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

Show all filings for VALLEY FINANCIAL CORP /VA/

Form 10-Q for VALLEY FINANCIAL CORP /VA/


14-Nov-2012

Quarterly Report


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

Management's discussion and analysis of the financial condition and results of operations of the Company as of September 30, 2012 and December 31, 2011 and for the three and nine month periods ended September 30, 2012 and 2011 is as follows. The discussion should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Written Agreement with the Federal Reserve The Federal Reserve Bank of Richmond ("Federal Reserve") terminated the September 30, 2010 Written Agreement ("Written Agreement") between the Company and the Federal Reserve on August 20, 2012.

Critical Accounting Estimates

General
The Company's financial statements are prepared in accordance with Accounting Principles Generally Accepted in the United States ("GAAP") and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates, which in the case of the determination of our allowance for loan losses, deferred tax assets, and foreclosed assets have been critical to the determination of our financial position and results of operations.

Management considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company's financial statements.

For a discussion on the Company's critical accounting estimates, see the Company's Annual Report on Form 10-K for the year ended December 31, 2011.

Non-GAAP Financial Measures
The Company measures the net interest margin as an indicator of profitability. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax-equivalent net interest income is considered in the calculation of this ratio. Tax-equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for 2012 and 2011 is 34%. The reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.

                                   Three months ended                Nine months ended
In thousands                     9/30/2012        9/30/2011       9/30/2012       9/30/2011
Net interest income, non
tax-equivalent                  $      6,464     $     6,163     $    19,186     $    18,364
Less: tax-exempt interest
income                                  (131 )          (134 )          (396 )          (447 )
Add: tax-equivalent of
tax-exempt interest income               197             203             600             677
Net interest income,
tax-equivalent                  $      6,530     $     6,232     $    19,390     $    18,594


Results of Operations

Net Income

2012 Compared to 2011

Net income for the three-month period ending September 30, 2012 was $1,697,000 as compared to net income of $1,570,000 for the same period last year, an increase of $127,000 or 8%. After the dividend on preferred stock and accretion of discounts on warrants, net income available to common shareholders was a record $1,452,000, or $0.30 per diluted common share, as compared to $1,328,000 or $0.28 per diluted common share for the third quarter of 2011, an increase of 7%. The Company's earnings for the third quarter of 2012 produced an annualized return on average total assets of 0.86% and an annualized return on average shareholders' equity of 10.54%, as compared to 0.80% and 10.77%, respectively for the same period last year. For the nine-month period ending September 30, 2012, net income available to common shareholders was $4,491,000 as compared to $3,161,000 for the same period last year, an increase of $1,330,000 or 42%.

2011 Compared to 2010

Net income for the three-month period ended September 30, 2011 was $1,570,000 as compared to net income of $1,048,000 for the same period in 2010, an increase of $522,000 or 50%. After the dividend on preferred stock and accretion of discounts on warrants, net income available to common shareholders was $1,328,000, or $0.28 per diluted common share, as compared to $809,000 or $0.17 per diluted common share for the third quarter of 2010. The Company's earnings for the third quarter of 2011 produced an annualized return on average total assets of 0.80% and an annualized return on average shareholders' equity of 10.77%, as compared to 0.54% and 7.66%, respectively for the same period last year. For the nine-month period ending September 30, 2011, net income available to common shareholders was $3,161,000 or $0.67 per diluted common share as compared to $2,433,000 or $0.52 per diluted common share for the same period in 2010.

The following table shows our key performance ratios for the periods ended September 30, 2012, December 31, 2011 and September 30, 2011:

                                Key Performance Ratios(1)
                                9 months ended       12 months ended       9 months ended
                                  9/30/2012            12/31/2011            9/30/2011
Return on average assets                   0.89 %                0.73 %               0.66 %
Return on average equity(2)               11.21 %                9.88 %               9.10 %
Net interest margin(3)                     3.55 %                3.39 %               3.40 %
Cost of funds                              0.87 %                1.17 %               1.20 %
Yield on earning assets                    4.41 %                4.54 %               4.58 %
Basic net earnings per
common share                   $           0.95     $            1.01     $           0.67
Diluted net earnings per
common share                   $           0.93     $            1.00     $           0.67

1. Ratios are annualized.

2. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities available-for-sale.

3. Calculated on a fully taxable equivalent basis ("FTE").

Net Interest Income
The primary source of the Company's banking revenue is net interest income, which represents the difference between interest income on earning assets and interest expense on liabilities used to fund those assets. Earning assets include loans, securities, and federal funds sold. Interest bearing liabilities include deposits and borrowings. To compare the


tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 34% federal corporate income tax rate.

Net interest income is affected by changes in interest rates, volume of interest bearing assets and liabilities, and the composition of those assets and liabilities. The "interest rate spread" and "net interest margin" are two common statistics related to changes in net interest income. The interest rate spread represents the difference between the yields earned on interest earning assets and the rates paid for interest bearing liabilities. The net interest margin is defined as the percentage of net interest income to average earning assets. Earning assets obtained through noninterest bearing sources of funds such as regular demand deposits and shareholders' equity result in a net interest margin that is higher than the interest rate spread.

2012 Compared to 2011
Net interest income for the three-month period ended September 30, 2012 was $6,464,000, a $301,000 or 5% increase when compared to the $6,163,000 reported for the same period in 2011. The Company's net interest margin, at 3.58%, increased by 17 basis points over the 3.41% reported for the same quarter last year. In comparison to the linked quarter, the Company's net interest margin increased by 1 basis point over the 3.57% reported for the second quarter of 2012. Net interest income for the nine-month period ended September 30, 2012 was $19,186,000, an $822,000 or 5% increase when compared to the $18,364,000 reported for the same period in 2011.

The increase in net interest income and corresponding increase in net interest margin was primarily attributable to the reduction in funding costs over the previous 12 months. The Company's cost of funds was 0.80% during the three-month period ended September 30, 2012 compared to the 1.13% reported in the same period last year. Decreased rates on our Prime Money Market accounts and more aggressive pricing on time deposits have led to the decrease in funding costs. The Company's yield on earning assets declined to 4.36% in comparison to the 4.52% yield from the same prior year period and the 4.39% yield earned in the linked quarter. We believe that continued margin expansion will be difficult due to the downward pressure we are seeing on yields in both our loan and investment portfolio.

2011 Compared to 2010
Net interest income for the three-month period ended September 30, 2011 was $6,163,000, a $1,085,000 or 21% increase when compared to the $5,078,000 reported for the same period in 2010. The Company's net interest margin increased by 59 bps to 3.41% compared to the 2.82% reported for the third quarter of 2010. Net interest income for the nine-month period ended September 30, 2011 was $18,364,000, a $3,109,000, or 20% increase when compared to the $15,255,000 reported for the same period in 2010.

Noninterest Income

2012 Compared to 2011
Noninterest income for the three-month period ended September 30, 2012 was $1,189,000, a decrease of $184,000 or 13% compared to the $1,373,000 for the same period last year. However, included in the current and prior year results were gains taken on the sale of securities totaling $118,000 and $541,000, respectively. Absent these gains, noninterest income improved $239,000 or 29%, led by the Company's mortgage division and an increase in service charges on deposit accounts. Mortgage fee income increased $92,000 or 137% while service charge income increased $77,000 or 21%. Noninterest income for the nine-month period ended September 30, 2012 was $3,211,000, a $23,000 or 1% increase when compared to the $3,188,000 reported for the same period in 2011. Excluding realized gains on the sale of securities, noninterest income has risen by $882,000, or 41% as compared to the same period last year. For the nine-month period, results were impacted by increases in the Company's wealth management and mortgage divisions, which outperformed the prior year's nine-month totals by $316,000 and $289,000 respectively.

2011 Compared to 2010
Noninterest income for the three-month period ended September 30, 2011 was $1,373,000, an increase of $497,000, or 57%, compared to the $876,000 for the same period in 2010. The third quarter of 2011 included $541,000 in realized gains from the sale of securities compared to $0 in the same prior in 2010. The Company recorded $110,000 in gains


from partnership interests in the third quarter of 2010 compared to $0 in the three months ended September 30, 2011. Excluding these nonrecurring items, noninterest income would have totaled $832,000, an increase of $66,000, or 9%, from the same period in 2010. In comparison to third quarter of 2010, brokerage fee income increased $65,000, or 53% and mortgage fee income decreased $20,000, or 23%. For the nine-month period ended September 30, 2011, noninterest income was $3,188,000, an increase of $1,116,000, or 54%, compared to the $2,072,000 in the same period in 2010. Excluding realized gains on the sale of securities and partnership interests, noninterest income would have totaled $2,171,000, an increase of $162,000, or 8%, from the same period in 2010.

Noninterest Expense

2012 Compared to 2011
Noninterest expense for the three-month period ended September 30, 2012 was $5,214,000, a decrease of $128,000, or 2%, compared to the $5,342,000 recorded in same period last year. The Company's efficiency ratio for the third quarter of 2012 was 66.8%, as compared to 69.6% for the same period last year. Specific items to note are as follows:

Insurance expense decreased $212,000 or 48%;

Professional fees decreased by $125,000 or 30% due to reduced legal expenses;

Net foreclosed asset expense decreased by $104,000 or 18% due to reduced impairment losses taken on its foreclosed asset portfolio during the third quarter of 2012 as compared to 2011;

Compensation expense increased by $257,000 as a result of equity and merit increases for all employees which went into effect January 1, 2012, increased commissions in our Mortgage and Valley Wealth Management areas and increased incentive and profit sharing accruals based upon the Company's performance year-to-date;

Occupancy and equipment expense increased by $35,000 or 10% due increased rental expenses as a result of expansion of office space in our downtown location; and

Data processing expense increased $49,000 or 19% due to increased online banking usage (73% increase in number of online banking users) and the addition of new fraud prevention software for monitoring customer transactions.

Noninterest expense for the nine-month period ended September 30, 2012 was $14,926,000, an $888,000 or 6% decrease when compared to the $15,814,000 reported for the same period in 2011.

2011 Compared to 2010

Noninterest expense for the three-month period ended September 30, 2011 was $5,342,000, an increase of $1,062,000, or 25%, compared to $4,280,000 in the same period of 2010. The Company's efficiency ratio improved slightly for the quarter to 69.6% as compared to 69.7% for the same quarter in the prior year. Specific items to note are as follows:

Compensation expense increased $416,000 due to year-end profit sharing accruals as well as increased pension costs and merit, equity, and promotional increases that went into effect during 2011;

Net foreclosed asset expense increased by $398,000 due to increased write-downs on foreclosed assets as compared to the same period in 2010;

The $158,000 increase in insurance expense is attributable to FDIC insurance premiums; and

Professional fees increased $110,000 due primarily to litigation costs incurred.

Noninterest expense for the nine-month period ended September 30, 2011 was $15,814,000, an increase of $2,998,000, or 23%, compared to $12,816,000 in the same period in 2010. The primary increases in noninterest expense were in compensation, foreclosed asset, legal and FDIC insurance expenses.


Asset Quality

Summary of Allowance for Loan Losses

2012 Compared to 2011
The allowance for loan losses ("ALLL") was $8,548,000 as of September 30, 2012, compared to $9,650,000 as of December 31, 2011 and $10,013,000 reported a year earlier. The ratio of the allowance for loan losses to total loans outstanding was approximately 1.58% at September 30, 2012, which compares to approximately 1.90% of total loans at December 31, 2011 and 1.96% of total loans at September 30, 2011. A total of $2,210,000 in specific reserves was included in the balance of the allowance for loan losses as of September 30, 2012 for impaired loans, which compares to a total of $2,099,000 as of December 31, 2011 and $1,048,000 at September 30, 2011. Total reserves represented 100% of the non-accrual loan balances as of September 30, 2012, as compared to 106% reported in the same period last year.

The Company recorded no provision for loan losses during the third quarter of 2012 compared to a net provision expense of $164,000 in the same period last year. Net charge-offs as a percentage of average loans receivable was 0.08% for the third quarter of 2012, compared to 0.09% for the same quarter in the prior year. Net charge-offs were $443,000 for the quarter ended September 30, 2012 in comparison to $450,000 for the same quarter one year ago.

We have been successful in gradually reducing the level of the allowance for loan losses needed over the past 12-18 months based upon our significantly reduced level of charge-offs, reduction in overall watch list credits, reduction in non-accrual loans, as well as an overall reduction in new credits migrating to watch list or impaired status during this period. While we reserved no provision for loan losses in the third quarter, we did see an increase in nonaccrual loans during the quarter and we may need to make additional provisions in the future if we see additional increases in this category.

We believe the allowance for loan losses is adequate to provide for expected losses in the loan portfolio, but there are no assurances that it will be.

2011 Compared to 2010

The allowance for loan losses was $10,013,000 as of September 30, 2011, compared to $11,003,000 as of December 31, 2010 and $10,669,000 reported as of September 30, 2010. The ratio of the allowance for loan losses to total loans outstanding was approximately 1.96% at September 30, 2011, which compares to approximately 2.02% of total loans at December 31, 2010 and 1.98% of total loans at September 30, 2010. A total of $1,048,000 in specific reserves was included in the balance of the allowance for loan losses as of September 30, 2011 for impaired loans, which compares to a total of $1,280,000 as of December 31, 2010 and $1,018,000 at September 30, 2010.

The Company recorded provision for potential loan losses of $164,000 for the third quarter of 2011, a decrease of $68,000 as compared to the same period in 2010. Total reserves represented 94% of the non-accrual loan balances as of September 30, 2011, decreased from the 103% coverage of non-accrual loans as of June 30, 2011 but a significant increase from the 65% reported as of September 30, 2010.

Non-Performing Assets
Non-performing assets include nonaccrual loans, loans past due 90 days or more, restructured loans and foreclosed/ repossessed property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will be placed on nonaccrual status automatically when principal or interest is past due 90 days or more, unless the loan is both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.

A restructured loan is a loan in which the original contract terms have been modified due to a borrower's financial condition or there has been a transfer of assets in full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not normally consider.


Based on generally accepted accounting standards for receivables, a loan is impaired when, based on current information and events, it is likely that a creditor will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the loan agreement.

The Company's ratio of non-performing assets as a percentage of total assets increased 11 basis points to 4.44% as compared to 4.33% one year earlier and increased 45 basis points from the 3.99% reported at June 30, 2012. The uptick in non-performing assets during the third quarter is primarily attributable to one relationship moving to nonaccrual status and the increase in loans past due 90 days or more. These loans have been evaluated individually for potential loss exposure and we determined that new specific reserves in the amount of $550,000 were needed for these relationships at September 30, 2012. Due to the substantial reduction in charge-offs during our 8-quarter look-back period as compared to the June 30, 2012 analysis, the additional specific reserves were offset by a reduction in our general reserves..

Nonperforming assets at September 30, 2012, December 31, 2011 and September 30, 2011 are presented in the following table:

                           Nonperforming Assets

In thousands                    9/30/2012       12/31/2011       9/30/2011
Nonaccrual loans               $     8,547     $      8,638     $     9,412
Loans past due 90 days or
more                                   876                4           3,124
Restructured loans                   3,324            2,305           2,187
Total nonperforming loans      $    12,747     $     10,947     $    14,723

Foreclosed, repossessed and
idled properties                    22,151           17,040          17,915
Total nonperforming assets     $    34,898     $     27,987     $    32,638

If nonaccrual loans had performed in accordance with their original terms, additional interest income would have been recorded in the amount of $253,000 for the nine months ended September 30, 2012; $550,000 for the year ended December 31, 2011; and $437,000 for the nine months ended September 30, 2011.

Higher Risk Loans
Certain types of loans, such as option ARM products, interest-only loans, subprime loans, and loans with initial teaser rates, can have a greater risk of non-collection than other loans. We do not offer option ARM, interest-only, or subprime mortgage loans.

Junior-lien mortgages can also be considered higher risk loans and our junior lien portfolio currently consists of balances totaling $24,043,000 (4.4% of total portfolio) at September 30, 2012. Loans included in this category that were initially made with high loan-to-value ratios of 100% or greater have current balances totaling $1,397,000 at September 30, 2012. Since 2003, we have experienced net charge-offs totaling $830,000 in junior lien mortgages.

Financial Condition

Total assets at September 30, 2012 were $785,292,000, up $11,788,000 or 2% from $773,504,000 at December 31, 2011. The principal components of the Company's assets at the end of the period were $22,134,000 in cash and cash equivalents, $142,867,000 in securities available-for-sale, $26,475,000 in securities held-to-maturity and $541,968,000 in gross loans. Total assets at December 31, 2011 were $773,504,000 with the principal components consisting of $30,724,000 in cash and cash equivalents, $160,465,000 in securities available-for-sale, $28,770,000 in securities held-to-maturity and $508,586,000 in gross loans.


Total liabilities at September 30, 2012 were $719,116,000, up from $713,391,000 at December 31, 2011, an increase of $5,725,000 or 1%. Deposits decreased $13,161,000 or 2% to $617,547,000 from the $630,708,000 level at December 31, 2011 while FHLB advances increased $15,000,000 to $53,000,000 at September 30, 2012. Total shareholders' equity at September 30, 2012 was $66,176,000, up from $60,113,000 at December 31, 2011, an increase of $6,063,000 or 10%. Likewise, the Company's book value per share increased by 13% from $8.98 at December 31, 2011 to $10.19 at September 30, 2012.

During the past 12 months, the Company has experienced gross loan growth of $33,382,000 or 7%. This growth has been funded through a combination of a reduction in excess cash, cash flows and sales from our investment portfolio and an increase in FHLB advances. With our current loan to deposit ratio close to our internal maximum threshold of 90% , we will be focused on raising new core deposits in the coming months.

Capital Adequacy
The management of capital in a regulated financial services industry must properly balance return on equity to shareholders while maintaining sufficient capital levels and related risk-based capital ratios to satisfy regulatory requirements. The Company's capital management strategies have been developed to provide attractive rates of returns to shareholders, while maintaining its "well-capitalized" position at the banking subsidiary.

The primary source of additional capital to the Company is earnings retention, which represents net income less dividends declared. The Company is current on all dividend payments for the Series A Preferred Stock. With the Company's improved capital levels, the Company's Board of Directors declared a quarterly cash dividend in the amount of $0.035 per share, payable November 1, 2012 to common shareholders of record October 15, 2012. Additionally, the Company will make its first TARP redemption payment in the amount of $1,601,900 on November 14, 2012. The Company currently expects to make quarterly redemptions during 2013 of similar amounts, based on its earnings, financial condition and obtaining continued regulatory permission.

The Company and its banking subsidiary also are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and the subsidiary bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act ("FDICIA"), the Company and its banking subsidiary must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and its banking subsidiary to maintain minimum amounts and ratios of total and Tier 1 capital to average assets. As of September 30, 2012 and December 31, 2011, the Company and the subsidiary bank met all minimum capital adequacy requirements to which they are subject and are categorized as "well capitalized". These capital amounts and ratios are included in Note 10 of the consolidated financial statements incorporated by reference herein.

Interest Rate Risk
Interest rate risk is the exposure to fluctuations in the Company's future earnings (earnings at risk) and value (economic value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest earning assets and interest bearing liabilities that reprice within a specified time period as a result of scheduled maturities and repayment and contractual interest rate changes. At September 30, 2012 the Company is asset sensitive as simulation results indicate that net interest income would rise by approximately 2% if rates were to rise 200 basis points.
For a further discussion on interest rate risks, see the Company's Annual Report on Form 10-K for the year ended December 31, 2011.


Liquidity
One of the principal goals of the Bank's asset and liability management strategy is to maintain adequate liquidity. Liquidity measures our ability to meet our maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund our operations and to provide for customers' credit needs. Liquidity represents a financial institution's ability to meet present . . .

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