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

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Form 10-K for FIRST CAPITAL INC


27-Mar-2013

Annual Report


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

General

As the holding company for the Bank, the Company conducts its business primarily through the Bank. The Bank's results of operations depend primarily on net interest income, which is the difference between the income earned on its interest-earning assets, such as loans and investments, and the cost of its interest-bearing liabilities, consisting primarily of deposits, retail repurchase agreements and borrowings from the Federal Home Loan Bank of Indianapolis. The Bank's net income is also affected by, among other things, fee income, provisions for loan losses, operating expenses and income tax provisions. The Bank's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government legislation and policies concerning monetary and fiscal affairs, housing and financial institutions and the intended actions of the regulatory authorities.

Management uses various indicators to evaluate the Company's financial condition and results of operations, including the following:

Net income and earnings per share - Net income attributable to the Company was $3.9 million, or $1.41 per share for 2012 compared to $4.0 million, or $1.43 per share for 2011. However, had the voluntary early retirement program discussed below not been established in 2012, net income would have been $4.3 million, or $1.53 per share for 2012, resulting in increases of 7.4% and 7.0%, respectively.

Return on average assets and return on average equity - Return on average assets for 2012 was 0.86% compared to 0.90% for 2012, and return on average equity for 2012 was 7.54% compared to 8.04% for 2011. Excluding the net effect of the voluntary early retirement program would increase the return on average assets for 2012 to 0.94% and the return on average equity to 8.20%, resulting in increases of 4.4% and 2.0%, respectively.

Efficiency ratio - The Company's efficiency ratio (defined as noninterest expenses divided by net interest income plus noninterest income) was 66.4% for 2012 compared to 64.2% for 2011. Excluding the expense associated with the voluntary early retirement program, the efficiency ratio would have been 63.7% for 2012 which compares very favorably to our peers.

Asset quality - Net loan charge-offs decreased from $2.1 million for 2011 to $971,000 for 2012. In addition, total nonperforming assets (consisting of nonperforming loans and foreclosed real estate) decreased from $8.4 million, or 1.92% of total assets at December 31, 2011 to $8.2 million, or 1.78% of total assets at December 31, 2012. The allowance for loan losses was 1.64% of total loans and 60.16% of nonperforming loans at December 31, 2012 compared to 1.47% of total loans and 53.86% at December 31, 2011.

Shareholder return - Total shareholder return, including the increase in the Company's stock price from $18.53 at December 31, 2011 to $19.47 at December 31, 2012 and dividends of $0.76 per share, was 9.2% for 2012.

Management's discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of the Company and the Bank. The information contained in this section should be read in conjunction with the consolidated financial statements and the accompanying notes to consolidated financial statements included elsewhere in this report.


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Operating Strategy

The Company is the parent company of an independent community-oriented financial institution that delivers quality customer service and offers a wide range of deposit, loan and investment products to its customers. The commitment to customer needs, the focus on providing consistent customer service, and community service and support are the keys to the Bank's past and future success. The Company has no other material income other than that generated by the Bank and its subsidiaries.

The Bank's primary business strategy is attracting deposits from the general public and using those funds to originate residential mortgage loans, multi-family residential loans, commercial real estate and business loans and consumer loans. The Bank invests excess liquidity primarily in interest-bearing deposits with the Federal Home Loan Bank of Indianapolis and other financial institutions, federal funds sold, U.S. government and agency securities, local municipal obligations and mortgage-backed securities.

In recent years, the Company's operating strategy has also included strategies designed to enhance profitability by increasing sources of noninterest income and improving operating efficiency while managing its capital and limiting its credit risk and interest rate risk exposures. To accomplish these objectives, the Company has focused on the following:

Monitoring asset quality and credit risk in the loan and investment portfolios, with an emphasis on reducing nonperforming assets and originating high-quality commercial and consumer loans.

Being active in the local community, particularly through our efforts with local schools, to uphold our high standing in our community and marketing to our next generation of customers.

Improving profitability by expanding our product offerings to customers and investing in technology to increase the productivity and efficiency of our staff.

Continuing to emphasize commercial real estate and other commercial business lending as well as consumer lending. The Bank will also continue to focus on increasing secondary market lending as a source of noninterest income.

Growing commercial and personal demand deposit accounts which provide a low-cost funding source.

Evaluating vendor contracts for potential cost savings and efficiencies.

Continuing our capital management strategy to enhance shareholder value through the repurchase of Company stock and the payment of dividends.

Evaluating growth opportunities to expand the Bank's market area and market share through acquisitions of other financial institutions or branches of other institutions.


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Critical Accounting Policies and Estimates

The accounting and reporting policies of the Company comply with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions, which are integral to understanding reported results. Critical accounting policies are those policies that require management to make assumptions about matters that are highly uncertain at the time an accounting estimate is made; and different estimates that the Company reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the Company's financial condition, changes in financial condition or results of operations. Most accounting policies are not considered by management to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical in the preparation of financial statements. These factors include, among other things, whether the estimates are significant to the financial statements, the nature of the estimates, the ability to readily validate the estimates with other information including third parties or available prices, and sensitivity of the estimates to changes in economic conditions and whether alternative accounting methods may be utilized under generally accepted accounting principles.

Significant accounting policies, including the impact of recent accounting pronouncements, are discussed in Note 1 of the accompanying Notes to Consolidated Financial Statements. Those policies considered to be critical accounting policies are described below.

Allowances for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, the OCC, as an integral part of its examination process, periodically reviews our allowance for loan losses and may require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. Note 1 and Note 4 of the accompanying Notes to Consolidated Financial Statements describe the methodology used to determine the allowance for loan losses as well as changes to the methodology for determining the allowance for loan losses during the year ended December 31, 2012.

Valuation Methodologies. In the ordinary course of business, management applies various valuation methodologies to assets and liabilities that often involve a significant degree of judgment, particularly when active markets do not exist for the items being valued. Generally, in evaluating various assets for potential impairment, management compares the fair value to the carrying value. Quoted market prices are referred to when estimating fair values for certain assets, such as certain investment securities. For investment securities for which quoted market prices are not available, the Company obtains fair value measurements from an independent pricing service. However, for those items for which market-based prices do not exist and an independent pricing service is not readily available, management utilizes significant estimates and assumptions to value such items. Examples of these items include goodwill and other intangible assets, foreclosed and other repossessed assets, impaired loans, stock-based compensation and certain other financial investments. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on the Company's results of operations. Note 20 and Note 21 of the accompanying Notes to Consolidated Financial Statements describe the methodologies used to determine the fair value of investment securities, impaired loans, foreclosed real estate and other assets. There were no changes in the valuation techniques and related inputs used during the year ended December 31, 2012.


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Results of Operations for the Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

Net Income. Net income attributable to the Company was $3.9 million ($1.41 per share diluted; weighted average common shares outstanding of 2,785,286, as adjusted) for the year ended December 31, 2012 compared to $4.0 million ($1.43 per share diluted; weighted average common shares outstanding of 2,786,410, as adjusted) for the year ended December 31, 2011.

Net Interest Income. Net interest income decreased $178,000, or 1.1%, from $16.5 million for 2011 to $16.3 million for 2012 primarily due to a decrease in the interest rate spread, the difference between the average tax-equivalent yield on interest-earning assets and the average cost of interest-bearing liabilities, partially offset by an increase in interest-earning assets.

Total interest income decreased 7.3% from $20.3 million for 2011 to $18.8 million for 2012. This decrease was primarily a result of the average tax-equivalent yield on interest-earning assets decreasing from 5.06% for 2011 to 4.59% for 2012 partially offset by an increase in the average balance of interest-earning assets from $412.2 million for 2011 to $422.8 million for 2012. Interest on loans decreased $1.2 million as a result of the average tax-equivalent yield on loans decreasing from 5.89% for 2011 to 5.70% for 2012 and the average balance of loans decreasing from $292.1 million for 2011 to $281.4 million for 2012. Interest on investment securities (including Federal Home Loan Bank stock) decreased $319,000 for 2012 compared to 2011 due to the average tax-equivalent yield of investment securities decreasing from 3.34% for 2011 to 2.73% for 2012, partially offset by the average balance of investment securities increasing from $107.7 million for 2011 to $118.4 million for 2012. Management continued to focus loan origination efforts on commercial and consumer loans during 2012. The majority of the new commercial loans originated during 2012 were adjustable-rate loans. Adjustable-rate loans comprised 55% of the total loan portfolio at the end of 2012, compared to 52% at the end of 2011. Market interest rates remained at near historic lows throughout 2012, so as loans and investment securities mature or pay down they are replaced with lower yielding new loan originations and investment purchases.

Total interest expense decreased $1.3 million, from $3.8 million for 2011 to $2.5 million for 2012, due to a decrease in the average cost of funds from 1.08% for 2011 to 0.73% for 2012, and a decrease in the average balance of interest-bearing liabilities from $347.0 million for 2011 to $339.1 million for 2012. Interest expense on deposits decreased 34.5% from $3.1 million for 2011 to $2.0 million for 2012 as a result of a decrease in the average cost of interest-bearing deposits, which decreased from 0.96% for 2011 to 0.64% for 2012 and a decrease in the average balance of interest-bearing deposits from $323.3 million for 2011 to $318.7 million for 2012. Interest expense on Federal Home Loan Bank advances decreased 34.0% from $585,000 for 2011 to $386,000 for 2012. The average cost of Federal Home Loan Bank advances decreased from 4.02% for 2011 to 3.75% for 2012, and the average balance of Federal Home Loan Bank advances decreased from $14.6 million for 2011 to $10.3 million for 2012, due to scheduled pay downs of advances. For further information, see "Average Balance Sheets" below. The changes in interest income and interest expense resulting from changes in volume and changes in rates for 2012 and 2011 are shown in the schedule captioned "Rate/Volume Analysis" included herein.

Provision for Loan Losses. The provision for loan losses was $1.5 million for 2012 compared to $1.8 million for 2011. The consistent application of management's allowance methodology resulted in a decrease in the provision for loan losses for 2012 compared to the prior year primarily due to a decrease in net charge-offs. Net charge-offs decreased when comparing the two periods, from $2.1 million for 2011 to $971,000 for 2012. The provisions were recorded to bring the allowance to the level determined in applying the allowance methodology after reduction for net charge-offs during the year and to allow for inherent loss exposure due to weakened general economic conditions such as depreciating collateral values, job losses and continued pressures on household budgets in the Bank's market area.


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Provisions for loan losses are charges to earnings to maintain the total allowance for loan losses at a level considered reasonable by management to provide for probable known and inherent loan losses based on management's evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specified impaired loans and economic conditions. Although management uses the best information available, future adjustments to the allowance may be necessary due to changes in economic, operating, regulatory and other conditions that may be beyond the Bank's control. While the Bank maintains the allowance for loan losses at a level that it considers adequate to provide for estimated losses, there can be no assurance that further additions will not be made to the allowance for loan losses and that actual losses will not exceed the estimated amounts.

Noninterest income. Noninterest income increased $486,000 to $4.5 million for 2012 compared to $4.1 million for 2011. Gains on the sale of loans increased $355,000 when comparing the two periods primarily due to the low rate environment which has led to increased refinancing activity, and the continuing recovery of the local housing market. Service charges on deposit accounts also increased $70,000 for 2012 compared to 2011 due to an increase in ATM and debit card fee income.

Noninterest expense. Noninterest expense increased $642,000, or 4.9%, to $13.9 million for 2012 compared to $13.2 million for 2011. The increase was primarily due to increases of $461,000 in compensation and benefits expenses and $122,000 in data processing expenses. The increase in compensation and benefits expenses was primarily due to the voluntary early retirement program which was effective September 30, 2012. Fourteen employees participated in the program which resulted in a pre-tax charge to earnings of $693,000 on September 30, 2012. This was partially offset by the pre-tax savings of $132,000 the Company recognized during the quarter ended December 31, 2012 due to the overall reduction in compensation and benefits following the voluntary retirements. The increase in data processing expenses was primarily due to an increase in ATM processing fees and more customers using alternate delivery channels for traditional banking services.

Income tax expense. The Company recognized income tax expense of $1.6 million (effective tax rate of 28.4%) for 2012, compared to $1.5 million (effective tax rate of 27.9%) for 2011. The increase in income tax expense and the effective tax rate for 2012 is primarily due to a decrease in tax exempt income.


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Average Balances and Yields. The following table sets forth certain information for the periods indicated regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earnings assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average historical cost balances of assets or liabilities, respectively, for the periods presented and do not give effect to changes in fair value that are included as a separate component of stockholders' equity. Average balances are derived from daily balances. Tax-exempt income on loans and investment securities has been adjusted to a tax equivalent basis using the federal marginal tax rate of 34%.

                                                                                          Year Ended December 31,
                                                          2012                                      2011                                      2010
                                                                      Average                                   Average                                   Average
                                           Average                     Yield/        Average                     Yield/        Average                     Yield/
(Dollars in thousands)                     Balance      Interest        Cost         Balance      Interest        Cost         Balance      Interest        Cost
Interest-earning assets:
Loans (1) (2):
Taxable (3)                               $ 278,874     $  15,916         5.71 %    $ 290,527     $  17,124         5.89 %    $ 310,644     $  18,598         5.99 %
Tax-exempt                                    2,501           135         5.40 %        1,533            84         5.48 %          187            13         6.95 %

Total loans                                 281,375        16,051         5.70 %      292,060        17,208         5.89 %      310,831        18,611         5.99 %

Investment securities:
Taxable (3)                                  92,980         1,771         1.90 %       81,085         2,017         2.49 %       74,313         2,132         2.87 %
Tax-exempt                                   25,417         1,464         5.76 %       26,585         1,574         5.92 %       27,029         1,606         5.94 %

Total investment securities                 118,397         3,235         2.73 %      107,670         3,591         3.34 %      101,342         3,738         3.69 %

Federal funds sold and interest-bearing
deposits with banks                          21,998            58         0.26 %       12,466            38         0.30 %       14,679            35         0.24 %

Total interest-earning assets               421,770        19,344         4.59 %      412,196        20,837         5.06 %      426,852        22,384         5.24 %

Noninterest-earning assets                   31,953                                    31,596                                    30,738

Total assets                              $ 453,723                                 $ 443,792                                 $ 457,590

Interest-bearing liabilities:
Interest-bearing demand deposits          $ 156,704     $     487         0.31 %    $ 157,667     $     842         0.53 %    $ 159,286     $   1,224         0.77 %
Savings accounts                             55,369            61         0.11 %       46,234            90         0.19 %       43,990           103         0.23 %
Time deposits                               106,625         1,493         1.40 %      119,359         2,184         1.83 %      132,693         3,092         2.33 %

Total deposits                              318,698         2,041         0.64 %      323,260         3,116         0.96 %      335,969         4,419         1.32 %

Retail repurchase agreements                 10,074            38         0.38 %        9,174            59         0.64 %        8,142            73         0.90 %
FHLB advances                                10,287           386         3.75 %       14,557           585         4.02 %       23,116         1,010         4.37 %

Total interest-bearing liabilities          339,059         2,465         0.73 %      346,991         3,760         1.08 %      367,227         5,502         1.50 %

Noninterest-bearing liabilities:
Noninterest-bearing deposits                 60,509                                    46,001                                    41,220
Other liabilities                             2,169                                     1,422                                     1,407

Total liabilities                           401,737                                   394,414                                   409,854
Stockholders' equity                         51,986                                    49,378                                    47,736

Total liabilities and stockholders'
equity (4)                                $ 453,723                                 $ 443,792                                 $ 457,590

Net interest income                                     $  16,879                                 $  17,077                                 $  16,882

Interest rate spread                                                      3.86 %                                    3.98 %                                    3.74 %

Net interest margin                                                       4.00 %                                    4.14 %                                    3.96 %

Ratio of average interest - earning
assets to average interest-bearing
liabilities                                                             124.39 %                                  118.79 %                                  116.24 %

(1) Interest income on loans includes fee income of $654,000, $662,000 and $633,000 for the years ended December 31, 2012, 2011, and 2010, respectively.

(2) Average loan balances include loans held for sale and nonperforming loans.

(3) Includes taxable debt and equity securities and Federal Home Loan Bank Stock.

(4) Stockholders' equity attributable to First Capital, Inc.


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Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income and interest expense computed on a tax-equivalent basis. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); (ii) effects attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) effects attributable to changes in rate and volume (change in rate multiplied by changes in volume). Tax exempt income on loans and investment securities has been adjusted to a tax-equivalent basis using the federal marginal tax rate of 34%.

                                                    2012 Compared to 2011                                  2011 Compared to 2010
                                                 Increase (Decrease) Due to                             Increase (Decrease) Due to
                                                                  Rate/                                                   Rate/
                                        Rate        Volume        Volume         Net           Rate         Volume       Volume         Net
                                                                                   (In thousands)
Interest-earning assets:
Loans:
Taxable                               $   (533 )    $  (696 )    $     21      $ (1,208 )    $   (303 )    $ (1,191 )    $    20      $ (1,474 )
Tax-exempt                                  (1 )         53            (1 )          51            (3 )          94          (20 )          71

Total investment securities               (534 )       (643 )          20        (1,157 )        (306 )      (1,097 )          0        (1,403 )

Investment securities:
Taxable                                   (476 )        300           (70 )        (246 )        (282 )         193          (26 )        (115 )
Tax-exempt                                 (43 )        (69 )           2          (110 )          (5 )         (27 )          0           (32 )

Total investment securities               (519 )        231           (68 )        (356 )        (287 )         166          (26 )        (147 )

Federal funds sold and
interest-bearing deposits with
banks                                       (5 )         29            (4 )          20             9            (5 )         (1 )           3

Total net change in income on
interest-earning assets                 (1,058 )       (383 )         (52 )      (1,493 )        (584 )        (936 )        (27 )      (1,547 )

. . .
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