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CFFI > SEC Filings for CFFI > Form 10-Q on 8-Nov-2012All Recent SEC Filings

Show all filings for C & F FINANCIAL CORP

Form 10-Q for C & F FINANCIAL CORP


8-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Corporation's expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute "forward-looking statements" as defined by federal securities laws and may include, but are not limited to, statements regarding profitability, liquidity, the Corporation's and each business segment's loan portfolio, allowance for loan losses, trends regarding the provision for loan losses, trends regarding net loan charge-offs, trends regarding levels of nonperforming assets and troubled debt restructurings and expenses associated with nonperforming assets, provision for indemnification losses, levels of noninterest income and expense, interest rates and yields, the deposit portfolio, including trends in deposit maturities and rates, interest rate sensitivity, market risk, regulatory developments, monetary policy implemented by the Federal Reserve including quantitative easing programs, capital requirements, growth strategy and financial and other goals. These statements may address issues that involve estimates and assumptions made by management and risks and uncertainties. Actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, changes in:

? interest rates

? general business conditions, as well as conditions within the financial markets

? general economic conditions, including unemployment levels

? the legislative/regulatory climate, including the Dodd-Frank Act and regulations promulgated thereunder and the Consumer Financial Protection Bureau (CFPB) and the regulatory and enforcement activities of the CFPB

? monetary and fiscal policies of the U.S. Government, including policies of the Treasury and the Federal Reserve Board

? the value of securities held in the Corporation's investment portfolios

? the quality or composition of the loan portfolios and the value of the collateral securing those loans

? the inventory level and pricing of used automobiles

? the level of net charge-offs on loans and the adequacy of our allowance for loan losses

? the level of indemnification losses related to mortgage loans sold

? demand for loan products

? deposit flows

? the strength of the Corporation's counterparties

? competition from both banks and non-banks

? demand for financial services in the Corporation's market area

? technology

? reliance on third parties for key services

? the commercial and residential real estate markets

? demand in the secondary residential mortgage loan markets

? the Corporation's expansion and technology initiatives

? accounting principles, policies and guidelines

Any forward-looking statements should be considered in context with the various disclosures made by us about our businesses in our public filings with the Securities and Exchange Commission, including without limitation the risks identified above and those more specifically described in Item 1A. "Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2011.

The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Corporation. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.


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CRITICAL ACCOUNTING POLICIES

The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.

Allowance for Loan Losses: We establish the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower's ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available.

Allowance for Indemnifications: The allowance for indemnifications is established through charges to earnings in the form of a provision for indemnifications, which is included in other noninterest expenses. A loss is charged against the allowance for indemnifications under certain conditions when a purchaser of a loan (investor) sold by C&F Mortgage incurs a loss due to borrower misrepresentation, fraud, early default, or underwriting error. The allowance represents an amount that, in management's judgment, will be adequate to absorb any losses arising from indemnification requests. Management's judgment in determining the level of the allowance is based on the volume of loans sold, historical experience, current economic conditions and information provided by investors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

Impairment of Loans: We consider a loan impaired when it is probable that the Corporation will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due. We measure impairment on a loan-by-loan basis for commercial, construction and residential loans in excess of $500,000 by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. We maintain a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. Troubled debt restructurings (TDRs) are also considered impaired loans, even if the loan balance is less than $500,000. A TDR occurs when we agree to significantly modify the original terms of a loan due to the deterioration in the financial condition of the borrower.

Impairment of Securities: Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value.
Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.

Other Real Estate Owned (OREO): Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of like properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Corporation may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further other-than-temporary deterioration in market conditions.

Goodwill: Goodwill is no longer subject to amortization over its estimated useful life. In assessing the recoverability of the Corporation's goodwill, all of which was recognized in connection with the Bank's acquisition of C&F Finance Company in September 2002, we must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in determining if goodwill is impaired were increases in future income, sales multiples in determining terminal value and the discount rate applied to future cash flows. As part of the impairment test, we performed a sensitivity analysis by increasing the discount rate,


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lowering sales multiples and reducing increases in future income. We completed the annual test for impairment during the fourth quarter of 2011 and determined there was no impairment to be recognized in 2011. With the adoption of Accounting Standards Update 2011-08, Intangible-Goodwill and Other-Testing Goodwill for Impairment, in 2012, the Corporation will no longer be required to complete a test for impairment unless, based on an assessment of qualitative factors related to goodwill, we determine that it is more likely than not that the fair value of C&F Finance Company is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Corporation will perform a test for impairment and we may be required to record impairment charges.

Retirement Plan: The Bank maintains a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Bank's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the interest crediting rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.

Derivative Financial Instruments: The Corporation recognizes derivative financial instruments at fair value as either an other asset or an other liability in the consolidated balance sheets. The derivative financial instruments have been designated as and qualify as cash flow hedges. The effective portion of the gain or loss on the cash flow hedges is reported as a component of other comprehensive income, net of deferred taxes, and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.

Accounting for Income Taxes: Determining the Corporation's effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Corporation's tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

For further information concerning accounting policies, refer to Item 8 "Financial Statements and Supplementary Data" under the heading "Note 1: Summary of Significant Accounting Policies" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011.

OVERVIEW

Our primary financial goals are to maximize the Corporation's earnings and to deploy capital in profitable growth initiatives that will enhance long-term shareholder value. We track three primary financial performance measures in order to assess the level of success in achieving these goals: (i) return on average assets (ROA), (ii) return on average common equity (ROE), and
(iii) growth in earnings. In addition to these financial performance measures, we track the performance of the Corporation's three principal business activities: retail banking, mortgage banking, and consumer finance. We also actively manage our capital through growth and dividends, while considering the need to maintain a strong regulatory capital position.

Financial Performance Measures

Net income for the Corporation was $4.5 million for the three months ended September 30, 2012, compared with $3.5 million for the three months ended September 30, 2011. Net income for the Corporation was $12.5 million for the first nine months of 2012, compared with $9.6 million for the first nine months of 2011. Net income available to common shareholders was $4.5 million, or $1.36 per common share assuming dilution, for the three months ended September 30, 2012, compared with $3.1 million, or $0.96 per common share assuming dilution, for the three months ended September 30, 2011. Net income available to common shareholders was $12.2 million, or $3.69 per common share assuming dilution for the first nine months of 2012, compared with $8.5 million, or $2.69 per common share assuming dilution for the first nine months of 2011. The difference between reported net income and net income available to common shareholders is a result of the Preferred Stock dividends and amortization of the Warrant related to the Corporation's participation in the CPP. The Corporation's earnings for the third quarter and first nine months of 2012 were primarily a result of the strong earnings in the Consumer Finance segment, which continues to benefit from
(1) sustained loan growth and (2) the low funding costs on its variable-rate borrowings. The Mortgage Banking segment benefited from higher gains on loans sold and ancillary loan production fees as a result of higher loan production and correspondingly higher sales volume during 2012, as well as lower professional fees. The Retail Banking segment benefited from the effects of (1) the continued low interest rate environment on the cost of deposits, (2) lower provisions for loan losses and (3) higher interchange activity fee.


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The Corporation's ROE and ROA were 18.48 percent and 1.88 percent, respectively, on an annualized basis for the third quarter of 2012, compared with 15.86 percent and 1.42 percent, respectively, for the third quarter of 2011. For the first nine months of 2012, on an annualized basis, the Corporation's ROE and ROA were 17.74 percent and 1.75 percent, respectively, compared with 14.92 percent and 1.28 percent, respectively, for the first nine months of 2011. The increase in these ratios during 2012 was primarily due to the earnings improvement of the Retail Banking and Mortgage Banking segments and the sustained earnings strength of the Consumer Finance segment. In addition, the effect of dividends on the Corporation's Preferred Stock on net income available to common shareholders was lessened for the third quarter and first nine months of 2012 by the redemptions of Preferred Stock in July 2011 and in April 2012.

Principal Business Activities. An overview of the financial results for each of the Corporation's principal business segments is presented below. A more detailed discussion is included in "Results of Operations."

Retail Banking: C&F Bank reported net income of $705,000 for the third quarter of 2012, compared to a net loss of $217,000 for the third quarter of 2011. For the first nine months of 2012, C&F Bank reported net income of $1.6 million, compared to a net loss of $495,000 for the first nine months of 2011. The more significant factors contributing to the improvement in financial results for the three and nine months ended September 30, 2012, relative to the same periods of 2011, were the effects of the continued low interest rate environment on the cost of deposits, lower provisions for loan losses and higher activity-based interchange income. Partially offsetting these positive factors were the negative effects of the following: (1) a decrease in average loans to nonaffiliates resulting from weak demand in the current economic environment and intensified competition for loans in our markets, (2) a decline in overdraft fee income and (3) slightly higher occupancy expenses associated with depreciation and maintenance of technology related to expanding the banking services we offer to customers and improving operational efficiency and security.

The Bank's nonperforming assets were $19.4 million at September 30, 2012, compared to $16.1 million at December 31, 2011. Nonperforming assets at September 30, 2012 included $14.8 million in nonaccrual loans, compared to $10.0 million at December 31, 2011, and $4.6 million in foreclosed properties, compared to $6.1 million at December 31, 2011. Troubled debt restructurings were $17.9 million at September 30, 2012, of which $11.4 million were included in nonaccrual loans, as compared to $17.1 million of troubled debt restructurings at December 31, 2011, of which $8.4 million were included in nonaccrual loans. The increase in nonaccrual loans primarily resulted from two commercial relationships secured by undeveloped residential property totaling $7.5 million as of September 30, 2012, of which $5.4 million was included in troubled debt restructurings at September 30, 2012. Management believes it has provided adequate loan loss reserves for the retail banking segment's loans. Foreclosed properties at September 30, 2012 consist of both residential and non-residential properties. These properties are evaluated regularly and have been written down to their estimated fair values less selling costs.

Mortgage Banking: C&F Mortgage Corporation reported net income of $736,000 for the third quarter of 2012, compared to $477,000 for the third quarter of 2011. For the first nine months of 2012, C&F Mortgage Corporation reported net income of $1.6 million, compared to $1.0 million for the first nine months of 2011. The more significant factors contributing to the improvements in financial results for the three months and nine months ended September 30, 2012, relative to the same periods of 2011, were (1) higher gains on sales of loans and ancillary loan production fees, (2) higher net interest income on loans held for sale and (3) lower legal and consulting expenses. Loan origination volume increased to $239.5 million in the third quarter of 2012, a 54.9 percent increase as compared to $154.6 million in the third quarter of 2011, and to $619.5 million in the first nine months of 2012, a 44.8 percent increase as compared to $427.7 million in the first nine months of 2011. For the third quarter of 2012, the amount of loan originations for refinancings and home purchases were $105.4 million and $134.1 million, respectively, compared to $37.1 million and $117.5 million, respectively, for the third quarter of 2011. For the first nine months of 2012, the amount of loan originations for refinancings and home purchases were $240.9 million and $378.6 million, respectively, compared to $97.2 million and $330.5 million, respectively, for the first nine months of 2011. The increases in loan originations are a result of the continued low interest rate environment that has led to increased mortgage borrowing and refinancing activity. These increases have led to correspondingly higher sales volume, which increased to $240.6 million for the third quarter of 2012, compared to $154.6 million during the third quarter of 2011, and which increased to $611.4 million for the first nine months of 2012, compared to $458.5 million during the first nine months of 2011. In connection with the higher sales volumes in 2012, the mortgage banking segment incurred higher production and income-based compensation expense. Higher personnel costs have also been incurred in non-production salaries in order to manage the increasingly complex regulatory environment in which the mortgage banking segment operates and higher provisions for indemnifications have been recognized in connection with loans sold to investors.

Consumer Finance: C&F Finance Company reported net income of $3.2 million for the third quarter of 2012, compared to net income of $3.4 million for the third quarter of 2011. For the first nine months of 2012, C&F Finance reported net income of $9.8 million, compared to net income of $9.5 million for the first nine months of 2011. The more significant factors contributing to the consumer finance segment's financial results for the three and nine months ended September 30, 2012 compared to the same periods in 2011 were (1) an 8.9 percent and a 9.7 percent increase in average loans outstanding for the three and nine months ended September 30, 2012, respectively, and (2) the sustained low cost of the consumer finance segment's variable-rate borrowings. Factors negatively affecting the financial results for the three and nine months ended September 30, 2012, relative to the same periods of 2011, were (1) increases of $610,000 and $965,000 in the provision for loan losses for the three and nine months ended September 30, 2012, respectively, resulting from higher net charge-offs attributable to a decline in the resale value of repossessed vehicles and the effects of the current economic environment, (2) increases of $269,000 and $662,000 in personnel costs for the three and nine months ended September 30, 2012, respectively, resulting from an increase in the number of personnel to support expansion into new markets and loan growth and (3) increases of $13,000 and $162,000 in occupancy expenses for the three and nine months ended September 30, 2012, respectively, resulting from C&F Finance Company's relocation in April 2011 to a larger leased headquarters building and depreciation and maintenance of technology to support growth.

Despite the increase in the dollar amount of charge-offs, as mentioned above, the 2.37 percent annualized charge-off rate for the first nine months of 2012 was slightly lower than the 2.39 percent charge-off rate for the year ended December 31, 2011. The allowance


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for loan losses as a percentage of consumer finance loans was relatively stable at 7.90 percent as of September 30, 2012, compared with 7.94 percent at December 31, 2011. Management believes that the current allowance for loan losses is adequate to absorb probable losses in the Consumer Finance segment's loan portfolio.

Other and Eliminations: The net loss for the three months ended September 30, 2012 for this combined segment was $126,000, compared to a net loss of $118,000 for the three months ended September 30, 2011. The net loss for the first nine months of 2012 for this combined segment was $471,000, compared to a net loss of $467,000 for the first nine months of 2011. Revenue and expense of this combined segment include the results of operations of our investment, insurance and title subsidiaries, interest expense associated with the Corporation's trust preferred capital notes, other general corporate expenses and the effects of intercompany eliminations.

Capital Management. Total shareholders' equity was $98.5 million at September 30, 2012, compared to $96.1 million at December 31, 2011, which was an increase of $2.4 million. The increase in shareholders' equity resulting from net income for the first nine months of 2012 was offset in part by dividends declared and the redemption of the Corporation's Preferred Stock, as described below. The Corporation declared cash dividends of 27 cents and 79 cents per common share during the third quarter and first nine months of 2012, respectively, which was a 19.2 percent and a 20.8 percent payout ratio of net income available to common shareholders for the third quarter and first nine months of 2012, respectively.

On April 11, 2012, the Corporation redeemed the remaining 10,000 shares of its Preferred Stock issued to Treasury in January 2009 under the CPP. The redemption consisted of $10.0 million in liquidation value and $78,000 of accrued and unpaid dividends associated with the Preferred Stock. As a result of this redemption, the Corporation will pay no future dividends on the Preferred Stock. The Corporation funded this redemption without raising additional capital because of its strong capital position and financial performance. The redemption results in no dilution to common shareholders because no new capital was issued. In connection with this redemption, the Corporation accelerated the accretion of the remaining Preferred Stock discount, which reduced net income available to common shareholders by approximately $151,000 in the second quarter of 2012, but eliminated any future accretion.

RESULTS OF OPERATIONS

The following table presents the average balance sheets, the amounts of interest earned on earning assets, with related yields, and interest expense on interest-bearing liabilities, with related rates, for the three and nine months ended September 30, 2012 and 2011. Loans include loans held for sale. Loans placed on nonaccrual status are included in the balances and are included in the computation of yields, but had no material effect. Interest on tax-exempt loans and securities is presented on a taxable-equivalent basis (which converts the income on loans and investments for which no income taxes are paid to the equivalent yield as if income taxes were paid using the federal corporate income tax rate of 34 percent).


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TABLE 1: Average Balances, Income and Expense, Yields and Rates

                                                Three Months Ended September 30,
                                         2012                                      2011
(Dollars in              Average       Income/        Yield/        Average       Income/       Yield/
thousands)               Balance       Expense         Rate         Balance       Expense        Rate
Assets
Securities:
Taxable                 $  19,327     $      78           1.61 %   $  18,842     $      78          1.63 %
. . .
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