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CNOB > SEC Filings for CNOB > Form 10-K on 27-Mar-2013All Recent SEC Filings

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

Form 10-K for CONNECTONE BANCORP, INC.


27-Mar-2013

Annual Report


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

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements in this document discuss future expectations, contain projections or results of operations or financial conditions or state other "forward-looking" information. Those statements are subject to known and unknown risk; uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. We based the forward-looking statements on various factors and using numerous assumptions. Important factors that may cause actual results to differ from those contemplated by forward-looking statements include those disclosed under Item 1A-Risk Factors as well as the following factors:

the success or failure of our efforts to implement our business strategy;

the effect of changing economic conditions and, in particular, changes in interest rates;

changes in government regulations, tax rates and similar matters;

our ability to attract and retain quality employees; and

other risks which may be described in our future filings with the SEC

We do not promise to update forward-looking information to reflect actual results or changes in assumptions or other factors that could affect those statements.

Critical Accounting Policies and Estimates

"Management's Discussion and Analysis of Financial Condition and Results of Operations," is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to our audited consolidated financial statements contains a summary of our significant accounting policies. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses involves 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. This critical policy and its application are periodically reviewed with the Audit Committee and our Board of Directors.

The allowance for loan losses is based upon management's evaluation of the adequacy of the allowance, including an assessment of known and probable incurred losses included in the portfolio, including 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, 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 our allowance for loan losses. Such agencies may require us to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of our loans are secured by real estate in the State of New Jersey. Accordingly, the collectability of a substantial portion of the carrying value of our loan portfolio is susceptible to changes in local market conditions and may be adversely affected by declines in real estate values, or if the Central or Northern areas of New Jersey 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 our control.


Overview and Strategy

We serve as a holding company for the Bank, which is our primary asset and only operating subsidiary. We follow a business plan that emphasizes the delivery of customized banking services in our market area to customers who desire a high level of personalized service and responsiveness. The Bank conducts a traditional banking business, making commercial loans, consumer loans and residential and commercial real estate loans. In addition, the Bank offers various non-deposit products through non-proprietary relationships with third party vendors. The Bank relies upon deposits as the primary funding source for its assets. The Bank offers traditional deposit products.

Many of our customer relationships start with referrals from existing customers. We then seek to cross sell our products to customers to grow the customer relationship. For example, we will frequently offer an interest rate concession on credit products for customers that maintain a non-interest bearing deposit account at the Bank. This strategy has lowered our funding costs and helped slow the growth of our interest expense even as we have substantially increased our total deposits. It has also helped fuel our significant loan growth. We believe that the Bank's significant growth and increasing profitability demonstrate the need for and success of our brand of banking.

Our results of operations depend primarily on our net interest income, which is the difference between the interest earned on our interest-earning assets and the interest paid on funds borrowed to support those assets, primarily deposits. Net interest margin is the difference between the weighted average rate received on interest-earning assets and the weighted average rate paid to fund those interest-earning assets, which is also affected by the average level of interest-earning assets as compared with that of interest-bearing liabilities. Net income is also affected by the amount of non-interest income and non-interest expenses.

Operating Results Overview

Net income for the year ended December 31, 2012 was $8.4 million, an increase of $1.7 million, or 26.3%, compared to net income of $6.7 million for 2011. Net income available to common shareholders for the year ended December 31, 2012 was $8.1 million, an increase of $2.0 million, or 33.0%, compared to net income available to common shareholders of $6.1 million for 2011. Diluted earnings per share were $2.63 for 2012, a 20.6% increase from $2.18 for 2011. Net income available to common shareholders and diluted earnings per share were impacted by three series of convertible preferred stock issued at various times between 2009 and 2012. During 2012, all three series of preferred stock were converted into common shares and, as of December 31, 2012, stockholders' equity was comprised solely of common equity.

The increases in net income, net income available to common shareholders, and diluted earnings per share were primarily attributable to significant increases in net interest income due to the Company's rapid growth in loans and deposits, and in its customer base. Partially offsetting the revenue increases were higher noninterest expenses, largely staff-related, commensurate with the Company's growing infrastructure. Credit costs have kept pace with both loan growth and a changing mix in the loan portfolio, while benefitting from overall sound credit quality.

Net Interest Income

For the year ended December 31, 2012, net interest income was $34.5 million, an increase of $7.0 million, or 25.5%, compared to net interest income of $27.5 million in 2011. The increase in net interest income was largely attributable to growth in average interest-earning assets, principally loans, which increased by 29.6% to $743.2 million in 2012 from $573.6 million in 2011. The net interest margin remained relatively stable at 4.20% in 2012 as compared to 4.21% for the prior year period, as reduced yields on our loan portfolio resulting from the persistently low interest rate environment were offset by a lower cost of funds and a higher level of loan prepayment fees.

Average Balance Sheets

The following table sets forth certain information relating to our average assets and liabilities for the years ended December 31, 2012, 2011 and 2010 and reflect the average yield on assets and


average cost of liabilities for the periods indicated. Such yields are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown.

                                                                                                                     For the Years Ended
                                                         December 31, 2012                                            December 31, 2011                                            December 31, 2010
                                           Average                                  Average             Average                                  Average             Average                                  Average
                                           Balance               Interest             Rate              Balance               Interest             Rate              Balance               Interest             Rate
                                                                                                                    (dollars in thousands)
Interest earning assets:
Investment securities(1)                $      31,009          $      1,079            3.48 %        $      43,980          $      1,505            3.42 %        $      48,154          $      1,805            3.75 %
Loans receivable(2)(3)                        743,178                39,677            5.34 %              573,648                32,113            5.60 %              446,048                27,054            6.07 %
Federal funds sold and interest-
earning deposits with banks                    46,902                    31            0.07 %               35,339                    58            0.16 %               49,110                   104            0.21 %

Total interest-earning assets                 821,089                40,787            4.97 %              652,967                33,676            5.16 %              543,312                28,963            5.33 %
Allowance for loan losses                     (11,196 )                                                     (8,651 )                                                     (5,855 )
Non-interest earning assets                    21,558                                                       20,976                                                       23,394

Total assets                            $     831,451                                                $     665,292                                                $     560,851

Interest-bearing liabilities:
Savings, NOW, Money Market,
Interest Checking                       $     313,475                 1,397            0.45 %        $     270,374                 2,356            0.87 %        $     242,918                 2,621            1.08 %
Time deposits                                 229,150                 3,380            1.48 %              160,580                 2,532            1.58 %              134,355                 2,273            1.69 %

Total interest-bearing deposits               542,625                 4,777            0.88 %              430,954                 4,888            1.13 %              377,273                 4,894            1.30 %
Borrowings                                     77,473                 1,349            1.74 %               68,217                 1,121            1.64 %               57,720                   956            1.66 %
Capital lease obligation                        3,224                   193            5.99 %                3,293                   198            6.01 %                3,346                   201            6.01 %

Total interest-bearing liabilities            623,322                 6,319            1.01 %              502,464                 6,207            1.24 %              438,339                 6,051            1.38 %
Noninterest-bearing deposits                  138,155                                                      106,174                                                       77,722
Other liabilities                               4,345                                                        2,970                                                        2,214
Stockholders' equity                           65,629                                                       53,684                                                       42,576

Total liabilities and
stockholders' equity                    $     831,451                                                $     665,292                                                $     560,851

Net interest income/interest rate
spread                                                         $     34,468            3.95 %                               $     27,469            3.92 %                               $     22,912            3.95 %

Net interest margin(4)                                                                 4.20 %                                                       4.21 %                                                       4.22 %


(1) Average balances are calculated on amortized cost and include investments in restricted stock.

(2) Includes loan fee income.

(3) Loans receivable include non-accrual loans.

(4) Represents net interest income divided by average total interest-earning assets.


Rate/Volume Analysis

The following table presents, by category, the major factors that contributed to
the changes in net interest income. Changes due to both volume and rate have
been allocated in proportion to the relationship of the dollar amount change in
each.


                                                      For the Year Ended                                     For the Year Ended
                                                December 31, 2012 versus 2011                          December 31, 2011 versus 2010
                                                     Increase (Decrease)                                    Increase (Decrease)
                                                   Due to Change in Average                               Due to Change in Average
                                         Volume              Rate               Net             Volume              Rate               Net
Interest Income:
Investment securities                  $    (452 )       $       26         $    (426 )       $    (150 )       $     (150 )       $    (300 )
Loan receivable                            8,969             (1,405 )           7,564             6,923             (1,864 )           5,059
Federal funds sold and interest-               -                  -                 -                 -                  -                 -
earning deposits with banks                   33                (60 )             (27 )             (26 )              (20 )             (46 )

Total interest income                  $   8,550         $   (1,439 )       $   7,111         $   6,747         $   (2,034 )       $   4,713

Interest Expense:
Savings, NOW, Money Market,
Interest Checking                      $     464         $   (1,423 )       $    (959 )       $     377         $     (642 )       $    (265 )
Time deposits                                999               (151 )             848               397               (138 )             259
Borrowings                                   158                 70               228               172                 (7 )             165
Capital lease obligation                      (4 )               (1 )              (5 )              (3 )                0                (3 )

Total interest expense                 $   1,617         $   (1,505 )       $     112         $     943         $     (787 )       $     156

Net interest income                    $   6,933         $       66         $   6,999         $   5,804         $   (1,247 )       $   4,557

Provision for Loan Losses

In determining the provision for loan losses, management considers national and local economic trends and conditions; trends in the portfolio including orientation to specific loan types or industries; experience, ability and depth of lending management in relation to the complexity of the portfolio; effects of changes in lending policies, trends in volume and terms of loans; levels and trends in delinquencies, impaired loans and net charge-offs and the results of independent third party loan and lease review.

For the year ended December 31, 2012, the provision for loan losses was $4.0 million, an increase of $1.6 million, compared to the provision for loan losses of $2.4 million for the same period in 2011. The increase is substantially attributable to the increased loan growth in 2012 versus 2011.

Non-Interest Income

The Company's non-interest income consists primarily of service charges on deposit accounts, gains on sale of residential mortgages, card (ATM, credit and debit cards) income and fees from a title insurance agency in which the Bank is a 49% owner. Non-interest income amounted to $1.1 million for both 2012 and 2011. Card income grew by approximately $80,000 in 2012 versus 2011, while 2011 included $96,000 in securities gains. To date, the Bank has de-emphasized fee income, focusing instead on customer growth and retention.

Non-Interest Expense

Noninterest expenses have increased significantly since inception of the Bank as we have expanded our geographic reach and invested in our infrastructure to support our strong asset growth. For the year ended December 31, 2012, noninterest expenses totaled $17.5 million, a $2.4 million, or 16.1%, increase from $15.1 million for the year ended December 31, 2011. The largest factor contributing to the year-over-year increase was salaries and employee benefits expense, which increased by $1.4 million to $8.4 million in 2012 from $6.9 million in 2011; this increase was


primarily a result of increased staffing levels, particularly at the executive and senior management level. Also contributing to the increase were data processing expenses ($260,000), advertising and promotion expenses ($133,000) and other expenses ($574,000). The increases in these categories were all primarily related to the Company's increased volume of business.

Management continues to focus efforts on supporting growth primarily by adding to staff, investing in technology, and by enhancing risk controls. At the same time, management seeks to contain costs whenever prudent. Our success in this regard is evident in the recent improvements in our efficiency ratio, a widely-followed metric in the banking industry which measures operating expenses as a percentage of net revenue. The ratio is computed by dividing total noninterest expense by the sum of net interest income and noninterest income less securities gains/(losses). The Company's efficiency ratio improved from 52.9% in 2011 to 49.1% in 2012.

Income Taxes

Income tax expense was $5.7 million for the year ended December 31, 2012 versus $4.5 million for the year ended December 31, 2011. The effective tax rate was approximately 40% for all periods presented representing the combined federal and state statutory tax rates for a New Jersey corporation, and reflecting no tax-advantaged investments such as municipal securities or bank owned life insurance. Management has thus far taken a conservative approach to the Company's tax position and is currently exploring various strategies to potentially lower our effective tax rates in the future.

Financial Condition Overview

At December 31, 2012, total assets were $930.0 million, an increase of $200.2 million, or 27.4%, from $729.7 million at December 31, 2011. At December 31, 2012, net loans receivable were $835.6 million, an increase of $215.8 million, or 34.8%, from $619.8 million at December 31, 2011. At December 31, 2012, total deposits were $769.3 million, an increase of $159.9 million, or 26.2%, compared to $609.4 million at December 31, 2011.

Loan Portfolio

The Bank's lending activities are generally oriented to small-to-medium sized businesses, high net worth individuals, professional practices and consumer and retail customers living and working in the Bank's market area of Hudson, Bergen and Monmouth Counties, New Jersey. The Bank has not made loans to borrowers outside of the United States. The Bank believes that its strategy of high-quality customer service, competitive rate structures and selective marketing have enabled it to gain market entry.

Commercial loans are loans made for business purposes and are primarily secured by collateral such as cash balances with the Bank, marketable securities held by or under the control of the Bank, business assets including accounts receivable, taxi medallions, inventory and equipment and liens on commercial and residential real estate. Commercial construction loans are loans to finance the construction of commercial or residential properties secured by first liens on such properties. Commercial real estate loans include loans secured by first liens on completed commercial properties, including multi- family properties, to purchase or refinance such properties. Residential mortgages include loans secured by first liens on residential real estate, and are generally made to existing customers of the Bank to purchase or refinance primary and secondary residences. Home equity loans and lines of credit include loans secured by first or second liens on residential real estate for primary or secondary residences. Consumer loans are made to individuals who qualify for auto loans, cash reserve, credit cards and installment loans.

During 2012 and 2011, loan portfolio growth was positively impacted in several ways including (i) an increase in demand for small business lines of credit, and business term loans as economic conditions have stabilized and begun to improve,
(ii) industry consolidation and lending restrictions involving larger competitors allowing the Bank to gain market share, (iii) an increase in refinancing strategies employed by borrowers during the current low rate environment, and (iv) the Bank's


success in attracting highly experienced commercial loan officers with substantial local market knowledge.

Gross loans at December 31, 2012 totaled $849.3 million, an increase of $219.8 million, or 34.9%, over gross loans at December 31, 2011 of $629.5 million. The biggest component of our loan portfolio at December 31, 2012 and December 31, 2011 was commercial real estate loans. Our commercial real estate loans at December 31, 2012 were $549.2 million, an increase of $173.5 million, or 46.2%, over commercial real estate loans at December 31, 2011 of $375.7 million. Our commercial loans were $147.5 million at December 31, 2012, an increase of $39.4 million, or 36.4%, over commercial loans at December 31, 2011 of $108.1 million. Our commercial construction loans at December 31, 2012 were $36.9 million, an increase of $8.4 million, or 29.2%, over commercial construction loans at December 31, 2011 of $28.5 million. Our residential real estate loans were $83.0 million at December 31, 2012, a decrease of $5.7 million, or 6.4%, over residential real estate loans at December 31, 2011 of $88.7 million. Our home equity loans were $31.0 million at December 31, 2012, an increase of $3.4 million, or 12.3%, over home equity loans of $27.6 million at December 31, 2011. Our consumer loans at December 31, 2012 were $1.8 million, an increase of $0.9 million, 102.2%, over consumer loans of $0.9 million at December 31, 2011. The growth in our loan portfolio reflects the success of our business strategy, in particular emphasizing high-quality customer service strategy, which has led to continued customer referrals.

The following table sets forth the classification of our gross loans held for investment by loan portfolio class as of December 31, 2012, 2011, 2010, 2009, and 2008:

                                                                                                                      As of December 31,
                                           2012                                     2011                                     2010                                     2009                                     2008
                                                     Percent                                  Percent                                  Percent                                  Percent                                  Percent
                                 Amount             of Total              Amount             of Total              Amount             of Total              Amount             of Total              Amount             of Total
                                                                                                                    (dollars in thousands)
Commercial                   $     147,455              17.4 %        $     108,066              17.2 %        $     106,544              21.6 %        $      78,217              19.6 %        $      58,686              19.3 %
Commercial real estate             549,218              64.7 %              375,719              59.7 %              259,694              52.5 %              230,324              57.8 %              155,272              51.2 %
Commercial construction             36,872               4.3 %               28,543               4.5 %               37,065               7.5 %               24,111               6.1 %               36,473              12.0 %
Residential real estate             82,962               9.8 %               88,666              14.1 %               64,648              13.1 %               39,764              10.0 %               31,033              10.2 %
Home equity                         30,961               3.6 %               27,575               4.4 %               25,056               5.1 %               25,000               6.3 %               21,617               7.1 %
Consumer                             1,801               0.2 %                  890               0.1 %                1,179               0.2 %                  870               0.2 %                  617               0.2 %

Total gross loans            $     849,269             100.0 %        $     629,459             100.0 %        $     494,186             100.0 %        $     398,286             100.0 %        $     303,698             100.0 %


The following table sets forth the classification of our gross loans held for investment by loan portfolio class and by fixed and adjustable rate loans as of December 31, 2012 and 2011 in term of contractual maturity.

                                             As of December 31, 2012                                          As of December 31, 2011
                               Due Under             Due 1-5           Due More than           Due Under             Due 1-5           Due More than
                               One Year               Years              Five Years             One Year              Years              Five Years
. . .
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