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COFS > SEC Filings for COFS > Form 10-Q on 14-Nov-2012All Recent SEC Filings

Show all filings for CHOICEONE FINANCIAL SERVICES INC

Form 10-Q for CHOICEONE FINANCIAL SERVICES INC


14-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. ("ChoiceOne" or the "Registrant") and its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and the Bank's wholly-owned subsidiary, ChoiceOne Insurance Agencies, Inc. This discussion should be read in conjunction with the consolidated financial statements and related notes.


FORWARD-LOOKING STATEMENTS

This discussion and other sections of this quarterly report contain forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and ChoiceOne itself. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "may," "could," variations of such words and similar expressions are intended to identify such forward-looking statements. Management's determination of the provision and allowance for loan losses, the carrying value of goodwill and loan servicing rights, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary) and management's assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Registrant's Annual Report on Form 10-K; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit availability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Goodwill
Generally accepted accounting principles require that the fair value of the assets and liabilities of an acquired entity be recorded at their fair value on the date of acquisition. The fair values are determined using both internal computations and information obtained from outside parties when deemed necessary. The net difference between the price paid for the acquired company and the net value of its balance sheet is recorded as goodwill. Accounting principles also require that goodwill be evaluated for impairment on an annual basis or more frequently whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Management performed its annual review of goodwill as of June 30, 2012. ChoiceOne engaged an outside consulting firm to assist in the goodwill impairment analysis. The following steps were used in the valuation:
determination of the reporting unit, determination of the appropriate standard of value, determination of the appropriate level of value, calculation of fair value, and comparison of the fair value computed to the equity carrying value. It was determined that the relevant reporting unit to be valued was ChoiceOne Bank. The standard of value used in the valuation was fair value as determined by generally accepted accounting principles. The appropriate level of value was determined to be the controlling interest level. The appraisal methodology used to calculate the fair value included the following valuation approaches:

Income Approach: A discounted cash flow value was calculated based on earnings capacity. The discount rate used for the calculation was 12.50%. The growth assumption for assets was 1.8% for the first year and 2.0% in subsequent years. In addition, it was assumed that cost savings of 20% of noninterest expense would occur as a result of synergies and cost reductions from a change in control.

Market Approach: The analysis was based on price-to-earnings multiples, price-to-tangible-book value ratios, and core deposit premiums for selected bank sale transactions.

The Asset Approach was also an approach reviewed, but it was not used in determining the fair value since it did not render a control level indication of value. The results from the valuation approaches were used to calculate an estimate of the fair value of ChoiceOne's equity. The fair value was compared to the carrying value of equity to determine whether the Step 1 test under generally accepted accounting principles that govern the valuation of goodwill was passed. The goodwill analysis determined that the fair value of ChoiceOne's equity exceeded the carrying value by 10.8%. Based on this assessment, management believed that there was no indication of goodwill impairment.


RESULTS OF OPERATIONS
Summary
Net income for the third quarter of 2012 was $1,122,000, which represented an increase of $236,000 or 27% compared to the same period in 2011. Net income for the first nine months of 2012 was $3,158,000, which represented an increase of $664,000 or 27% over the same period in 2011. A reduction in the provision for loan losses and growth in noninterest income was offset by a decrease in net interest income and an increase in noninterest expense in both the third quarter and first nine months of 2012 compared to the same periods in the prior year. Basic and diluted earnings per common share were $0.34 for the third quarter of 2012 and $0.96 for the first nine months of 2012, compared to $0.27 and $0.76, respectively, for the same periods in 2011. The return on average assets and return on average shareholders' equity percentages were 0.84% and 7.13%, respectively, for the first three quarters of 2012, compared to 0.69% and 5.97%, respectively, for the same period in 2011.

Dividends
Cash dividends of $429,000 or $0.13 per share were declared in the third quarter of 2012, compared to $394,000 or $0.12 per share in the third quarter of 2011. The cash dividends declared in the first nine months of 2012 were $1,220,000 or $0.37 per share, compared to $1,182,000 or $0.36 per share declared in the same period in 2011. The cash dividend payout percentage was 39% for the first nine months of 2012, compared to 47% in the same period a year ago.

Interest Income and Expense
Tables 1 and 2 on the following pages provide information regarding interest income and expense for the nine-month periods ended September 30, 2012 and 2011, respectively. Table 1 documents ChoiceOne's average balances and interest income and expense, as well as the average rates earned or paid on assets and liabilities. Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. These tables are referred to in the discussion of interest income, interest expense and net interest income.

Table 1 - Average Balances and Tax-Equivalent Interest Rates

(Dollars in thousands)                          Nine Months Ended September 30,
                                         2012                                     2011
                          Average                                  Average
                          Balance      Interest        Rate        Balance      Interest        Rate
Assets:
Loans (1)                $ 308,141     $  12,795         5.54 %   $ 315,767     $  13,792         5.82 %
Taxable securities (2)
(3)                         89,213         1,471         2.20        69,586         1,312         2.51
Nontaxable securities
(1) (2)                     37,569         1,523         5.41        33,556         1,452         5.77
Other                       12,076            19         0.21         8,870            16         0.24
Interest-earning
assets                     446,999        15,808         4.72       427,779        16,572         5.17
Noninterest-earning
assets                      54,117                                   56,895
Total assets             $ 501,116                                $ 484,674

Liabilities and
Shareholders' Equity:
Interest-bearing
demand deposits          $ 138,216           300         0.29 %   $ 125,356           416         0.44 %
Savings deposits            49,166            27         0.07        45,413            42         0.12
Certificates of
deposit                    139,843         1,316         1.25       154,525         1,822         1.57
Advances from Federal
Home Loan Bank               7,408           247         4.45         8,464           230         3.62
Other                       22,287           171         1.02        20,650           217         1.40
Interest-bearing
liabilities                356,920         2,061         0.77       354,408         2,727         1.03
Noninterest-bearing
demand deposits             81,350                                   71,147
Other
noninterest-bearing
liabilities                  3,749                                    3,456
Total liabilities          442,019                                  429,011
Shareholders' equity        59,097                                   55,663
Total liabilities and
shareholders' equity     $ 501,116                                $ 484,674

Net interest income
(tax-equivalent basis)
- interest spread                         13,747         3.95 %                    13,845         4.14 %
Tax-equivalent
adjustment (1)                              (526 )                                   (504 )
Net interest income                    $  13,221                                $  13,341
Net interest income as
a percentage of
earning assets
(tax-equivalent basis)                                   4.10 %                                   4.32 %


(1) Adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 34% for the periods presented.
(2) Includes the effect of unrealized gains or losses on securities.
(3) Taxable securities include dividend income from Federal Home Loan Bank and Federal Reserve Bank stock.


Table 2 - Changes in Tax-Equivalent Net Interest Income

                                                     Nine Months Ended September 30,
(Dollars in thousands)                                       2012 Over 2011
                                               Total              Volume             Rate
Increase (decrease) in interest income
(1)
Loans (2)                                   $       (997 )     $       (328 )     $      (669 )
Taxable securities                                   159                414              (255 )
Nontaxable securities (2)                             71                207              (136 )
Other                                                  3                  6                (3 )
Net change in tax-equivalent income                 (764 )              299            (1,063 )

Increase (decrease) in interest expense
(1)
Interest-bearing demand deposits                    (116 )               61              (177 )
Savings deposits                                     (15 )                5               (20 )
Certificates of deposit                             (506 )             (162 )            (344 )
Advances from Federal Home Loan Bank                  17                (43 )              60
Other                                                (46 )               25               (71 )
Net change in interest expense                      (666 )             (114 )            (552 )
Net change in tax-equivalent net interest
income                                      $        (98 )     $        413       $      (511 )


(1) The volume variance is computed as the change in volume (average balance) multiplied by the previous year's interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year's volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
(2) Interest on nontaxable investment securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 34% for the periods presented.

Net Interest Income
The presentation of net interest income on a tax-equivalent basis is not in accordance with generally accepted accounting principles ("GAAP"), but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine net interest income on a tax-equivalent basis were $526,000 and $504,000 for the nine months ended September 30, 2012 and 2011, respectively. These adjustments were computed using a 34% federal income tax rate.

As shown in Tables 1 and 2, tax-equivalent net interest income decreased $98,000 in the first nine months of 2012 compared to the same period in 2011. The relationship between growth in average interest-earning assets and a smaller amount of growth in average interest-bearing liabilities caused net interest income to increase $413,000 in the first nine months of 2012 compared to the same period in the prior year. A reduction of 19 basis points in the net interest spread from 4.14% in the first nine months of 2011 to 3.95% in the first nine months of 2012 resulted in a $511,000 decrease in net interest income.


The average balance of loans decreased $7.6 million in the first nine months of 2012 compared to the same period in 2011. Average commercial and industrial and commercial real estate loans were $8.2 million lower and average residential mortgage loans were $0.6 million lower in the first nine months of 2012 than in the same period in 2011. This was offset by a $1.2 million increase in the average balance of consumer loans in the first nine months of 2012 compared to the same period in the prior year. The decrease in the average loans balance combined with a 28 basis point decrease in the average rate earned caused tax-equivalent interest income from loans to decline $997,000 in the first nine months of 2012 compared to the same period in the prior year. The average balance of total securities grew $23.6 million in the first nine months of 2012 compared to the same period in 2011. Additional securities were purchased in 2011 and in the first three quarters of 2012 due to the declining balance in loans and to provide earning asset growth. The growth in securities, partially offset by the effect of lower interest rates earned, caused interest income to increase $230,000 in the first nine months of 2012 compared to the same period in 2011.

The average balance of interest-bearing demand deposits increased $12.9 million in the first nine months of 2012 compared to the same period in 2011. The effect of the higher average balance, offset by a 15 basis point decline in the average rate paid, caused interest expense to decrease $116,000 in the first nine months of 2012 compared to the same period in 2011. The average balance of savings deposits increased $3.8 million in the first nine months of 2012 compared to the same period in the prior year. The impact of the savings deposit growth was offset by a 5 basis point drop in the average rate paid, which caused interest expense to decrease $15,000 in the first nine months of 2012 compared to the same period in 2011. The average balance of certificates of deposit was down $15.5 million in the first nine months of 2012 compared to the same period in 2011. The average balance of local certificates was $12.6 million lower while the average balance of nonlocal certificates was $2.1 million lower in 2012 than in 2011. The decline in certificates of deposit plus a 32 basis point reduction in the average rate paid on certificates caused interest expense to fall $506,000 in the first nine months of 2012 compared to the same period in 2011. A small increase in the average balance of other interest-bearing liabilities in the first nine months of 2012 compared to the first nine months of 2011 offset by the effect of a 38 basis point decrease in the average rate paid caused a $46,000 decrease in interest expense.

ChoiceOne's net interest income spread was 3.95% in the first nine months of 2012, compared to 4.14% for the first nine months of 2011. The decline in the interest spread was due to a 45 basis point decrease in the average rate earned on interest-earning assets in the first nine months of 2012 compared to the same period in 2011, which was partially offset by a 26 basis point decrease in the average rate paid on interest-bearing liabilities. The reduction in the average rate earned on interest-earning assets was caused by relatively low general market rates which affected new loan originations and securities purchases in 2011 and the first nine months of 2012. Interest rates on loans are also being impacted by rate pressure from some of ChoiceOne's competing financial institutions. The lower rate paid on interest-bearing liabilities resulted from repricing of local deposits as general market interest rates remained low during 2011 and the first nine months of 2012.

Provision and Allowance for Loan Losses
The allowance for loan losses grew $560,000 from December 31, 2011 to September 30, 2012. The provision for loan losses was $500,000 in the third quarter and $1,975,000 in the first nine months of 2012, compared to $950,000 and $2,800,000, respectively, in the same periods in 2011. The reduction in the provision for loan losses was due to a lower level of net charge-offs in the third quarter and first nine months of 2012 than in the same periods in 2011. Nonperforming loans were $7.5 million as of September 30, 2012, compared to $8.3 million as of June 30, 2012 and $6.7 million as of December 31, 2011. The increase in nonperforming loans since the end of 2011 was due to growth of $0.7 million in troubled debt restructurings. The allowance for loan losses was 1.91% of total loans as of September 30, 2012, compared to 1.84% at June 30, 2012 and 1.63% at December 31, 2011.

Charge-offs and recoveries for respective loan categories for the nine months ended September 30 were as follows:

(Dollars in thousands)                   2012                               2011
                             Charge-offs       Recoveries       Charge-offs       Recoveries
Agricultural                $           -     $          4     $           -     $          6
Commercial and industrial             377               45               159                9
Consumer                              261              177               262              177
Real estate, commercial               518              213             1,092               51
Real estate, residential              784               86             1,502               77
                            $       1,940     $        525     $       3,015     $        320


Net charge-offs in the third quarter and first nine months of 2012 were $336,000 and $1,415,000, respectively, compared to $918,000 in the third quarter of 2011 and $2,695,000 in the first nine months of 2011. Net charge-offs on an annualized basis as a percentage of average loans were 0.61% in the first nine months of 2012 compared to 1.14% for the same period in the prior year. Management is aware that the economic climate in Michigan will continue to affect business and personal borrowers and may cause charge-offs to remain at heightened levels in future quarters. Management has worked and intends to continue to work with delinquent borrowers in an attempt to lessen the negative impact to ChoiceOne. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur throughout 2012, the provision and allowance for loan losses will be reviewed by the Bank's management and adjusted as necessary.

Noninterest Income
Total noninterest income increased $142,000 in the third quarter of 2012 and $524,000 in the first nine months of 2012 compared to the same periods in 2011. A decline in customer service charges of $23,000 in the third quarter and $152,000 in the first nine months of 2012 compared to the same periods in the prior year was due to lower overdraft fees. Growth of gains on loan sales of $321,000 in the third quarter and $810,000 in the first nine months of 2012 compared to the same periods in 2011 resulted from increased residential mortgage refinancing activity which supported $35.0 million of loan sales in the first nine months of 2012, compared to $17.9 million in the first nine months of 2011. Increases of $16,000 in the third quarter and $240,000 in the first nine months of 2012 in gains on sales of securities when compared to the same periods in 2011 resulted from more sales activity in the first nine months of 2012 than in the same period of the prior year and higher percentage gains on sales due to the relatively low general market rates. Increases of $108,000 in the third quarter and $389,000 in the first nine months of 2012 in losses on sales and write-downs of other assets when compared to the same periods in 2011 resulted from more write-downs of foreclosed properties. Earnings on life insurance policies included $135,000 in the first quarter of 2012 from a death benefit received. Part of the decline in other noninterest income was caused by lower ATM surcharge fee income of $24,000 in the third quarter of 2012 and $66,000 in the first three quarters of 2012 compared to the same periods in 2011.

Noninterest Expense
Total noninterest expense increased $249,000 in the third quarter of 2012 and $341,000 in the first nine months of 2012 compared to the same periods in 2011. The increase of $139,000 in salaries and benefits in the third quarter of 2012 and $281,000 in the first nine months of 2012 compared to the same periods in 2011 resulted from higher commission expense related to mortgage loan originations, incentive bonus and profit sharing accruals, and health insurance costs. Growth in data processing expense of $67,000 in the third quarter and $77,000 in the first nine months of 2012 compared to the same periods in the prior year was caused by higher software maintenance costs. An increase of $52,000 in the third quarter and $68,000 in the first nine months of 2012 compared to the same periods in 2011 was due to more usage of outside consultants. FDIC insurance cost decreased $28,000 in the third quarter of 2012 and $115,000 in the first nine months of 2012 compared to the same periods in the prior year due to a change in the assessment base for insurance beginning in the second quarter of 2011.

Income Tax Expense
Income tax expense was $949,000 in the first nine months of 2012 compared to $724,000 for the same period in 2011. The effective tax rate was 23.1% for 2012 and 22.5% for 2011. The difference between the effective tax rate and the statutory federal tax rate of 34% was primarily due to tax exempt income from securities and bank-owned life insurance.

FINANCIAL CONDITION

Securities

The securities available for sale portfolio increased $8.6 million in the third quarter of 2012 and $23.9 million in the first nine months of 2012. Various securities totaling $58.5 million were purchased in the first nine months of 2012 to provide earning assets and to replace maturities, principal repayments, and calls within the securities portfolio. Approximately $24.8 million in various securities were called or matured since the end of 2011. Principal repayments on securities totaled $2.8 million in the first nine months of 2012. Approximately $6.8 million of securities were sold in the first nine months of 2012 for a net gain of $307,000.

Loans
The loan portfolio (excluding loans held for sale) declined $2.3 million in the third quarter of 2012 and $17.6 million in the first nine months of 2012. With the exception of refinancing activity in residential real estate loans, loan demand in the first nine months of 2012 was sluggish due to the lackluster Michigan economy and relatively low real estate values. In addition, increased competition has caused loan prepayments to accelerate in 2012. Balances in all loan categories except for commercial and industrial loans and consumer loans declined since the end of 2011, with a decrease of $11.4 million in agricultural loans and $6.5 million in commercial real estate loans contributing most of the decline. Much of the decrease in agricultural loans in 2012 resulted from seasonal pay-downs on lines of credit.


Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. The total balance of loans classified as impaired was $4.9 million as of September 30, 2012, compared to $5.9 million as of June 30, 2012 and $4.5 million as of December 31, 2011.

As part of its review of the loan portfolio, management also monitors the various nonperforming loans. Nonperforming loans are comprised of: (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or loans past due 90 days or more, which are considered troubled debt restructurings.

The balances of these nonperforming loans were as follows:

(Dollars in thousands)
                                                     September 30,         December 31,
                                                          2012                 2011
Loans accounted for on a nonaccrual basis           $          4,146      $         4,155
Accruing loans contractually past due 90 days or
more as to principal or interest payments                        357                   70
Loans considered troubled debt restructurings,
which are not included above                                   3,025                2,448
Total                                               $          7,528      $         6,673

. . .

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