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FCCY > SEC Filings for FCCY > Form 10-K on 22-Mar-2013All Recent SEC Filings

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Form 10-K for 1ST CONSTITUTION BANCORP


22-Mar-2013

Annual Report


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

This discussion should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report. Throughout the following sections, the "Company" refers to 1st Constitution Bancorp and, as the context requires, its wholly-owned subsidiary, 1st Constitution Bank (the "Bank") and the Bank's wholly-owned subsidiaries, 1st Constitution Investment Company of New Jersey, Inc., FCB Assets Holdings, Inc., 1st Constitution Title Agency, L.L.C., 204 South Newman Street Corp. and 249 New York Avenue, LLC. 1st Constitution Capital Trust II ("Trust II"), a subsidiary of the Company, is not included in the Company's consolidated financial statements as it is a variable interest entity and the Company is not the primary beneficiary. The purpose of this discussion and analysis is to assist in the understanding and evaluation of the Company's financial condition, changes in financial condition and results of operations.


Table of Contents

Critical Accounting Policies and Estimates

"Management's Discussion and Analysis of Financial Condition and Results of Operation" is based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to the Company's Consolidated Financial Statements for the year ended December 31, 2012 contains a summary of the Company's significant accounting policies. Management believes the Company's policies with respect to the methodologies for the determination of the allowance for loan losses and for determining other-than-temporary security impairment involve a higher degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. These critical policies and their application are periodically reviewed with the Audit Committee and the Board of Directors. The provision for loan losses is based upon management's evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available to it, the level of the allowance for loan losses remains an estimate which is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of the Company's loans are secured by real estate in the State of New Jersey. Accordingly, the collectibility of a substantial portion of the carrying value of the Company's loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or should the Central New Jersey area experience an adverse economic shock. Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond the Company's control.

Real estate acquired through foreclosure, or a deed-in-lieu of foreclosure, is recorded at fair value less estimated selling costs at the date of acquisition or transfer, and subsequently at the lower of its new cost or fair value less estimated selling costs. Adjustments to the carrying value at the date of acquisition or transfer are charged to the allowance for loan losses. The carrying value of the individual properties is subsequently adjusted to the extent it exceeds estimated fair value less estimated selling costs, at which time a provision for losses on such real estate is charged to operations. Appraisals are critical in determining the fair value of the other real estate owned amount. Assumptions for appraisals are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly affect the valuation of a property. The assumptions supporting such appraisals are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable.

Management utilizes various inputs to determine the fair value of its investment portfolio. To the extent they exist, unadjusted quoted market prices in active markets (level 1) or quoted prices on similar assets (level 2) are utilized to determine the fair value of each investment in the portfolio. In the absence of quoted prices, valuation techniques would be used to determine fair value of any investments that require inputs that are both significant to the fair value measurement and unobservable (level 3). Valuation techniques are based on various assumptions, including, but not limited to cash flows, discount rates, rate of return, adjustments for nonperformance and liquidity, and liquidation values. A significant degree of judgment is involved in valuing investments using level 3 inputs. The use of different assumptions could have a positive or negative effect on consolidated financial condition or results of operations.

Management must periodically evaluate if unrealized losses (as determined based on the securities valuation methodologies discussed above) on individual securities classified as held to maturity or available for sale in the investment portfolio are considered to be other-than-temporary. The analysis of other-than-temporary impairment requires the use of various assumptions, including, but not limited to, the length of time an investment's book value is greater than fair value, the severity of the investment's decline, as well as any credit deterioration of the investment. If the decline in value of an investment is deemed to be other-than-temporary, the investment is written down to fair value and a non-cash impairment charge is recognized in the period of such evaluation.

Rights Offering to Existing Shareholders

During the third quarter of 2012, the Company launched a shareholders' common stock rights offering, which expired on October 5, 2012. The Company received gross proceeds of $5.0 million from holders of subscription rights who exercised their basic subscription rights and from holders who exercised the over-subscription privilege. The rights offering was fully subscribed. Accordingly, the Company issued a total of 555,555 shares of common stock to the holders of subscription rights who validly exercised their subscription rights, including pursuant to the exercise of the over-subscription privilege.


Table of Contents

Acquisition of Three Branches in 2011

On March 25, 2011, the Bank acquired certain deposit and other liabilities, real estate and related assets of the Rocky Hill, Hillsborough and Hopewell, New Jersey banking offices from another financial institution for a purchase price of $9.85 million (the "March 2011 Acquisition").

The Company accounted for the March 2011 Acquisition using applicable accounting guidance regarding business combinations. The fair value of savings and transaction deposit accounts acquired was assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand. A core deposit intangible was ascribed to the value of non-maturity deposits based upon an independent third party evaluation which was prepared using the actual characteristics of the deposits and assumptions we believe to be reasonable. Certificates of deposit accounts were valued utilizing a discounted cash flows analysis based upon the underlying accounts' contractual maturities and interest rates. The present value of the projected cash flow was then determined using discount rates based upon certificate of deposit interest rates available in the marketplace for accounts with similar terms. The fair value of the three branch buildings was determined via appraisals performed by qualified independent third party appraisers. The fair value of loans acquired, all of which were performing, was assumed to approximate amortized cost based upon the small size and nature of those loans.

As a result of the March 2011 Acquisition, the three branches became branches of the Bank. Included in the March 2011 Acquisition were the assumption of deposit liabilities of $111.9 million, primarily consisting of demand deposits, and the acquisition of cash of approximately $101.5 million, fixed assets of approximately $4.6 million, which includes, without limitation, ownership of the real estate and improvements upon which the branches are situated, and loans of $862,000. The Bank recorded goodwill of approximately $3.2 million and a core deposit intangible asset of approximately $1.7 million as a result of the March 2011 Acquisition.

Results of Operations

The Company reported net income for the year ended December 31, 2012 of $5,060,504, an increase of 28.7% from the $3,931,443 reported for the year ended December 31, 2011. The increase was due primarily to increases in net interest income and noninterest income, which were partially offset by increases in non-interest expenses and income taxes during the year ended December 31, 2012 compared to the prior year.

Diluted net income per common share was $0.90 for the year ended December 31, 2012 compared to $0.74 reported for the year ended December 31, 2011. Basic net income per common share for the year ended December 31, 2012 was $0.92 as compared to $0.74 reported for the year ended December 31, 2011. All per share information has been restated for the effect of a 5% stock dividend declared on December 20, 2012 and paid on January 31, 2013 to shareholders of record on January 14, 2013.

Return on average assets ("ROA") and return on average equity ("ROE") were 0.65% and 8.63%, respectively, for the year ended December 31, 2012, compared to 0.54% and 7.60%, respectively, for the year ended December 31, 2011 and 0.50% and 5.78%, respectively, for the year ended December 31, 2010. Key performance ratios improved for the 2012 fiscal year as compared to the prior year due to the higher net income for the year ended December 31, 2012 as compared to the year ended December 31, 2011.

The Bank's results of operations depend primarily on net interest income, which is primarily affected by the market interest rate environment, the shape of the U.S. Treasury yield curve, and the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Other factors that may affect the Bank's operating results are general and local economic and competitive conditions, government policies and actions of regulatory authorities. The net interest margin for the year ended December 31, 2012 was 3.98% as compared to the 3.55% net interest margin recorded for the year ended December 31, 2011, an increase of 43 basis points. The Company will continue to closely monitor the mix of earning assets and funding sources to maximize net interest income during this challenging interest rate environment.

Net Interest Income

Net interest income, the Company's largest and most significant component of operating income, is the difference between interest and fees earned on loans and other earning assets, and interest paid on deposits and borrowed funds. This component represented 84.0% of the Company's non-GAAP net revenues for the year ended December 31, 2012. Net interest income also depends upon the relative amount of average interest earning assets, average interest-bearing liabilities, and the interest rate earned or paid on them, respectively.


Table of Contents

The following tables set forth the Company's consolidated average balances of assets and liabilities and shareholders' equity as well as interest income and expense on related items, and the Company's average yield or rate for the years ended December 31, 2012, 2011 and 2010. The average rates are derived by dividing interest income and expense by the average balance of assets and liabilities, respectively.

Average Balance Sheets with Resultant Interest and Rates

(yields on a tax-equivalent basis)                2012                                                 2011                                                 2010

                                        Average                            Average           Average                            Average           Average                            Average
                                        Balance          Interest           Yield            Balance          Interest           Yield            Balance          Interest           Yield

Assets:
Federal Funds Sold/Short-Term
     Investments                     $  31,405,164     $     81,697              0.26 %   $  49,462,259     $    126,729              0.26 %   $  18,009,601     $     45,023              0.25 %
Investment Securities:
  Taxable                              170,089,425        4,434,108              2.61 %     200,218,556        5,422,190              2.71 %     197,134,646        4,782,984              2.43 %
  Tax-exempt (4)                        51,118,158        2,482,451              4.86 %      45,377,934        2,208,221              4.87 %      11,961,266          670,657              5.61 %

  Total                                221,207,583        6,916,559              3.13 %     245,596,490        7,630,411              3.11 %     209,095,912        5,453,641              2.61 %

Loan Portfolio (1):
  Construction                          56,802,621        3,673,709              6.47 %      60,260,579        3,865,334              6.41 %      71,590,569        4,373,609              6.11 %
  Residential Real Estate               11,673,215          603,748              5.17 %      11,323,077          705,087              6.23 %      10,866,758          635,681              5.85 %
   Home Equity                          10,226,081          574,910              5.62 %      12,194,011          698,822              5.73 %      13,500,060          786,419              5.83 %
  Commercial and Commercial
    Real Estate                        145,308,719       10,873,003              7.48 %     134,446,807       10,153,005              7.55 %     139,672,655       10,456,470              7.49 %
   Mortgage Warehouse Lines            204,852,547        9,734,919              4.75 %     131,955,449        6,459,208              4.89 %     139,430,511        6,707,820              4.81 %
   Installment                             341,400           23,419              6.86 %         452,504           31,342              6.93 %         523,354           39,409              7.53 %
   All Other Loans                      34,382,628        1,159,794              3.37 %      24,052,479          903,288              3.76 %      30,644,358         1020,458              3.33 %
  Total                                463,587,211       26,643,502              5.75 %     374,684,906       22,816,086              6.09 %     406,228,265       24,019,866              5.91 %

Total Interest-Earning
Assets                                 716,199,958       33,641,758              4.70 %     669,743,655       30,573,226              4.56 %     633,333,778       29,518,530              4.66 %

Allowance for Loan Losses               (6,370,415 )                                         (5,959,591 )                                         (5,249,095 )
Cash and Due From Banks                 12,570,141                                           13,136,295                                            9,468,512
Other Assets                            52,092,249                                           44,527,891                                           29,680,680
Total Assets                         $ 774,491,933                                        $ 721,448,250                                        $ 667,233,875

Liabilities and Shareholders'
Equity:
Interest-Bearing Liabilities:
  Money Market and NOW Accounts      $ 203,419,423     $    988,999              0.49 %   $ 172,790,166     $  1,703,342              0.99 %   $ 121,849,620     $  1,705,233              1.40 %
  Savings Accounts                     192,958,737        1,163,967              0.60 %     179,903,197        1,387,585              0.77 %     177,605,496        1,896,323              1.07 %
  Certificates of Deposit under
$100,000                                70,100,750        1,077,425              1.54 %      73,470,718        1,260,946              1.72 %      87,523,084        1,525,160              1.74 %
  Certificates of Deposit of
     $100,000 and Over                  76,526,600        1,084,312              1.42 %      79,898,632        1,308,249              1.64 %      73,573,668        1,521,153              2.07 %
  Other Borrowed Funds                  17,804,645          450,462              2.53 %      18,400,493          444,185              2.41 %      35,883,534        1,100,354              3.07 %
  Trust Preferred Securities            18,557,000          385,977              2.08 %      18,557,000          683,057              3.68 %      18,557,000        1,071,275              5.69 %

Total Interest-Bearing Liabilities     579,367,155        5,151,142              0.89 %     543,020,206        6,787,364              1.25 %     514,992,402        8,819,498              1.71 %

Net Interest Spread (2)                                                          3.81 %                                               3.31 %                                               2.95 %

 Demand Deposits                       127,558,073                                          117,876,295                                           87,482,143
Other Liabilities                        8,912,516                                            8,800,907                                            7,497,664
Total Liabilities                      715,837,744                                          669,697,408                                          609,972,209
Shareholders' Equity                    58,654,189                                           51,750,842                                           57,261,666
Total Liabilities and
Shareholders' Equity                 $ 774,491,933                                        $ 721,448,250                                        $ 667,233,875

        Net Interest Margin (3)                        $ 28,490,616              3.98 %                     $ 23,785,862              3.55 %                     $ 20,699,032              3.27 %

(1) Loan origination fees are considered an adjustment to interest income. For the purpose of calculating loan yields, average loan balances include nonaccrual loans with no related interest income. Please refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation under the heading "Non-Performing Assets" for a discussion of the Bank's policy with regard to non-accrual loans.

(2) The interest rate spread is the difference between the average yield on interest earning assets and the average rate paid on interest bearing liabilities.

(3) The net interest margin is equal to net interest income divided by average interest earning assets.

(4) Tax equivalent basis.


Table of Contents

Changes in net interest income and margin result from the interaction between the volume and composition of interest earning assets, interest bearing liabilities, related yields, and associated funding costs. The Rate/Volume Table demonstrates the impact on net interest income of changes in the volume of interest earning assets and interest bearing liabilities and changes in interest rates earned and paid.

The Company's net interest income increased on a tax equivalent basis by $4,704,754, or 19.8%, to $28,490,616 for the year ended December 31, 2012, from the $23,785,862 reported for the year ended December 31, 2011. As indicated in the Rate/Volume Table, the principal factor contributing to the increase in net interest income for the year ended December 31, 2012 was an increase in interest income of $3,068,532, resulting from increased volumes on the interest-earning loan portfolio.

The Company's net interest income increased on a tax equivalent basis by $3,086,830, or 14.9%, to $23,785,862 for the year ended December 31, 2011, from the $20,699,032 reported for the year ended December 31, 2010. As indicated in the Rate/Volume Table, the principal factor contributing to the increase in net interest income for the year ended December 31, 2011 was a decrease in the interest expense of $2,032,134, resulting from decreased rates on the interest-bearing liability components, and an increase in interest income from investment securities.

 Rate/Volume Table                                                                     Amount of Increase (Decrease)
                                                                  2012 versus 2011                                      2011versus 2010
                                                                  Due to Change in:                                    Due to Change in:
(Tax-equivalent basis)                               Volume             Rate             Total             Volume             Rate             Total

Interest Income:
  Loans:
    Construction                                   $  (224,718 )    $     33,093      $   (191,625 )    $   (707,655 )    $    199,380      $   (508,275 )
    Residential Real Estate                             20,250          (121,589 )        (101,339 )          27,403            42,003            69,406
    Home Equity                                       (111,632 )         (12,280 )        (123,912 )         (75,120 )         (12,477 )         (87,597 )
    Commercial and Commercial Real Estate              817,096           (97,093 )         720,003          (389,342 )          85,877          (303,465 )
    Mortgage Warehouse Lines                         3,512,559          (236,848 )       3,275,711          (359,853 )         111,241          (248,612 )
    Installment                                         (7,653 )            (270 )          (7,923 )          (5,131 )          (2,936 )          (8,067 )
    All Other Loans                                    369,363          (112,857 )         256,506          (234,225 )         117,055          (117,170 )
Total Loans                                          4,375,263          (547,842 )       3,827,421        (1,743,923 )         540,143        (1,203,780 )
  Investment Securities :
    Taxable                                           (802,182 )        (185,901 )        (988,083 )          81,084           558,122           639,206
    Tax-exempt                                         279,157            (4,931 )         274,226         1,750,376          (212,812 )       1,537,564
Total Investment Securities                           (523,026 )        (190,831 )        (713,857 )       1,831,460           345,310         2,176,770
  Federal Funds Sold / Short-Term Investments          (45,032 )               0           (45,032 )         433,110          (351,404 )          81,706
Total Interest Income                                3,807,205          (738,673 )       3,068,532           520,647           534,049         1,054,696

Interest Expense :
    Money Market and NOW Accounts                  $   149,846          (864,189 )    $   (714,343 )    $    605,430      $   (607,321 )    $     (1,891 )
    Savings Accounts                                    91,373          (314,991 )        (223,618 )          24,332          (533,070 )        (508,738 )
    Certificates of Deposit under $100,000             (55,598 )        (127,923 )        (183,521 )        (248,115 )         (16,099 )        (234,214 )
    Certificates of Deposit of $100,000 and Over       (51,731 )        (172,206 )        (223,937 )         117,195          (330,099 )        (212,904 )
    Other Borrowed Funds                               (15,082 )          21,359             6,277          (478,034 )        (178,135 )        (656,169 )
    Trust Preferred Securities                               0          (297,080 )        (297,080 )               0          (388,218 )        (388,218 )
Total Interest Expense                                 118,808        (1,755,030 )      (1,636,222 )          20,808        (2,052,942 )      (2,032,134 )

Net Interest Income                                $ 3,688,397      $  1,016,357      $  4,704,754      $    499,839      $  2,586,991      $  3,086,830

Average interest earning assets increased by $46,456,303, or 6.9%, to $716,199,958 for the year ended December 31, 2012 from $669,743,655 for the year ended December 31, 2011. The average total loan portfolio increased by $88,902,035, or 23.7%, to $463,587,211 for the year ended December 31, 2012 from $374,684,906 for the year ended December 31, 2011. Due to a restructuring of the components of the Company's loan portfolio during 2012, loan yields averaged 5.75% for the year ended December 31, 2012, 34 basis points lower than for the year ended December 31, 2011. The average investment securities portfolio decreased 9.9%, while the yield on that portfolio increased 2 basis points for the year ended December 31, 2012 compared to the year ended December 31, 2011. Overall, the yield on interest earning assets increased 14 basis points to 4.70% in the year ended December 31, 2012 from 4.56% in the year ended December 31, 2011.


Table of Contents

Average interest earning assets increased by $36,409,877, or 5.7%, to $669,743,655 for the year ended December 31, 2011 from $633,333,778 for the year ended December 31, 2010. The average total loan portfolio decreased by $31,543,359, or 7.8%, to $374,684,906 for the year ended December 31, 2011 from $406,228,265 for the year ended December 31, 2010. Due to a marginal increase in the level of market interest rates during 2011, loan yields averaged 6.09% for the year ended December 31, 2011, 18 basis points higher than for the year ended December 31, 2010. The average investment securities portfolio increased 17.5%, while the yield on that portfolio increased 50 basis points for the year ended December 31, 2011 compared to the year ended December 31, 2010. Overall, the yield on interest earning assets decreased 10 basis points to 4.56% in the year ended December 31, 2011 from 4.66% in the year ended December 31, 2010.

Interest expense decreased by $1,636,222, or 24.1%, to $5,151,142 for the year ended December 31, 2012, from $6,787,364 for the year ended December 31, 2011. This decrease in interest expense was principally attributable to higher levels of interest-bearing liabilities priced at a significantly lower market interest rate level. Money market and NOW accounts, increased on average by $30,629,257 in 2012, or 17.7%, as compared to 2011, contributing to the funding of loan portfolio growth. The cost on these deposits decreased 50 basis points in 2012 as compared to 2011. Average interest bearing liabilities rose 6.7% in 2012 from 2011. The cost of total interest-bearing liabilities decreased 36 basis points to 0.89% in 2012 from 1.25% in 2011.

Interest expense decreased by $2,032,134, or 23.0%, to $6,787,364 for the year . . .

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