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| ESSA > SEC Filings for ESSA > Form 10-K on 14-Dec-2012 | All Recent SEC Filings |
14-Dec-2012
Annual Report
Business Strategy
Our business strategy is to grow and improve our profitability by:
• Increasing customer relationships through the offering of excellent service and the distribution of that service through effective delivery systems;
• Continuing to transform into a full service community bank by meeting the financial services needs of our customers;
• Continuing to develop into a high performing financial institution, in part by increasing interest revenue and fee income;
• Remaining within our risk management parameters; and
• Employing affordable technology to increase profitability and improve customer service.
We intend to continue to pursue our business strategy, subject to changes necessitated by future market conditions and other factors. We also intend to focus on the following:
• Increasing customer relationships through a continued commitment to service and enhancing products and delivery systems. We will continue to increase customer relationships by focusing on customer satisfaction with regard to service, products, systems and operations. We have upgraded and expanded certain of our facilities, including our corporate center and added additional branches to provide additional capacity to manage future growth and expand our delivery systems.
• Remaining within our risk management parameters. We place significant emphasis on risk management and compliance training for all of our directors, officers and employees. We focus on establishing regulatory compliance programs to determine the degree of such compliance and to maintain the trust of our customers and community.
• Employing cost-effective technology to increase profitability and improve customer service. We will continue to upgrade our technology in an efficient manner. We have implemented new software for marketing purposes and have upgraded both our internal and external communication systems.
• Continuing our emphasis on commercial real estate lending to improve our overall performance. We intend to continue to emphasize the origination of higher interest rate margin commercial real estate loans as market conditions, regulations and other factors permit. We have expanded our commercial banking capabilities by adding experienced commercial bankers, and enhancing our direct marketing efforts to local businesses.
• Expanding our banking franchise through branching and acquisitions. We will continue to integrate the nine former First Star Branches that we acquired during 2012. The most significant event in that integration is the conversion of the computer banking system used by the former First Star branches to the computer banking system used by ESSA Bank & Trust. The conversion is planned for January, 2013. Post conversion, all 26 ESSA Bank & Trust branches will be using the same computer banking system. We will attempt to use our stock holding company structure, to expand our market footprint through de novobranching as well as through additional acquisitions of banks, savings institutions and other financial service providers in our primary market area. We will also consider establishing de novo branches or acquiring additional financial institutions in contiguous counties. We will continue to review and assess locations for new branches both within Monroe County and the contiguous counties around Monroe. There can be no assurance that we will be able to consummate any new acquisitions or establish any additional new branches. We may continue to explore acquisition opportunities involving other banks and thrifts, and possibly financial service companies, when and as they arise, as a means of supplementing internal growth, filling gaps in our current geographic market area and expanding our customer base, product lines and internal capabilities, although we have no current plans, arrangements or understandings to make any acquisitions.
• Maintaining the quality of our loan portfolio. Maintaining the quality of our loan portfolio is a key factor in managing our growth. We will continue to use customary risk management techniques, such as independent internal and external loan reviews, risk-focused portfolio credit analysis and field inspections of collateral in overseeing the performance of our loan portfolio.
Critical Accounting Policies
We consider accounting policies that require management to exercise significant judgment or discretion or make significant assumptions that have, or could have, a material impact on the carrying value of certain assets or on income, to be critical accounting policies. We consider the following to be our critical accounting policies:
Allowance for Loan Losses. The allowance for loan losses is the estimated amount considered necessary to cover credit losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses which is charged against income. In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of our most critical. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management due to the high degree of judgment involved, the subjectivity of the assumptions utilized and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses.
As a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans and discounted cash flow valuations of properties are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisals and discounted cash flow valuations are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly impact the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals and discounted cash flow valuations are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.
Management performs a quarterly evaluation of the adequacy of the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the underlying collateral, the financial strength of the borrower, results of internal and external loan reviews and other relevant factors. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant revision based on changes in economic and real estate market conditions.
The analysis of the allowance for loan losses has two components: specific and general allocations. Specific allocations are made for loans that are determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. The general allocation is determined by segregating the remaining loans by type of loan, risk weighting (if applicable) and payment history. We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allocations. Actual loan losses may be significantly more than the allowance for loan losses we have established which could have a material negative effect on our financial results.
Other-than-Temporary Investment Security Impairment. Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term "other-than-temporary" is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Deferred Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. We consider the
determination of this valuation allowance to be a critical accounting policy because of the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income. These judgments and estimates are reviewed on a continual basis as regulatory and business factors change. A valuation allowance for deferred tax assets may be required if the amount of taxes recoverable through loss carryback declines, or if we project lower levels of future taxable income. Such a valuation allowance would be established through a charge to income tax expense which would adversely affect our operating results.
Comparison of Financial Condition at September 30, 2012 and September 30, 2011
Total Assets. Total assets increased $321.3 million, or 29.3%, to $1.4 billion at September 30, 2012, compared to $1.10 billion at September 30, 2011. This increase was primarily due to the acquisition of First Star Bank which was completed on July 31, 2012. Increases in investment securities available for sale, loans receivable, goodwill, deferred income taxes and other assets were partially offset by a decrease in interest-bearing deposits with other institutions.
Interest-Bearing Deposits with Other Institutions. Interest-bearing deposits with other institutions decreased $27.4 million, or 85.8%, to $4.5 million at September 30, 2012 from $31.9 million at September 30, 2011. The primary reason for the decrease was a decrease in the Company's interest bearing demand deposit account at the FHLB-Pittsburgh of $27.5 million. This decrease was primarily due to the prepayment of approximately $52.0 million of former First Star FHLBank Pittsburgh advances shortly after the completion of the First Star acquisition on July 31, 2012. The funds used to complete the prepayment came from the sale of approximately $26.0 million of former First Star investment securities available for sale and approximately $26.0 million from cash. In addition, the Company prepaid approximately $8.2 million of former First Star junior subordinated debt, $10.0 million of its own repurchase agreements and $27.0 million of its own FHLB advances during September, 2012.
Investment Securities Available for Sale. Investment securities available for sale increased $84.2 million, or 34.3% to $329.6 million at September 30, 2012 from $245.4 million at September 30, 2011. The increase was due primarily to the First Star merger. The Company acquired approximately $113.0 million of investment securities available for sale from the First Star acquisition. Approximately $26.0 million of these securities were promptly sold and the proceeds used to help fund the prepayment of $52.0 million of FHLBank Pittsburgh advances.
Net Loans. Net loans increased $211.7 million, or 28.7%, to $950.4 million at September 30, 2012 from $738.6 million at September 30, 2011. The primary reasons for the increase were increases in residential and commercial real estate loans. Residential real estate loans increased by $113.1 million to $696.7 million at September 30, 2012 from $583.6 million at September 30, 2011. Residential real estate loans acquired as part of the First Star acquisition were $113.7 million. Commercial real estate loans increased by $80.8 million to $160.2 million at September 30, 2012 from $79.4 million at September 30, 2011. Commercial and commercial real estate loans acquired from First Star were $87.3 million.
Goodwill and Deferred Income Taxes. Goodwill increased to $8.5 million at September 30, 2012 from $40,000 at September 30, 2011. For the same period, deferred income taxes increased $8.3 million to $11.3 million from $3.0 million. Both of these increases were due primarily to the acquisition of First Star Bank. Please refer to Footnote 18 of the Company's consolidated financial statements for additional details regarding the acquisition.
Other Assets. Other assets increased $16.9 million, or 130.7% to $29.8 million at September 30, 2012 from $12.9 million at September 30, 2011. The primary reasons for the increase were increases in accounts receivable of $6.7 million at September 30, 2012 compared to September 30, 2011 and in the Company's investment in low income tax credits of $5.0 million for the same period. Accounts receivable increased primarily due to $6.0 million of brokered deposits that the Company contracted for prior to September 30, 2012 but for which the funds were not received until October 1, 2012. As previously disclosed, the Company has committed approximately $8.0 to a low income housing project of which $7.4 million had been disbursed at September 30, 2012.
Deposits. Deposits increased by $357.7 million, or 56.1%, to $995.6 million at September 30, 2012 from $637.9 million at September 30, 2011. The Company acquired $340.1 million of deposits as a result of the First Star merger. Overall, the increases in deposits at September 30, 2012 compared to September 30, 2011 included increases in non-interest bearing demand accounts of $8.5 million or 25.4%, NOW accounts of $44.8 million or 68.9%, money market accounts of $41.0 million or 35.8%, savings and club accounts of $29.1 million or 39.8% and certificates of deposit of $234.3 million or 66.6%. Included in the certificates of deposit was an increase of $36.0 million or 29.7% in brokered certificates of deposit. The increase in brokered certificates of deposit was the result of the Company's decision to purchase brokered certificates based on cost compared to other available funding sources. At September 30, 2012, the Company had $156.8 million of brokered certificates of deposit outstanding.
Borrowed Funds. Borrowed funds, short term and other, decreased $53.7 million or 18.6% to $234.7 million at September 30, 2012 from $288.4 million at September 30, 2011. Included in borrowed funds at September 30, 2012 were $45.0 million of repurchase agreements with various financial institution third parties. Except for these borrowings, all borrowed funds are from the FHLB. The decrease in borrowed funds was primarily due to the use of cheaper funding sources to replace maturing FHLB borrowings. Additionally, as previously announced the Company prepaid $10.0 million of longer term, higher costing repurchase agreements and $27.0 million of FHLB borrowings during September, 2012.
Stockholders' Equity. Stockholders' equity increased by $13.7 million, or 8.5% to $175.4 million at September 30, 2012 from $161.7 million at September 30, 2011. The primary reason for the increase was the issuance of approximately 1.2 million additional shares of ESSA Bancorp common stock as a result of the merger with First Star. As previously disclosed, the total purchase price of the First Star acquisition was $24.6 million. As per the merger agreement, one half of the purchase price, or $12.3 million, was paid for with ESSA Bancorp common stock.
Comparison of Operating Results for the Years Ended September 30, 2012 and September 30, 2011
Net Income. Net income decreased $5.0 million, or 95.9%, to $215,000 for the fiscal year ended September 30, 2012 from $5.3 million for the fiscal year ended September 30, 2011. The decrease was primarily due to $1.4 million in merger related costs and $4.6 million in prepayment penalties incurred on borrowings during the year ended September 30, 2012.
Net Interest Income. Net interest income increased by $172,000, or 0.60%, to $29.1 million for fiscal year 2012 from $28.9 million for fiscal year 2011.
Interest Income. Interest income decreased $2.0 million or 4.2% to $45.2 million for fiscal year 2012 from $47.2 million for fiscal year 2011. The decrease resulted from a 41 basis point decrease in the overall yield on interest earning assets to 4.13% for fiscal year 2012 from 4.54% for fiscal year 2011 which decreased interest income by $4.1 million. This decrease was partially offset by a $55.2 million increase in average interest earning assets which had the effect of increasing interest income by $2.1 million. The increase in average interest earning assets during 2012 compared to 2011 included increases in average loans of $34.7 million, average investments of $18.2 million and average other interest earning assets of $6.6 million. These increases were partially offset by decreases in average mortgage-backed securities of $2.2 million and regulatory stock of $2.1 million. The average yield on loans decreased to 4.90% for the fiscal year 2012, from 5.2% for the fiscal year 2011. The average yields on investment securities decreased to 2.13% from 2.56% and the average yields on mortgage backed securities decreased to 2.61% from 3.36% for the 2012 and 2011 periods, respectively.
Interest Expense. Interest expense decreased $2.1 million, or 11.8% to $16.1 million for fiscal year 2012 from $18.3 million for fiscal year 2011. The decrease resulted from a 36 basis point decrease in the overall cost of interest-bearing liabilities to 1.71% for fiscal 2012 from 2.07% for fiscal 2011 which decreased interest expense by $2.4 million. A $57.5 million increase in average interest-bearing liabilities had the effect of increasing interest expense by $287,000 as borrowed funds matured and were replaced by lower cost alternatives. Average savings and club accounts increased by $9.2 million, average NOW accounts increased $7.0 million, average money market accounts decreased $828,000 and average certificates of deposit increased $75.5 million. For fiscal 2012, average borrowed funds decreased $33.3 million over 2011. The cost of money market accounts decreased to 0.28% for fiscal year 2012 from 0.47% for fiscal year 2011. The cost of savings and club accounts decreased to 0.10% for fiscal 2012 from 0.22% for fiscal 2011. The cost of certificates of deposit decreased to 1.71% from 2.01% and the cost of borrowed funds decreased to 3.24% from 3.60% for fiscal 2012 and 2011, respectively.
Provision for Loan Losses. The Company establishes provisions for loan losses, which are charged to earnings, at a level necessary to absorb known and inherent losses that are both probable and reasonably estimable at the date of the financial statements. In evaluating the level of the allowance for loan losses, management considers historical loss experience, the types of loans and the amount of loans in the loan portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, peer group information and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events occur. After an
evaluation of these factors, the Company made a provision of $2.6 million for fiscal year 2012 compared to a $2.1 million provision for the 2011 fiscal year. The allowance for loan losses was $7.3 million or 0.76% of loans outstanding at September 30, 2012, compared to $8.2 million, or 1.09% of loans outstanding at September 30, 2011.
Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Management reviews the level of the allowance on a quarterly basis, and establishes the provision for loan losses based on the factors set forth in the preceding paragraph. Historically, the Bank's loan portfolio has consisted primarily of one-to four-family residential mortgage loans. However, our current business plan calls for increases in commercial real estate loan originations. As management evaluates the allowance for loan losses, the increased risk associated with larger non-homogenous commercial real estate may result in large additions to the allowance for loan losses in future periods. Loans secured by commercial real estate generally expose a lender to greater risk of non-payment and loss than one-to-four family residential mortgage loans because repayment of the loans often depends on the successful operation of the property and the income stream of the underlying property. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one-to-four family residential mortgage loans. Accordingly, an adverse development with respect to one loan or one credit relationship can expose us to greater risk of loss compared to an adverse development with respect to a one-to-four family residential mortgage loan.
Although we believe that we use the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary, based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. In addition, the Federal Reserve Board, as an integral part of its examination process, will periodically review our allowance for loan losses. This agency may require us to recognize adjustments to the allowance, based on its judgments about information available to it at the time of its examination.
Non-Interest Income. Non-interest income increased $410,000 or 6.5%, to $6.7 million for the year ended September 30, 2012, from $6.3 million for the comparable 2011 period. The increase was primarily due to increases in earnings on bank-owned life insurance of $168,000 and insurance commissions of $387,000 which were partially offset by a decrease in the gains on the sales of loans and investments of $156,000. Earnings on bank-owned life insurance increased during fiscal 2012 as a result of the purchase of $7.0 million of additional bank-owned life insurance during fiscal 2011. Insurance commissions increased in fiscal 2012 because the Company's insurance subsidiary was not purchased until the third quarter of fiscal 2011.
Non-Interest Expense. Non-interest expense increased $7.0 million, or 26.7%, to $33.0 million for fiscal year 2012 from $26.0 million for the comparable period in 2011. The primary reasons for the increase were the increases in merger related costs of $1.4 million and prepayment penalties on borrowings of $4.6 million.
Income Taxes. Income tax expense of $33,000 was recognized for fiscal year 2012 compared to an income tax expense of $1.9 million recognized for fiscal year 2011. The primary reason for the decline was the decline in income before income taxes of $6.9 million.
Comparison of Operating Results for the Years Ended September 30, 2011 and September 30, 2010
Net Income. Net income increased $746,000, or 16.5%, to $5.3 million for the fiscal year ended September 30, 2011 from $4.5 million for the fiscal year ended September 30, 2010. The increase was primarily the result of an increase in net interest income. This increase was partially offset by a decrease in non-interest income.
Net Interest Income. Net interest income increased by $945,000, or 3.4%, to $28.9 million for fiscal year 2011 from $28.0 million for fiscal year 2010. The increase was primarily attributable to an increase of 13 basis points in the interest rate spread to 2.47% for fiscal year 2010 from 2.34% for fiscal year 2010, offset in part by a decrease in the Company's net average interest-earning assets of $17.2 million.
Interest Income. Interest income decreased $2.1 million or 4.2% to $47.2 million for fiscal year 2011 from $49.3 million for fiscal year 2010. The decrease resulted from a 37 basis point decrease in the overall yield on interest earning assets to 4.54% for fiscal year 2011 from 4.91% for fiscal year 2010 which decreased interest income by $4.7 million. This decrease was partially offset by a $35.4 million increase in average interest earning assets which had the effect of increasing interest income by $2.6 million. The average balance of loans during 2011 increased $12.2 million over the average balance during 2010, along with decreases in the average balance of investment securities of $2.0 million and increases in mortgage-backed securities of $24.6 million. In addition, average FHLB stock decreased $2.1 million and the average balance of other interest earning assets increased $2.7 million. The primary reason for the increase in mortgage backed securities was the investment of deposit and loan proceeds in excess of those needed to fund loan growth. As a member of the FHLB system, the Bank maintains an investment in the capital stock of the FHLB in an amount not less than 45 basis points of the outstanding FHLB member asset value plus 4.6% of its outstanding FHLB borrowings, as calculated throughout the year. On December 23, 2008, the FHLB notified its members, including the Company, that it was suspending the payment of dividends on its capital stock and the repurchase of excess capital stock until further notice. The FHLB began repurchasing capital stock in February 2011. The increase in average other interest earning assets was the result of an increase in the average balance of interest earning deposits held by the Company in its FHLB demand account of $2.7 million. The average yield on loans decreased to 5.2% for the fiscal year 2011, from 5.51% for the fiscal year 2010. The average yields on investment securities decreased to 2.56% from 2.72% and the average yields on mortgage backed securities decreased to 3.36% from 3.97% for the 2011 and 2010 periods, respectively.
Interest Expense. Interest expense decreased $3.0 million, or 14.2% to $18.3 million for fiscal year 2011 from $21.3 million for fiscal year 2010. The decrease resulted from a 50 basis point decrease in the overall cost of interest-bearing liabilities to 2.07% for fiscal 2011 from 2.57% for fiscal 2010 which decreased interest expense by $2.6 million. A $52.6 million increase in average interest-bearing liabilities had the effect of decreasing interest expense by $466,000 as borrowed funds matured and were replaced by lower cost . . .
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