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BNCN > SEC Filings for BNCN > Form 10-K on 18-Mar-2013All Recent SEC Filings

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Form 10-K for BNC BANCORP


18-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is management's analysis to assist in the understanding and evaluation of the consolidated financial condition and results of operations of the Company. It should be read in conjunction with the consolidated financial statements and footnotes and the selected financial data presented elsewhere in this report.

The detailed financial discussion that follows focuses on 2012 results compared to 2011. Discussion of 2011 results compared to 2010 is predominantly in section "2011 Compared to 2010."

Overview and Executive Summary

BNC Bancorp was formed in 2002 to serve as a one-bank holding company for Bank of North Carolina, a full service commercial bank, incorporated under the laws of the State of North Carolina on November 15, 1991, that opened for business on December 3, 1991. We are registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve") under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act") and the bank holding company laws of North Carolina. BNC operates under the rules and regulations of and is subject to examination by the FDIC and the North Carolina Office of the Commissioner of Banks, North Carolina Department of Commerce (the "NCOCB"). BNC is also subject to certain regulations of the Federal Reserve governing the reserves to be maintained against deposits and other matters.

Our primary sources of revenue are interest and fee income from our lending and investing activities, primarily consisting of making business loans for small to medium-sized businesses, and, to a lesser extent, from our investment portfolio. We provide a wide range of banking services tailored to the particular banking needs of the communities we serve. We are principally engaged in the business of attracting deposits from the general public and using those deposits, together with other funding from our lines of credit, to make primarily consumer and commercial loans. We target business professionals and small to mid-size business customers with credit relationships in the $250,000 to $15 million range that are too small for the regional banks but too large for smaller community banks with lower legal lending limits. We offer our customers superior customer service, convenient branch locations and experienced bankers.

Net income for the year ended December 31, 2012 was $10.5 million, an increase of $3.5 million, or 50.8%, compared to net income of $6.9 million for the year ended December 31, 2011. Income available to common shareholders was $8.0 million, or $0.48 per diluted share, for 2012, an increase of $3.5 million, or 77.8%, compared to the $4.5 million, or $0.45 per diluted share, reported for the year ended December 31, 2011. Included in the financial results for the years ended December 31, 2012 and 2011 are $12.7 million and $7.8 million, respectively, of acquisition gains and $5.2 million and $1.1 million, respectively, of merger and transactional costs. The Company has also seen significant growth in mortgage originations, which have led to a $3.9 million increase in mortgage origination fees from 2011. The Company has also experienced a significant increase in non-interest expense of $14.4 million, primarily due to additional headcount and costs associated with the strategic acquisitions made in 2012.

Total assets at December 31, 2012 were $3.08 billion, an increase of $628.9 million, or 25.6%, compared to total assets of $2.45 billion at December 31, 2011. The increase was due to continued growth in our footprint, along with the aforementioned strategic acquisitionsduring 2012. See Note 2 to the accompanying Consolidated Financial Statements contained in Item 8 for a full description of the acquisition activities. Some highlights for 2012 are as follows:

total assets at year end were $3.08 billion, up from $2.45 billion at the end of 2011;

wholesale deposits, as a percentage of total assets, declined from 37% to 26% during 2012;

classified assets to capital declined from 76% to 44% during 2012;

net interest margin remained strong at 3.85% despite increased hedging costs;

acquired First Trust in Charlotte, expanding our presence in Charlotte by $323 million in deposits;

acquired KeySource in Durham, expanding our presence in the Triangle by $152 million in deposits;

acquired Chapel Hill and Cary offices from BHR, increasing our Triangle presence by approximately $24 million in deposits;

acquired Carolina Federal in Charleston, expanding our coastal South Carolina presence by $53 million in deposits;

marketed and closed a $72.5 million capital raise to some of the highest quality institutional investors in the financial institution space;

marketed and completed the auction of preferred stock issued under the U.S Treasury Capital Purchase Program to private investors;

successfully converted core systems on Blue Ridge, Regent, Carolina Federal, BHR, and KeySource in 2012;

added seasoned functional leaders in the areas of: Enterprise Risk Management, Human Resources, and Deposit Operations. All leaders are from quality institutions of $8 billion or larger; and

originated over $275 million in mortgages and generated $6.2 million of mortgage fees during 2012.

We continue to maintain strong capital ratios. Shareholders' equity increased $118.4 million to $282.2 million at December 31, 2012. We paid $4.9 million in common and preferred dividends, net of accretion, during 2012. All of our capital ratios exceeded the minimum thresholds established for a well-capitalized bank by regulatory measures.

Critical Accounting Policies and Estimates

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amount of revenues and expenses during the reporting period. The more critical accounting and reporting policies include accounting for the allowance for credit losses, valuation of goodwill and intangible assets, and valuation of assets acquired and liabilities assumed in business combinations. Accordingly, our significant accounting policies and effects of new accounting pronouncements are discussed in detail in Note 1 "Significant Accounting Policies" to the accompanying Consolidated Financial Statements contained in Item 8.

Allowance for Loan Losses

We establish an allowance for loan losses that represents management's best estimate of probable credit losses inherent in the portfolio at the balance sheet date. Estimates for loan losses are determined by management's ongoing review and grading of the loan portfolio, consideration of historical loan loss and delinquency experience, trends in past due and nonaccrual loans, risk characteristics of the various classifications of loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the appropriateness of the allowance for loan losses, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require additions to the allowance for loan losses or may require that certain loan balances be charged off or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. See Note 1, "Significant Accounting Policies" and Note 6, "Loans and Allowance for Loan Losses" to the accompanying Consolidated Financial Statements contained in Item 8.

Valuation of Goodwill and Intangible Assets

Business acquisitions are accounted for using the acquisition method of accounting. Under the acquisition method, we are required to record the assets acquired, including identified intangible assets, and liabilities assumed at their fair value, which often involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques, all of which are inherently subjective. The amortization of identified intangible assets is based upon the estimated economic benefits to be received, which is also subjective. The Company reviews identified intangible assets for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in which case an impairment charge would be recorded.

Goodwill is subject to impairment testing on at least an annual basis. In addition, goodwill is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Our annual goodwill impairment testing is performed as of June 30 each year.

The first step in testing for impairment is to determine the fair value of each reporting unit. The Company engaged an independent valuation firm to assist in the computation of the fair value estimates of each reporting unit as part of its impairment assessment. Our reporting unit for purposes of this testing was the Company as a whole. We utilized both income and market approaches to determine the fair value for the reporting unit. The income approach was based on discounted cash flows derived from assumptions of balance sheet and income statement activity. An internal forecast was developed by considering several long-term key business drivers such as anticipated loan and deposit growth, net interest margins, and asset quality. Long-term growth rates were estimated to assist in determining the terminal values. The discount rate was estimated based on the Capital Asset Pricing Model, which considered the risk-free interest rate (20-year Constant Maturity Treasury Bonds), market-risk premium, equity-risk premium, and a company-specific risk factor. For the market approach, assets, earnings, tangible common equity and tangible franchise premium multiples of comparable acquired companies were selected and applied to the reporting unit's applicable metrics. In addition, historic control premiums were applied to the Company's market value. The results of the income and market approaches were averaged to arrive at the final calculation of fair value. We determined the estimated fair value exceeded the carrying value (including goodwill) for the reporting unit.

The second step of impairment testing is necessary only if the carrying amount of either reporting unit exceeds its fair value, suggesting goodwill impairment. In such a case, we would estimate a hypothetical purchase price for the reporting unit (representing the unit's fair value) and then compare that hypothetical purchase price with the fair value of the unit's net assets (excluding goodwill). Any excess of the estimated purchase price over the fair value of the reporting unit's net assets represents the implied fair value of goodwill. An impairment loss would be recognized as a charge to earnings if the carrying amount of the reporting unit's goodwill exceeds the implied fair value of goodwill.

Subsequent to the 2012 annual impairment test, we updated our reporting structure in a manner that changed the composition of our reporting units. This change resulted in the Company recognizing two reporting units, which are our mortgage origination business and our banking operations unit, which contains all other activities performed by the Company. Goodwill was reassigned to the reporting units using a relative fair value allocation approach; other assets and liabilities, including applicable corporate assets, were allocated to the extent they are related to the operation of the respective reporting units. As a result, all goodwill was reallocated to the banking operations reporting unit. As a result of this change in reporting units, we performed an interim goodwill impairment analysis as of December 31, 2012 and determined the estimated fair value exceeded the carrying value (including goodwill) for the banking operations reporting unit.

Due to a decline in the value of our common stock subsequent to the date of the 2011 impairment testing date, we performed an interim goodwill impairment analysis as of December 31, 2011. We determined the estimated fair value exceeded the carrying value (including goodwill) for the reporting unit.

There were no impairment charges recorded in 2012, 2011, or 2010, respectively. We believe the estimates and assumptions used in the goodwill impairment analysis for our reporting unit are reasonable. However, if actual results and market conditions differ from the assumptions or estimates used, the fair value of each reporting unit could change in the future.

Valuation of Loans Acquired in Business Combinations

Assets acquired and liabilities assumed in business combinations are recorded at estimated fair value on their purchase date. Purchased loans acquired in a business combination, including loans covered by FDIC loss share agreements, are accounted for in accordance with the provisions of GAAP applicable to loans acquired with deteriorated credit quality.

At the time such purchased loans are acquired, management individually evaluates substantially all loans acquired in the transaction. This evaluation allows management to determine the estimated fair value of the purchased loans (not considering any FDIC loss sharing agreements) and includes no carryover of any previously recorded allowance for loan losses. In determining the estimated fair value of purchased loans, management considers a number of factors including, among other things, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, estimated holding periods, and net present value of cash flows expected to be received. To the extent that any purchased loan acquired in a FDIC-assisted acquisition is not specifically reviewed, management applies a loss estimate to that loan based on the average expected loss rates for the purchased loans that were individually reviewed in that purchased loan portfolio.

As provided for under GAAP, management has up to 12 months following the date of the acquisition to finalize the fair values of acquired assets and assumed liabilities. Once management has finalized the fair values of acquired assets and assumed liabilities within this 12-month period, management considers such values to be the Day 1 Fair Values.

In determining the Day 1 Fair Values of purchased loans, including covered loans, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans). The non-accretable difference is the difference between the contractually required payments and the cash flows expected to be collected in accordance with management's determination of the Day 1 Fair Values. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which would have a positive impact on interest income. Any such increase or decrease in expected cash flows will result in a corresponding decrease or increase, respectively, of the FDIC loss-share receivable for the portion of such reduced or additional loss expected to be collected from the FDIC.

The accretable yield on purchased loans, including covered loans, is the difference between the expected cash flows and the initial investment in the acquired loans. The accretable yield is recognized into earnings using the effective yield method over the term of the loans. Management separately monitors the purchased loan portfolio and periodically reviews loans contained within this portfolio against the factors and assumptions used in determining the Day 1 Fair Values.

In connection with the Company's FDIC-assisted acquisitions, the Company has recorded an FDIC indemnification asset to reflect the indemnification provided by the FDIC. Currently, the expected losses on covered assets for each of the Company's loss-share agreements would result in expected recovery of approximately 80% of incurred losses. Since the indemnified items are covered loans and covered foreclosed assets, which are measured at Day 1 Fair Values, the FDIC loss-share receivable is also measured and recorded at Day 1 Fair Values, and is calculated by discounting the cash flows expected to be received from the FDIC.

Analysis of Results of Operations

Consolidated net income for 2012 was $10.5 million, an increase of $3.5 million, or 50.8%, from the $6.9 million of net income for 2011. Net income available to common shareholders for 2012 was $8.0 million, or $0.48 per diluted share, compared to $4.5 million, or $0.45 per diluted share, for 2011. Comparability of earnings per share was impacted due to our second quarter 2012 capital raise, which increased our outstanding average diluted shares by approximately 3.5 million shares.

During 2012 we incurred $5.2 million of expenses associated with merger and acquisition activities, an increase from the $1.1 million incurred in 2011. These expenses reduced diluted earnings per share by $0.18 for 2012.

Two important and commonly used measures of bank profitability are return on average assets (net income as a percentage of average total assets) and return on average common shareholders' equity (net income available to common shareholders as a percentage of average common shareholders' equity). Our returns on average assets were 0.41% and 0.31% for the years ended December 31, 2012 and 2011, respectively. The returns on average common shareholders' equity were 5.11% and 4.12% for the years ended December 31, 2012 and 2011, respectively.

Net Interest Income

Net interest income is our primary source of revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, repricing frequencies, loan prepayment behavior, and the use of interest rate derivative financial instruments. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt loans and investment securities is computed on a fully-taxable equivalent basis ("FTE"). Net interest income and yield on interest-earning assets are discussed below on a FTE basis.

Net interest income was $86.4 million for the year ended December 31, 2012, an increase of $10.3 million, or 13.6%, from the $76.0 million earned in 2011. The increase in net interest income was primarily due to a $232.2 million, or 14.9%, increase in the average balance of portfolio loans, primarily from organic loan growth and our acquisitions of Carolina Federal, KeySource and, to a lesser extent, First Trust during 2012. The increase is also due to a $14.0 million, or 4.1%, increase in average investment securities during 2012, which was due to acquisitions of investment securities due to our enhanced liquidity position in 2012. We also experienced a $41.7 million increase in average interest-earning bank balances, which was due to a significantly higher liquidity position we maintained as a result of the proceeds from our capital raise, as well as cash received from our strategic acquisitions.

Included in interest income from loans was the impact of the purchase accounting adjustments that favorably affected net interest income in 2012. The accretion of yield and fair value discounts on the acquired loan portfolios totaled $6.7 million for the year ended December 31, 2012, which is consistent with the amount recognized in 2011. Factors affecting the amount of accretion include unscheduled loan payments, changes in estimated cash flows and impairment, and additional loans from acquisitions that will increase accretion.

The average yield on interest earning assets decreased by 32 basis points during the year ended December 31, 2012 from 5.63% to 5.31%. The average yield on portfolio loans and investment securities decreased 15 basis points and 51 basis points, respectively, from 2011 to 2012. The decrease is due to the origination and repricing of loans at lower interest rates, as well as the replacement of investment securities at lower interest rates.

Total interest expense was $32.9 million for the year ended December 31, 2012, which is unchanged compared to the year ended December 31, 2011. Average total interest-bearing liabilities increased $212.6 million during 2012 as compared to 2011, while the average rate on interest-bearing liabilities decreased by 17 basis points from 1.72% to 1.55% during 2012. The increase in interest-bearing liabilities was primarily from organic deposit growth and acquisitions of Carolina Federal, KeySource, First Trust and, to a lesser extent, the branches from BHR. Interest expense for 2012 was impacted by increased hedging costs related to our interest rate cap, offset by decreased funding costs.

Average borrowings decreased $19.9 million, or 13.8%, to $124.2 million during the year ended December 31, 2012. The decrease was primarily due to the paydown of short-term advances from the FHLB, as well as the maturity of a revolving line of credit during 2012. The paydown was made as a result of our enhanced liquidity position during 2012.

The net interest margin for 2012 was 3.85%, compared to 3.93% in 2011. This decrease was due to decreased interest rates and mix of interest-earning assets from continued downward pressure on market interest rates, partially offset by an improvement in cost of funds. As noted earlier, the cost of funds would have declined more dramatically except for higher hedging costs experienced in 2012 as compared to 2011.

The following tables set forth the major components of net interest income and the related annualized yields and rates for 2012, 2011 and 2010, as well as the variances between the periods caused by changes in interest rates versus changes in volumes (dollars in thousands).

Table 2

Average Balance and Net Interest Income (FTE)



                                                                                      Years Ended December 31,
                                                    2012                                        2011                                        2010
                                     Average                      Average        Average                      Average        Average                      Average
                                     balance       Interest        rate          balance       Interest        rate          balance       Interest        rate
Interest-earning assets:
Loans and leases (1)               $ 1,789,125     $  97,917          5.47 %   $ 1,556,937     $  87,424          5.62 %   $ 1,355,827     $  77,655          5.73 %
Loans held for sale                     24,774           751          3.03 %         4,320           167          3.87 %         3,280           133          4.05 %
Investment securities, taxable         115,741         4,808          4.15 %       119,797         5,688          4.75 %       150,011         7,579          5.05 %
Investment securities,
tax-exempt (2)                         237,299        15,475          6.52 %       219,270        15,541          7.09 %       202,088        14,773          7.31 %
Interest-earning balances and
other                                   77,484           290          0.37 %        35,745           118          0.33 %        88,118           208          0.24 %
Total interest-earning assets        2,244,423       119,241          5.31 %     1,936,069       108,938          5.63 %     1,799,324       100,348          5.58 %
Other assets                           300,295                                     272,456                                     227,937
Total assets                       $ 2,544,718                                 $ 2,208,525                                 $ 2,027,261
Interest-bearing liabilities:
Demand deposits                    $   941,070     $  14,242          1.51 %   $   814,518     $  11,557          1.42 %   $   700,648     $   9,278          1.32 %
Savings deposits                        56,881           266          0.47 %        36,564           162          0.44 %        18,937            46          0.24 %
Time deposits                        1,004,644        15,093          1.50 %       919,024        17,836          1.94 %       894,301        21,752          2.43 %
Borrowings                             124,223         3,290          2.65 %       144,073         3,365          2.34 %       151,505         3,671          2.42 %
Total interest-bearing
liabilities                          2,126,818        32,891          1.55 %     1,914,179        32,920          1.72 %     1,765,391        34,747          1.97 %
Non-interest-bearing deposits          188,569                                     125,969                                      96,526
Other liabilities                       16,376                                      11,409                                      15,385
Shareholders' equity                   212,955                                     156,968                                     149,959
Total liabilities and
shareholder's equity               $ 2,544,718                                 $ 2,208,525                                 $ 2,027,261
Net interest income and interest
rate spread                                        $  86,350          3.76 %                   $  76,018          3.91 %                   $  65,601          3.61 %
Net interest margin                                                   3.85 %                                      3.93 %                                      3.65 %

(1) Average outstanding balances are net of deferred costs and unearned discounts and include nonaccrual loans.

(2) Yields on tax-exempt investments have been adjusted to a fully taxable-equivalent basis using a blended income tax rate of 38.55%. The taxable-equivalent adjustment was $5.7 million, $5.6 million and $5.4 million for the year ended December 31, 2012, 2011 and 2010, respectively.

Table 3

Volume and Rate Variance Analysis

Years Ended December 31, 2012, 2011 and 2010



                                                     2012 vs. 2011                           2011 vs. 2010
                                              Increase (decrease) due to              Increase (decrease) due to
                                           Volume         Rate        Total        Volume         Rate        Total
Interest income:
Loans and leases                          $  12,873     $ (2,380 )   $ 10,493     $  11,406     $ (1,637 )   $  9,769
Loans held for sale                             705         (121 )        584            41           (7 )         34
Investment securities, taxable                 (181 )       (699 )       (880 )      (1,481 )       (410 )     (1,891 )
Investment securities, tax-exempt (1)         1,227       (1,293 )        (66 )       1,237         (469 )        768
Interest-earning balances and other             147           25          172           (95 )          5          (90 )
Total interest income                        14,771       (4,468 )     10,303        11,108       (2,518 )      8,590

Interest expense:
Deposits:
. . .
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