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

Show all filings for GERMAN AMERICAN BANCORP, INC. | Request a Trial to NEW EDGAR Online Pro

Form 10-K for GERMAN AMERICAN BANCORP, INC.


18-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

INTRODUCTION

German American Bancorp, Inc., is a NASDAQ-traded (symbol: GABC) financial services holding company based in Jasper, Indiana. German American, through its banking subsidiary German American Bancorp, operates 35 commercial and retail banking offices in 13 southern Indiana counties. The Company also owns a trust, brokerage, and financial planning subsidiary (German American Financial Advisors & Trust Company) and a full line property and casualty insurance agency (German American Insurance, Inc.).

Throughout this Management's Discussion and Analysis, as elsewhere in this report, when we use the term "Company", we will usually be referring to the business and affairs (financial and otherwise) of the Company and its subsidiaries and affiliates as a whole. Occasionally, we will refer to the term "parent company" or "holding company" when we mean to refer to only German American Bancorp, Inc., and the term "Bank" when we mean to refer to only the Company's bank subsidiary.

This Management's Discussion and Analysis includes an analysis of the major components of the Company's operations for the years 2010 through 2012 and its financial condition as of December 31, 2012 and 2011. This information should be read in conjunction with the accompanying consolidated financial statements and footnotes contained elsewhere in this report and with the description of business included in Item 1 of this Report (including the cautionary disclosure regarding "Forward Looking Statements and Associated Risks"). Financial and other information by segment is included in Note 15 to the Company's consolidated financial statements included in Item 8 of this Report and is incorporated into this Item 7 by reference.

The statements of management's expectations and goals concerning the Company's future operations and performance that are set forth in the following Management Overview and in other sections of this Item 7 are forward-looking statements, and readers are cautioned that these forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that is expressed or implied by any forward-looking statement. This Item 7, as well as the discussions in Item 1 ("Business") entitled "Forward-Looking Statements and Associated Risks" and in Item 1A ("Risk Factors") (which discussions are incorporated in this Item 7 by reference) list some of the factors that could cause the Company's actual results to vary materially from those expressed or implied by any such forward-looking statements.

MANAGEMENT OVERVIEW

The Company's 2012 net income totaled $24,055,000, or $1.90 per diluted share, which was a record level of earnings for the Company and represented an 18% increase on a per share basis over the Company's 2011 net income of $20,249,000, or $1.61 per diluted share. The Company's return on average equity for 2012 was 13.6%, representing the eighth consecutive year the Company has achieved a double-digit return on equity.

The record earnings performance during 2012 was attributable to both an increased level of net interest income, driven by a higher level of earnings assets within both the Company's loan portfolio and securities portfolio, and a reduced level of provision for loan loss, as the Company's asset quality remained strong while showing continued improvement. Net interest income improved by $2,267,000, or approximately 4%, during 2012 compared with 2011. Provision for loan loss declined $4,388,000, or 65%, during 2012 compared with 2011.

The Company's 2012 earnings were positively impacted by a $235,000, or 1%, increase in the level of non-interest income. The key drivers in the increased level of non-interest income was higher trust and investment product fees, increased levels of gains related to the liquidation of other real estate, and higher levels of gains on sales of residential mortgage loans. Non-interest expenses remained relatively stable during 2012 compared with 2011, increasing by $141,000 or less than 1%.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The financial condition and results of operations for German American Bancorp, Inc. presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements, and selected financial data appearing elsewhere within this Report, are, to a large degree, dependent upon the Company's accounting policies. The selection of and application of these policies involve estimates, judgments, and uncertainties that are subject to change. The critical accounting policies and estimates that the Company has determined to be the most susceptible to change in the near term relate to the determination of the allowance for loan losses, the valuation of securities available for sale, and the valuation allowance on deferred tax assets.

Allowance for Loan Losses

The Company maintains an allowance for loan losses to cover probable incurred credit losses at the balance sheet date. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. A provision for loan losses is charged to operations based on management's periodic evaluation of the necessary allowance balance. Evaluations are conducted at least quarterly and more often if deemed necessary. The ultimate recovery of all loans is susceptible to future market factors beyond the Company's control.

The Company has an established process to determine the adequacy of the allowance for loan losses. The determination of the allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on other classified loans and pools of homogeneous loans, and consideration of past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors, all of which may be susceptible to significant change. The allowance consists of two components of allocations, specific and general. These two components represent the total allowance for loan losses deemed adequate to cover losses inherent in the loan portfolio.

Commercial and agricultural loans are subject to a standardized grading process administered by an internal loan review function. The need for specific reserves is considered for credits when graded substandard or when: (a) the customer's cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or,
(d) other reasons where the ultimate collectibility of the loan is in question, or the loan characteristics require special monitoring. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that we believe indicates the loan is impaired. Specific allocations on impaired loans are determined by comparing the loan balance to the present value of expected cash flows or expected collateral proceeds. Allocations are also applied to categories of loans not considered individually impaired but for which the rate of loss is expected to be greater than historical averages, including those graded substandard and non-performing consumer or residential real estate loans. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values.

General allocations are made for other pools of loans, including non-classified loans, homogeneous portfolios of consumer and residential real estate loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a one-year historical average for loan losses for these portfolios, judgmentally adjusted for economic factors and portfolio trends.

Due to the imprecise nature of estimating the allowance for loan losses, the Company's allowance for loan losses includes a minor unallocated component. The unallocated component of the allowance for loan losses incorporates the Company's judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as economic uncertainties, lending staff quality, industry trends impacting specific portfolio segments, and broad portfolio quality trends. Therefore, the ratio of allocated to unallocated components within the total allowance may fluctuate from period to period.

Securities Valuation

Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income
(loss), net of tax. The Company obtains market values from a third party on a monthly basis in order to adjust the securities to fair value. Equity securities that do not have readily determinable fair values are carried at cost. Additionally, when securities are deemed to be other than temporarily impaired, a charge will be recorded through earnings; therefore, future changes in the fair value of securities could have a significant impact on the Company's operating results. In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Company intends to sell or believes it will be required to sell the securities prior to recovery. As of December 31, 2012, gross unrealized losses on the securities available-for-sale portfolio totaled approximately $195,000 and gross unrealized gains totaled approximately $16,739,000. As of December 31, 2012, held-to-maturity securities had a gross unrecognized gain of approximately $5,000.

Income Tax Expense

Income tax expense involves estimates related to the valuation allowance on deferred tax assets and loss contingencies related to exposure from tax examinations.

A valuation allowance reduces deferred tax assets to the amount management believes is more likely than not to be realized. In evaluating the realization of deferred tax assets, management considers the likelihood that sufficient taxable income of appropriate character will be generated within carryback and carryforward periods, including consideration of available tax planning strategies. Tax related loss contingencies, including assessments arising from tax examinations and tax strategies, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. In considering the likelihood of loss, management considers the nature of the contingency, the progress of any examination or related protest or appeal, the views of legal counsel and other advisors, experience of the Company or other enterprises in similar matters, if any, and management's intended response to any assessment.

RESULTS OF OPERATIONS

NET INCOME

Net income for the year ended December 31, 2012 totaled $24,055,000 or $1.90 per diluted share, an increase of $3,806,000 or approximately 18% on a per share basis, from the year ended December 31, 2011 net income of $20,249,000 or $1.61 per diluted share. For 2012, the improvement in earnings was attributable to both an increased level of net interest income, driven by a higher level of earning assets within both the Company's loan portfolio and securities portfolio, and a reduced level of provision for loan loss.

Net income increased $6,844,000 or 51% to $20,249,000 or $1.61 per share in 2011 compared to $13,405,000 or $1.21 per share in 2010. The $0.40 per share increase during 2011 equated to a 33% improvement over 2010. For 2011, the improvement was attributable to both significant core deposit growth within the Company's existing markets and the impact of the Bank of Evansville acquisition.

NET INTEREST INCOME

Net interest income is the Company's single largest source of earnings, and represents the difference between interest and fees realized on earning assets, less interest paid on deposits and borrowed funds. Several factors contribute to the determination of net interest income and net interest margin, including the volume and mix of earning assets, interest rates, and income taxes. Many factors affecting net interest income are subject to control by management policies and actions. Factors beyond the control of management include the general level of credit and deposit demand, Federal Reserve Board monetary policy, and changes in tax laws.

Net interest income increased $2,267,000 or 4% (an increase of $2,617,000 or 4% on a tax-equivalent basis) during the year ended December 31, 2012 compared with 2011. The increased net interest income during 2012 compared with 2011 was driven by a higher level of earning assets including both average loan growth and growth in the securities portfolio which resulted from growth of the Company's deposit base.

Average earning assets increased by approximately $114.0 million, or 7%, during 2012 compared with 2011. Average loans outstanding increased $33.7 million, or 3%, during 2012 compared with 2011. Average federal funds sold and other short-term investments decreased by $40.2 million, or 47%, during 2012 compared with 2011. The average securities portfolio increased approximately $120.6 million, or 24%, in 2012 compared to 2011. The key driver of the increased securities portfolio was the decline in the federal funds sold position and an increased level of average core deposits (core deposits defined as demand deposits - both interest and non-interest bearing, savings, money market and time deposits in denominations of less than $100,000). The increase in average core deposits totaled $104.5 million, or approximately 7%, during 2012 compared with 2011.

The tax equivalent net interest margin was 3.74% for the year ended December 31, 2012 compared to 3.84% in 2011. The yield on earning assets totaled 4.34% in 2012 compared to 4.79% in 2011 while the cost of funds (expressed as a percentage of average earning assets) totaled 0.60% during 2012 compared to 0.95% in 2011.

The decline in the net interest margin in 2012 compared with 2011 was largely attributable to the continued downward pressure on earning asset yields being driven by a historically low market interest rate environment and a very competitive marketplace for lending opportunities. Accretion of loan discounts on certain acquired loans contributed approximately 12 basis points to the net interest margin in 2012 compared with 13 basis points in 2011. The decline in the Company's cost of funds by 35 basis points during 2012 compared to 2011 was driven by a continued decline in deposit rates.

Net interest income increased $15,310,000 or 31% (an increase of $15,721,000 or 32% on a tax-equivalent basis) for the year ended December 31, 2011 compared with 2010. The tax equivalent net interest margin was 3.84% for 2011 compared with 3.98% during 2010. The yield on earning assets totaled 4.79% during 2011 compared to 5.23% in 2010 while the cost of funds totaled 0.95% during 2011 compared to 1.25% in 2010. The increased level of net interest income during 2011 compared with 2010 was primarily attributable to an increased level of average earning assets. The decline in the net interest margin expressed as a percentage was largely the result of the Company carrying a higher level of federal funds sold and other short-term investments during 2011 compared with 2010 and an increased securities portfolio driven by an increase in the Company's core deposit base. This core deposit increase was the result of the acquisition of American Community and growth from the Company's existing branch network.

Average earning assets increased by approximately $456.9 million or 37% during 2011 compared with 2010. Average loans outstanding increased by $208.1 million, or 23%, during 2011 compared with 2010. The increase in average loans was largely attributable to the American Community acquisition as of January 1, 2011 and the acquisition of two branch offices in the second quarter of 2010. Average federal funds sold and other short-term investments increased by $44.2 million during 2011 compared with 2010. The average securities portfolio increased by $204.6 million, or 69%, in 2011 compared with 2010. The key driver of the increased federal funds sold position and securities portfolio was an increased level of average core deposits. The increase in average core deposits totaled $451.4 million, or approximately 47%, during 2011 compared with 2010. The acquisition of the American Community and the branch acquisition completed in the second quarter of 2010 contributed approximately $304.6 million of the average core deposit growth while organic growth from the Company's existing branch network contributed approximately $146.8 of the average core deposit growth.

The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years. For tax-equivalent adjustments, an effective tax rate of 34% was used for all years presented (1).

Average Balance Sheet

(Tax-equivalent basis, dollars in thousands)



                                   Twelve Months Ended                             Twelve Months Ended                             Twelve Months Ended
                                    December 31, 2012                               December 31, 2011                               December 31, 2010
                          Principal      Income /       Yield /           Principal      Income /       Yield /           Principal      Income /       Yield /
                           Balance        Expense        Rate              Balance        Expense        Rate              Balance        Expense        Rate

ASSETS
Federal Funds Sold and
Other Short-term
Investments              $    44,999     $      91          0.20 %       $    85,217     $     216          0.25 %       $    41,020     $      76          0.19 %

Securities:
Taxable                      547,949        12,946          2.36 %           450,099        13,677          3.04 %           268,170         9,812          3.66 %
Non-taxable                   71,961         3,743          5.20 %            49,260         2,805          5.69 %            26,584         1,575          5.92 %
Total Loans and Leases
(2)                        1,147,891        61,951          5.40 %         1,114,181        64,684          5.81 %           906,127        53,540          5.91 %
TOTAL INTEREST
 EARNING ASSETS            1,812,800        78,731          4.34 %         1,698,757        81,382          4.79 %         1,241,901        65,003          5.23 %

Other Assets                 137,594                                         139,658                                         100,124
Less: Allowance for
Loan Losses                  (16,271 )                                       (14,712 )                                       (11,485 )

TOTAL ASSETS             $ 1,934,123                                     $ 1,823,703                                     $ 1,330,540

LIABILITIES AND
SHAREHOLDERS' EQUITY
Interest-bearing
Demand Deposits          $   512,232     $     972          0.19 %       $   478,486     $   2,374          0.50 %       $   281,355     $     953          0.34 %
Savings Deposits             435,475           792          0.18 %           392,166         1,940          0.49 %           237,610           735          0.31 %
Time Deposits                357,193         5,194          1.45 %           394,008         7,672          1.95 %           354,239         8,873          2.50 %
FHLB Advances and
Other Borrowings             118,201         3,954          3.35 %           126,922         4,194          3.30 %           150,737         4,961          3.29 %
TOTAL INTEREST-BEARING
LIABILITIES                1,423,101        10,912          0.77 %         1,391,582        16,180          1.16 %         1,023,941        15,522          1.52 %

Demand Deposit
Accounts                     313,812                                         256,544                                         173,091
Other Liabilities             20,003                                          15,812                                          13,641
TOTAL LIABILITIES          1,756,916                                       1,663,938                                       1,210,673

Shareholders' Equity         177,207                                         159,765                                         119,867

TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY     $ 1,934,123                                     $ 1,823,703                                     $ 1,330,540

COST OF FUNDS                                               0.60 %                                          0.95 %                                          1.25 %

NET INTEREST INCOME                      $  67,819                                        $ 65,202                                       $  49,481

NET INTEREST MARGIN                                         3.74 %                                          3.84 %                                          3.98 %

(1) Effective tax rates were determined as though interest earned on the Company's investments in municipal bonds and loans was fully taxable.

(2) Loans held-for-sale and non-accruing loans have been included in average loans. Interest income on loans includes loan fees of $3,164, $3,335, and $909 for 2012, 2011, and 2010, respectively.

The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates:

Net Interest Income - Rate / Volume Analysis

(Tax-Equivalent basis, dollars in thousands)

                                2012 compared to 2011                            2011 compared to 2010
                           Increase / (Decrease) Due to (1)                 Increase / (Decrease) Due to (1)
                       Volume             Rate            Net           Volume             Rate            Net
Interest Income:
Federal Funds Sold
and Other
Short-term
Investments          $       (88 )     $       (37 )   $     (125 )   $       104       $        36     $      140
Taxable Securities         2,646            (3,377 )         (731 )         5,754            (1,889 )        3,865
Non-taxable
Securities                 1,199              (261 )          938           1,294               (64 )        1,230
Loans and Leases           1,916            (4,649 )       (2,733 )        12,093              (949 )       11,144
Total Interest
Income                     5,673            (8,324 )       (2,651 )        19,245            (2,866 )       16,379

Interest Expense:
Savings and
Interest-bearing
Demand                       352            (2,903 )       (2,551 )         1,481             1,145          2,626
Time Deposits               (667 )          (1,810 )       (2,477 )           923            (2,124 )       (1,201 )
FHLB Advances and
Other Borrowings            (291 )              51           (240 )          (787 )              20           (767 )
Total Interest
Expense                     (606 )          (4,662 )       (5,268 )         1,617              (959 )          658

Net Interest
Income               $     6,279       $    (3,662 )   $    2,617     $    17,628       $    (1,907 )   $   15,721

(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

See the Company's Average Balance Sheet and the discussions headed USES OF FUNDS, SOURCES OF FUNDS, and "RISK MANAGEMENT - Liquidity and Interest Rate Risk Management" for further information on the Company's net interest income, net interest margin, and interest rate sensitivity position.

PROVISION FOR LOAN LOSSES

The Company provides for loan losses through regular provisions to the allowance for loan losses. The provision is affected by net charge-offs on loans and changes in specific and general allocations required on the allowance for loan losses. Provisions for loan losses totaled $2,412,000, $6,800,000, and $5,225,000 in 2012, 2011, and 2010, respectively.

The provision for loan loss declined $4,388,000, or 65%, during 2012 compared to 2011. During 2012, the provision for loan loss represented approximately 21 basis points of average outstanding loans while net charge-offs represented approximately 19 basis points of average outstanding loans. The significant decline in the Company's provision for loan loss during 2012 compared with 2011 was largely attributable to a lower level of net charge-offs and overall improvement in the level of adversely classified and non-performing loans.The Company's allowance for loan losses represented 1.29% of total loans at year-end 2012 compared with 1.37% at year-end 2011.

The level of provision for loan losses increased by $1,575,000 or 30% during 2011 compared with 2010. The increase in provision during 2011 compared with 2010 was largely the result of a higher level of net charge-offs and an upward trend in the Company's level of non-performing loans. During 2011, the provision for loan losses totaled 0.61% of average outstanding loans while net charge-offs represented 0.43% of average outstanding loans. The Company's allowance for loan losses represented 1.37% of total loans at year-end 2011 compared with 1.45% at year-end 2010. The decline in the allowance compared with total loans at year-end 2011 compared with year-end 2010 was attributable to the acquisition of the Bank of Evansville. Under acquisition accounting, loans are recorded at fair value which includes a credit risk component, and therefore the allowance on loans acquired is not carried over from the seller.

Provisions for loan losses in all periods were made at a level deemed necessary by management to absorb estimated, probable incurred losses in the loan portfolio. A detailed evaluation of the adequacy of the allowance for loan losses is completed quarterly by management, the results of which are used to determine provisions for loan losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other qualitative factors. Refer also to the sections entitled CRITICAL ACCOUNTING POLICIES AND ESTIMATES and "RISK MANAGEMENT - Lending and Loan Administration" for further discussion of the provision and allowance for loan losses.

NON-INTEREST INCOME



During 2012, non-interest income increased $235,000 or 1% compared with 2011 and
during 2011 increased $4,633,000 or 27% compared with 2010.



                                                                                      % Change From
Non-interest Income (dollars in thousands)        Years Ended December 31,              Prior Year
                                                 2012         2011         2010        2012       2011
Trust and Investment Product Fees            $  2,657     $  2,145     $  1,582          24 %       36 %
Service Charges on Deposit Accounts             4,076        4,154        4,065          (2 )        2
Insurance Revenues                              5,524        5,819        5,347          (5 )        9
Company Owned Life Insurance                      974        1,100          806         (11 )       36
Interchange Fee Income                          1,724        1,501        1,243          15         21
Other Operating Income                          1,955        1,452        1,740          35        (17 )
Subtotal                                       16,910       16,171       14,783           5          9
. . .
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