: November 3, 2006 /s/ Stephen W. Haley
---------------------------------
Stephen W. Haley
Executive Vice President and
Chief Financial Officer
(Principal Accounting Officer)
INDEX TO EXHIBITS
-----------------
Exhibit No. Description
---------- -----------
10.18 Deferred Compensation Plan of Farmers & Merchants Bank of Central
California executed October 17, 2006.
31(a) Certification of the Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31(b) Certification of the Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32 Certifications of the Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
33