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| PNBC > SEC Filings for PNBC > Form 10-Q on 11-May-2009 | All Recent SEC Filings |
11-May-2009
Quarterly Report
The following discussion provides information about Princeton National Bancorp, Inc.'s ("PNBC" or the "Corporation") financial condition and results of operations for the three month periods ended March 31, 2009 and 2008. This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto. This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), such as discussions of the Corporation's pricing and fee trends, credit quality and outlook, liquidity, new business results, expansion plans, anticipated expenses and planned schedules. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Corporation, are identified by use of the words "believe", "expect", "intend", "anticipate", "estimate", "project", or similar expressions. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the effect of the current severe disruption in financial markets and the United States government programs introduced to restore stability and liquidity, changes in interest rates, general economic conditions and the weakening state of the United States economy, legislative/regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Corporation's market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning the Corporation and its business, including a discussion of these and additional factors that could materially affect the Corporation's financial results, is included in the Corporation's 2008 Annual Report on Form 10-K under the headings "Item 1. Business" and "Item 1A. Risk Factors."
CRITICAL ACCOUNTING POLICIES AND USE OF SIGNIFICANT ESTIMATES
The Corporation has established various accounting policies that govern the application of U.S. generally accepted accounting principles in the preparation of the Corporation's financial statements. The significant accounting policies of the Corporation are described in the footnotes to the consolidated financial statements.. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities; management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and assumptions, which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.
The Corporation believes the allowance for loan losses is the critical accounting policy that requires the most significant judgments and assumptions used in the preparation of its consolidated financial statements. We determine probable incurred losses inherent in our loan portfolio and establish an allowance for those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, we use organizational history and experience with credit decisions and related outcomes. The allowance for loan losses represents our best estimate of losses inherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loan losses charged to expense and reduced by loans charged off, net of recoveries. We evaluate our allowance for loan losses quarterly. If our underlying assumptions later prove to be inaccurate based on subsequent loss evaluations, the allowance for loan losses is adjusted.
We estimate the appropriate level of allowance for loan losses by separately evaluating impaired and non-impaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a non-impaired loan is more subjective. Generally, the allowance assigned to non-impaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics, adjusted for qualitative factors including the volume and severity of identified classified loans, changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that our assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required.
Other Real Estate Owned
Other real estate owned acquired through loan foreclosure is initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. The adjustment at the time of foreclosure is recorded through the allowance for loan losses. Due to the subjective nature of establishing the fair value when the asset is acquired, the actual fair value of the other real estate owned or foreclosed asset could differ from the original estimate. If it is determined that fair value declines subsequent to foreclosure, a valuation allowance is recorded through non-interest expense. Operating costs associated with the assets after acquisition are also recorded as non-interest expense. Gains and losses on the disposition of other real estate owned and foreclosed assets are netted and posted to other non-interest expense.
Deferred Income Tax Assets/Liabilities
Our net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income. Deferred tax assets and liabilities are established for these items as they arise. From an accounting standpoint, deferred tax assets are reviewed to determine if they are realizable based on the historical level of our taxable income, estimates of our future taxable income and the reversals of deferred tax liabilities. In most cases, the realization of the deferred tax asset is based on our future profitability. If we were to experience net operating losses for tax purposes in a future period, the realization of our deferred tax assets would be evaluated for a potential valuation reserve.
Impairment of Goodwill and Intangible Assets
Core deposit and customer relationships, which are intangible assets with a finite life, are recorded on our balance sheets. These intangible assets were capitalized as a result of past acquisitions and are being amortized over their estimated useful lives of up to 15 years. Core deposit intangible assets, with finite lives will be tested for impairment when changes in events or circumstances indicate that its carrying amount may not be recoverable. Core deposit intangible assets were tested for impairment during 2008 and 2007, as part of the goodwill impairment test and no impairment was deemed necessary.
As a result of our acquisition activity, goodwill, an intangible asset with an indefinite life, was reflected on our balance sheet in prior periods. Goodwill is evaluated for impairment annually, unless there are factors present that indicate a potential impairment, in which case, the goodwill impairment test is performed more frequently than annually. Accordingly, as the Corporation's stock price at March 31, 2009 decreased below book value, a goodwill impairment test was performed and no impairment was deemed necessary (see Note 3 - "Goodwill and Intangible Assets" in the Notes to Consolidated Financial Statements).
Mortgaging Service Rights (MSRs)
MSR fair values are very sensitive to movements in interest rates as expected future net servicing income depends on the projected outstanding principal balances of the underlying loans, which can be greatly reduced by prepayments. Prepayments usually increase when mortgage interest rates decline and decrease when mortgage interest rates rise. For discussion regarding the impairment of MSRs, see Note 4 - "Originated Mortgage Servicing Rights" in the Notes to Consolidated Financial Statements.
Fair Value Measurements
The fair value of a financial instrument is defined as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Corporation estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. When the financial instruments are not actively traded, other observable market inputs, such as quoted prices of securities with similar characteristics, may be used, if available, to determine fair value. When observable market prices do not exist, the Corporation estimates fair value. The Corporation's valuation methods consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations and unexpected correlations can affect estimates of fair value. Imprecision in estimating these factors can impact the amount of revenue or loss recorded.
Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2- inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 - inputs that are unobservable and significant to the fair value measurement.
At the end of each quarter, the Corporation assesses the valuation hierarchy for each asset or liability measured. From time to time, assets or liabilities may be transferred within hierarchy levels due to changes in availability of observable market inputs to measure fair value at the measurement date. Transfers into or out of hierarchy levels are based upon the fair value at the beginning of the reporting period. A more detailed description of the fair values measured at each level of the fair value hierarchy can be found in Note 7- "Fair Value of Assets and Liabilities" in the Notes to Consolidated Financial Statements.
RESULTS OF OPERATIONS
Net income for the first quarter of 2009 was $1,156,000, or basic and diluted earnings per common share of $0.28, as compared to net income of $2,090,000 in the first quarter of 2008, or basic and diluted earnings per common share of $0.63. This represents a decrease of $934,000 (44.7%) or $.35 per basic and diluted common share. The lower net income figure is attributable to an increase in the provision for loan losses and insurance assessments by the FDIC. The annualized return on average assets and return on average equity decreased accordingly to 0.40% and 5.14%, respectively, for the first quarter of 2009, compared with 0.78% and 12.22% for the first quarter of 2008.
Net interest income before the provision for loan losses was $8,079,000 for the first quarter of 2009, compared to $7,454,000 for the first quarter of 2008 (an increase of $625,000 or 8.4%). The net yield on interest-earning assets (on a fully taxable equivalent basis) increased slightly to 3.40% in the first quarter of 2009 from 3.39% in the first quarter of 2008. However, growth in the balance sheet of $86.7 million in average interest-earning assets was the primary cause for the increase in net interest income over the past twelve months.
The Corporation's provision for loan loss expense recorded each quarter is determined by management's evaluation of the risk characteristics of the loan portfolio. As mentioned above, net charge-offs decreased during the first quarter of 2009 to $371,000, compared to net charge-offs of $481,000 for the first quarter of 2008. PNBC recorded a loan loss provision of $1,170,000 in the first quarter of 2009 compared to a provision of $368,000 in the first quarter of 2008. The allowance for loan losses is discussed more fully below.
Total non-interest expense for the first quarter of 2009 was $8,652,000, an increase of $1,092,000 (or 14.4%) from $7,560,000 in the first quarter of 2008. The largest difference between the first quarters of 2009 and 2008 was an increase in federal insurance assessments of $613,000, an increase of 729.8%. Most of this increase is attributable to the increase in the assessment rate as well as the expiration of credits from the FDIC in latter 2008. Additionally, the category of other operating expense increased $224,000 (or 21.2%) due mostly to an increase in loan administrative expenses. Annualized non-interest expense as a percentage of total average assets increased to 2.96% for the first three months of 2009, compared to 2.83% for the same period in 2008.
INCOME TAXES
The Corporation recorded an income tax benefit of $104,000 for the first quarter of 2009, as compared to income tax expense of $589,000 for the first quarter of 2008. The effective tax rate was (9.9%) for the three-month period ended March 31, 2009 and 22.0% for the three-month period ended March 31, 2008. The income tax benefit is due to a lower pre-tax income coupled with the effect of tax-exempt investment interest income. For more information on the Corporation's income taxes see Note 8 - "Income Taxes" in the Notes to Consolidated Financial Statements.
FDIC
On February 27, 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1,2009, at 12 to 45 basis points and, due to extraordinary circumstances, extended the period of the Restoration Plan to seven years. Also in March 2009, the FDIC Issued final rules on changes to the risk-based assessment system. The final rules both increase base assessment rates and incorporates additional assessments for excess reliance on brokered CDs and FHLB advances. The new rates would increase annual assessment rates from 5 to 7 basis points to 7 to 24 basis points. This new assessment takes effect April 1, 2009 and is payable at the end of September 2009. The Corporation is assessing the effect the new assessment rates will have on its consolidated financial statements.
Also on February 27, 2009, the FDIC adopted an interim rule to impose a 20 basis point emergency special assessment payable September 30. 2009 based on the second quarter 2009 assessment base, to help shore up the Deposit Insurance Fund ('DIF'). This assessment equates to a one-time cost of $200,000 per $100 million in assessment base. The interim rule also allows the Board to impose possible additional special assessments of up to 10 basis points thereafter to maintain public confidence in the DIF. Should the proposal become final, the Corporation estimates this assessment would have a material impact on its financial statements of approximately $1.7 million.
Total assets at March 31, 2009 increased to $1,215,484,000 from $1,163,130,000 at December 31, 2008 (an increase of $52.4 million or 4.5%). Total loan balances decreased by $16.0 million during the three month period to $774.8 million due to seasonal pay downs in the agricultural portfolio, along with the refinancing of adjustable-rate residential real estate loans into fixed rate products which are sold in the secondary market. Investment balances totaled $274,534,000 at March 31, 2009, compared to $251,115,000 at December 31, 2008 (an increase of $23.4 million or 9.3%), as excess liquidity is invested due to declining loan demand. Total deposits increased to $1,010,964,000 at March 31, 2009 from $962,132,000 at December 31, 2008 (an increase of $48.8 million or 5.1%). Comparing categories of deposits at March 31, 2009 to December 31, 2008, time deposits increased $39.4 million (or 7.2%), interest-bearing demand deposits increased $9.4 million (or 3.8%), savings deposits increased $5.1 million (or 8.4%), and demand deposits decreased $5.1 million (or 4.6%). Borrowings, consisting of customer repurchase agreements, federal funds purchased, notes payable, treasury, tax, and loan ("TT&L") deposits, and Federal Home Loan Bank advances, decreased from $118,016,000 at December 31, 2008 to $97,066,000 at March 31, 2009 (a decrease of $20.9 million or 17.8%). The majority of this decrease was due to the repayment of the note payable (balance of $16.05 million at December 31, 2008) with proceeds from the sale of preferred stock under the Capital Purchase Program.
CAPITAL PURCHASE PROGRAM
On January 23, 2009, the Corporation received $25,083 of equity capital by issuing to the United States Department of Treasury 25,083 shares of the Corporation's 5.00% Series B Fixed Rate Cumulative Perpetual Preferred Stock, no par value, with a liquidation preference of $1,000 per share and a ten-year warrant to purchase up to 155,025 shares of the Corporation's common stock, par value $0.01 per share, at an exercise price of $24.27 per share. The proceeds received were allocated to the preferred stock and common stock warrants based on their relative fair values. The resulting discount on the preferred stock is amortized against retained earnings and is reflected in the Corporation's consolidated statement of income as "Preferred shares dividends", resulting in additional dilution to the Corporation's earnings per common share. The warrants are immediately exercisable, in whole or in part, over a term of 10 years. The warrants were included in the Corporation's diluted average common shares outstanding (subject to anti-dilution). Both the preferred securities and warrants were accounted for as additions to the Corporation's regulatory Tier 1 and total capital.
The Series B Preferred stock is not mandatorily redeemable and will pay cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Any redemption requires Federal Reserve approval. The Series B Perpetual Preferred stock ranks senior to the Corporation's existing authorized Series A Junior Participating Preferred stock.
A company that participates must adopt certain standards for executive compensation, including (a) prohibiting "golden parachute" payments as defined in the Emergency Economic Stabilization Act of 2008 (EESA) to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution; and (d) accept restrictions on the payment of dividends and the repurchase of common stock.
For the three months ended March 31, 2009, the subsidiary bank charged off $412,000 of loans and had recoveries of $42,000, compared to charge-offs of $546,000 and recoveries of $65,000 during the three months ended March 31, 2008. The allowance for loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, underlying collateral, past loss experience, loan delinquencies, substandard and doubtful credits, and such other factors that, in management's reasonable judgment, warrant consideration. The adequacy of the allowance is monitored monthly. At March 31, 2009, the allowance was $5,864,000 which is 17.6% of non-performing loans and 0.76% of total loans, compared with $5,064,000 which was 15.3% of non-performing loans and 0.64% of total loans at December 31, 2008.
Non-performing loans increased to $33,278,000 or 4.30% of net loans at March 31, 2009, as compared to $33,038,000 or 4.18% of net loans at December 31, 2008. Approximately 60% of the non-performing loans is comprised of three larger credits, all of which are development loans in the Corporation's northern and eastern market areas. No specific reserves had been established for these three relationships as of March 31, 2009. All loans are individually evaluated and management continues to maintain adequate reserves in the allowance for loan losses.
At March 31, 2009 non-accrual loans were $33,137,000 compared to $30,383,000 at December 31, 2008. Impaired loans totaled $17,170,000 at March 31, 2009 compared to $3,540,000 at December 31, 2008. The total amount of loans ninety days or more past due and still accruing interest at March 31, 2009 was $142,000 compared to $2,655,000 at December 31, 2008. There was a specific loan loss reserve of $1,983,000 established for impaired loans as of March 31, 2009 compared to a specific loan loss reserve of $818,000 at December 31, 2008. PNBC's management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of March 31, 2009.
CAPITAL RESOURCES
Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the differences in the level of risk assets. At March 31, 2009, total risk-based capital of PNBC was 11.53%, compared to 8.30% at December 31, 2008. The Tier 1 capital ratio increased from 6.22% at December 31, 2008, to 7.99% at March 31, 2009. Total stockholders' equity to total assets at March 31, 2009 increased to 8.06% from 6.23% at December 31, 2008. The increase in these ratios is due to the equity investment received from the U.S. Treasury in the form of Preferred Stock as part of the Capital Purchase Program discussed above.
LIQUIDITY
Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital, or the sale of assets. Additional sources of liquidity include cash flow from the repayment of loans and the maturity of investment securities. Major uses of cash include the origination of loans and purchase of investment securities. Cash flows provided by financing and operating activities, offset by those used in investing activities, resulted in a net increase in cash and cash equivalents of $47,607,000 from December 31, 2008 to March 31, 2009. This increase was primarily the result of the proceeds received from the issuance of preferred stock, an increase in deposits and a decrease in loans, offset by net purchases of investments and the pay off of the Corporation's note payable. For more detailed information, see PNBC's Consolidated Statements of Cash Flows.
The Corporation generates agribusiness, commercial, mortgage and consumer loans to customers located primarily in North Central Illinois. The Corporation's loans are generally secured by specific items of collateral including real property, consumer assets and business assets. Although the Corporation has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon economic conditions in the agricultural industry.
In the normal course of business to meet the financing needs of its customers, the subsidiary bank is party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.
The subsidiary bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. At March 31, 2009, commitments to extend credit and standby letters of credit were approximately $135,882,000 and $4,819,000 respectively.
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