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KTYB > SEC Filings for KTYB > Form 10-K on 28-Mar-2013All Recent SEC Filings

Show all filings for KENTUCKY BANCSHARES INC /KY/ | Request a Trial to NEW EDGAR Online Pro

Form 10-K for KENTUCKY BANCSHARES INC /KY/


28-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis

This section presents an analysis of the consolidated financial condition of the Company and its wholly-owned subsidiary, Kentucky Bank, at December 31, 2012, 2011 and 2010, and the consolidated results of operations for each of the years in the three year period ended December 31, 2012. The following discussion and analysis of financial condition and results of operations should be read in conjunction with the 2012 Consolidated Financial Statements and Notes included in Item 8. When necessary, reclassifications have been made to prior years' data throughout the following discussion and analysis for purposes of comparability with 2012 data.

Critical Accounting Policies

Overview. The accounting and reporting policies of the Company and its subsidiary are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. Significant accounting policies are listed in Note 1 of the Company's 2012 Consolidated Financial Statements and Notes included in Item 8. Critical accounting and reporting policies include accounting for loans and the allowance for loan losses, goodwill and fair value. Different assumptions in the application of these policies could result in material changes in the consolidated financial position or consolidated results of operations.

Loan Values and Allowance for Loan Losses. Loans are stated at the amount of unpaid principal, reduced by an allowance for loan losses. Interest on loans is recognized on the accrual basis, except for those loans on the nonaccrual status. Interest income received on such loans is accounted for on the cash basis or cost recovery method. The allowance for loan losses is a valuation allowance for probable incurred credit 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 factors. The accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management. The loan portfolio also represents the largest asset group on the consolidated balance sheets. Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions "Asset Quality" and "Loan Losses" in this management's discussion and analysis of financial condition and results of operation, as well as Notes 1 and 4 of the Company's 2012 Consolidated Financial Statements and Notes.

Goodwill. Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected December 31 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on our balance sheet.


Fair Values. Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in the description of each asset and liability category in Note 17 of the Company's 2012 Consolidated Financial Statements and Notes. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

Forward-Looking Statements

This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets, including the tobacco market, the thoroughbred horse industry and the automobile industry relating to Toyota vehicles, in which the Company and its bank operate); competition for the Company's customers from other providers of financial and mortgage services; government legislation, regulation and monetary policy (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company's customers; and other risks detailed in the Company's filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company. The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Overview

We conduct our business through our one bank subsidiary, Kentucky Bank. Kentucky Bank is engaged in general full-service commercial and consumer banking. A significant part of Kentucky Bank's operating activities include originating loans, approximately 85% of which are secured by real estate at December 31, 2012. Kentucky Bank makes commercial, agricultural and real estate loans to its commercial customers, with emphasis on small-to-medium-sized industrial, service and agricultural businesses. It also makes residential mortgages, installment and other loans to its individual and other non-commercial customers. Kentucky Bank's primary market is Bourbon, Clark, Elliott, Harrison, Jessamine, Rowan, Scott, Woodford and surrounding counties in Kentucky.

Net income for the year ended December 31, 2012 was $7.0 million, or $2.59 per common share compared to $5.7 million, or $2.09 for 2011 and $4.9 million, or $1.81 for 2010. Earnings per share assuming dilution were $2.59, $2.09 and $1.81 for 2012, 2011 and 2010, respectively. For 2012, net income increased $1.3 million, or 23.2%. Net interest income increased $193 thousand, the loan loss provision decreased $400 thousand, total other income increased $2.5 million, while total other expenses increased $1.1 million and income tax expense increased $724 thousand.


For 2011, net income increased $747 thousand, or 15.1%. Net interest income increased $4.1 million, the loan loss provision decreased $800 thousand, total other income decreased $1.2 million, while total other expenses increased $2.6 million and income tax expense increased $354 thousand.

Return on average equity was 9.7% in 2012 compared to 8.7% in 2011 and 7.8% in 2010. Return on average assets was 1.03% in 2012 compared to 0.87% in 2011 and 0.71% in 2010.

Non-performing loans as a percentage of loans (including held for sale) were 3.51%, 1.83% and 3.20% as of December 31, 2012, 2011 and 2010, respectively.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income, the Company's largest source of revenue, on a tax equivalent basis increased from $21.8 million in 2010 to $25.9 million in 2011, and to $26.2 million in 2012. The taxable equivalent adjustment (nontaxable interest income on state and municipal obligations net of the related non-deductible portion of interest expense) is based on our Federal income tax rate of 34%.

Average earning assets and interest bearing liabilities both increased from 2011 to 2012. Average earning assets increased $29 million, or 4.9%. Average investment securities increased $11.7 million primarily due to increased deposits. Average loans increased $9.9 million as a result of improved economic conditions and increased demand over 2011. Average interest bearing liabilities increased $6.2 million, or 1.4% during this same period. This change was primarily from an increase of $29.2 million in "NOW" and money market accounts and an increase of $8.1 million in savings deposits; offset by a decrease of $23.0 million in certificates of deposit and other interest bearing deposits and a decrease of $6.3 million in Federal Home Loan Bank advances. The Company continues to actively pursue quality loans and fund these primarily with deposits and FHLB advances.

After peaking in 2006, bank prime rates began to decrease. Bank prime rates decreased 100 basis points in 2007, and another 400 basis points in 2008, and have remain unchanged since then. The tax equivalent yield on earning assets decreased from 5.29% in 2011 to 4.78% in 2012.

The volume rate analysis for 2012 that follows indicates that $2.6 million of the decrease in interest income is attributable to the decrease in rates, while the change in volume contributed to an increase of $960 thousand in interest income. Further, decreases in rates and volume caused a decrease in the cost of interest bearing liabilities. The average rate of these liabilities decreased from 1.22% in 2011 to 0.81% in 2012. Based on the volume rate analysis that follows, the lower level of interest rates contributed to a decrease of $1.4 million to interest expense and a change in volume contributed to a $439 thousand decrease in interest expense. As a result, the increase in the Company's 2012 net interest income is attributed mostly to decreases in rates in time deposits and increases in non-interest bearing deposit accounts.


The volume rate analysis for 2011 that follows indicates that $1.1 million of the decrease in interest income is attributable to the decrease in volume, while the change in rates contributed to an increase of $700 thousand in interest income. Further, decreases in rates caused a decrease in the cost of interest bearing liabilities. The average rate of these liabilities decreased from 1.94% in 2010 to 1.22% in 2011. Based on the volume rate analysis that follows, the lower level of interest rates contributed to a decrease of $2.7 million to interest expense. Of this, $2.4 million was attributed to the decrease in the cost of time deposits. In addition, the change in volume was responsible for a $1.8 million decrease in interest expense, of which, $1.3 million is attributed to the decrease in time deposit balances. As a result, the increase in the Company's 2011 net interest income is attributed mostly to decreases in rates and balances in time deposits.

The accompanying analysis of changes in net interest income in the following table shows the relationships of the volume and rate portions of these changes in 2012 vs. 2011 and 2011 vs. 2010. Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.

Changes in Interest Income and Expense



                                                                           (in thousands)
                                                  2012 vs. 2011                                       2011 vs. 2010
                                 Increase (Decrease)        Due to Change in         Increase (Decrease)        Due to Change in
                                       Volume              Rate       Net Change           Volume              Rate       Net Change
INTEREST INCOME
Loans                           $                 574   $    (1,258 ) $      (684 ) $                (603 ) $      713   $        110
Investment Securities                             369        (1,356 )        (987 )                  (469 )         (5 )         (474 )
Federal Funds Sold and
Securities Purchased under
Agreements to Resell                               (3 )          (2 )          (5 )                   (24 )         (6 )          (30 )
Deposits with Banks                                19             -            19                      10           (2 )            8
Total Interest Income                             959        (2,616 )      (1,657 )                (1,086 )        700           (386 )
INTEREST EXPENSE
Deposits
Demand                                            111          (301 )        (190 )                    56         (184 )         (128 )
Savings                                            14           (12 )           2                       7          (23 )          (16 )
Negotiable Certificates of
Deposit and Other Time
Deposits                                         (311 )        (921 )      (1,232 )                (1,345 )     (2,445 )       (3,790 )
Securities sold under
agreements to repurchase and
other borrowings                                  (40 )          14           (26 )                   (12 )        (50 )          (62 )
Federal Home Loan Bank
advances                                         (213 )        (191 )        (404 )                  (470 )        (35 )         (505 )
Total Interest Expense                           (439 )      (1,411 )      (1,850 )                (1,764 )     (2,737 )       (4,501 )
Net Interest Income             $               1,398   $    (1,205 ) $       193   $                 678   $    3,437   $      4,115


Average Consolidated Balance Sheets and Net Interest Analysis ($ in thousands)



                                       2012                                 2011                                2010
                          Average                  Average     Average                 Average     Average                  Average
                          Balance      Interest     Rate       Balance     Interest     Rate       Balance      Interest     Rate
ASSETS
Interest-Earning
Assets
Securities Available
for Sale (1)
U.S. Treasury and
Federal Agency
Securities               $  100,359   $    1,527      1.52 %  $  86,706   $    2,254      2.60 %  $   99,178   $    2,605      2.63 %
State and Municipal
obligations                  80,219        3,007      3.75 %     82,137        3,279      3.99 %      83,833        3,393      4.05 %
Other Securities              7,001          308      4.40 %      7,000          296      4.23 %       6,978          305      4.37 %
Total Securities
Available for Sale          187,579        4,842      2.58 %    175,843        5,829      3.31 %     189,989        6,303      3.32 %
Total Investment
Securities                  187,579        4,842      2.58 %    175,843        5,829      3.31 %     189,989        6,303      3.32 %
Tax Equivalent
Adjustment                                 1,640      0.87 %                   1,596      0.91 %                    1,626      0.86 %
Tax Equivalent Total                       6,482      3.46 %                   7,425      4.22 %                    7,929      4.17 %
Federal Funds Sold and
Agreements to
Repurchase                      389            -         -        4,783            5      0.10 %      27,049           35      0.13 %
Interest-Bearing
Deposits with Banks          18,749           30      0.16 %      6,753           11      0.16 %       1,056            4      0.38 %
Loans, Net of Deferred
Loan Fees (2)
Commercial                   48,006        2,550      5.31 %     46,852        2,567      5.48 %      45,817        2,584      5.64 %
Real Estate Mortgage        352,674       19,407      5.50 %    342,979       20,007      5.83 %     357,382       20,088      5.62 %
Installment                  17,369        1,403      8.08 %     18,304        1,470      8.03 %      15,332        1,262      8.23 %
Total Loans                 418,049       23,360      5.59 %    408,135       24,044      5.89 %     418,531       23,934      5.72 %
Total Interest-Earning
Assets                      624,766       29,872      4.78 %    595,514       31,485      5.29 %     636,625       31,902      5.01 %
Allowance for Loan
Losses                       (5,949 )                            (5,483 )                             (6,742 )
Cash and Due From
Banks                         6,898                              10,479                               12,891
Premises and Equipment       16,667                              16,992                               17,699
Other Assets                 39,261                              35,198                               34,279
Total Assets             $  681,643                           $ 652,700                           $  694,752
LIABILITIES
Interest-Bearing
Deposits
Negotiable Order of
Withdrawal ("NOW") and
Money Market
Investment Accounts      $  176,654   $      455      0.26 %  $ 147,484   $      645      0.44 %  $  136,870   $      773      0.56 %
Savings                      47,577           77      0.16 %     39,456           75      0.19 %      36,544           91      0.25 %
Certificates of
Deposit and Other
Deposits                    195,207        1,972      1.01 %    218,199        3,204      1.47 %     281,493        6,994      2.48 %
Total Interest-Bearing
Deposits                    419,438        2,504      0.60 %    405,139        3,924      0.97 %     454,907        7,858      1.73 %
Securities sold under
agreements to
repurchase and other
borrowings                   12,218          288      2.36 %     13,950          314      2.25 %      14,401          377      2.62 %
Federal Home Loan Bank
advances                     29,728          923      3.10 %     36,052        1,327      3.68 %      48,803        1,832      3.75 %
Total Interest-Bearing
Liabilities                 461,384        3,715      0.81 %    455,141        5,565      1.22 %     518,111       10,067      1.94 %
Noninterest-Bearing
Earning Demand
Deposits                    141,448                             128,643                              108,426
Other Liabilities             6,552                               3,830                                5,192
Total Liabilities           609,384                             587,614                              631,729
STOCKHOLDERS' EQUITY         72,259                              65,086                               63,023
Total Liabilities and
Stockholders' Equity     $  681,643                           $ 652,700                           $  694,752
Average Equity to
Average Total Assets          10.60 %                              9.97 %                               9.07 %
Net Interest Income                       24,517                              24,324                               20,209
Net Interest Income
(tax equivalent) (3)                      26,157                              25,920                               21,835
Net Interest Spread
(tax equivalent) (3)                                  3.97 %                              4.07 %                               3.07 %
Net Interest Margin
(tax equivalent) (3)                                  4.19 %                              4.35 %                               3.43 %



(1) Averages computed at amortized cost.

(2) Includes loans on a nonaccrual status and loans held for sale.

(3) Tax equivalent difference represents the nontaxable interest income on state and municipal securities net of the related non-deductible portion of interest expense.


Noninterest Income and Expenses

Noninterest income was $11.9 million in 2012 compared to $9.3 million in 2011 and $10.6 million in 2010. In 2012, increases in gains on sold mortgage loans and gains on sold securities account for the majority of the increase. In 2011, decreases in securities gains, service charges, net loan servicing fee income and gains on sold mortgage loans account for the majority of the decrease.

Securities gains were $1.8 million in 2012, $1.2 million in 2011 and $2.1 million in 2010. These gains are primarily attributed to selling securities which had gains in market value due to declining interest rates and the related inverse relationship of interest rates and market values. Some securities gains were taken in 2012, 2011 and 2010 and used to offset additions to the loan loss reserve and write-downs of other real estate properties owned.

Gains on loans sold were $2.3 million, $982 thousand and $1.1 million in 2012, 2011 and 2010, respectively. Loans held for sale are generally sold after closing to the Federal Home Loan Mortgage Corporation. During 2012, the loan servicing fee income, net of amortization expense for the mortgage servicing right asset, increased $172 thousand, compared to a decrease of $185 thousand in 2011. Net write-downs of the mortgage servicing right asset in 2012 were a net recovery $36 thousand compared to net write-downs of $148 thousand in the valuation allowance in 2011. Proceeds from the sale of loans were $67 million, $33 million and $38 million in 2012, 2011 and 2010, respectively. The volume of loan originations is inverse to rate changes with historic low rates spurring activity. The volume of loan originations during 2012 was $64 million, $32 million in 2011, and $37 million in 2010.

Other noninterest income, excluding security net gains and gains on the sale of mortgage loans, was $7.7 million in 2012, $7.2 million in 2011 and $7.4 million in 2010. Service charge income, and more particularly overdraft income, is the largest contributor to these numbers. Overdraft income was $3.4 million in 2012, $3.7 million in 2011 and $3.9 million in 2010. The decreases in 2012 and 2011 are primarily attributable to the slower economy, increased consumer awareness and regulatory pressures. Debit card interchange income was the second largest contributor to noninterest income, excluding security net gains and gains on the sale of mortgage loans. Debit card interchange income was $1.9 million in 2012, $1.7 million in 2011 and $1.5 million in 2010. Other income was $93 thousand in 2012, $190 thousand in 2011 and $148 thousand in 2010. The increase in other income during 2011 was attributed to the bank recording a gain of $55 thousand for the sale of a former branch building.


Noninterest expense increased $1.1 million in 2012 to $25.7 million, and increased $2.6 million in 2011 to $24.6 million from $22.0 million in 2010. The increase in salaries and benefits from $12.0 million in 2011 to $12.6 million in 2012 are attributable to normal salary and benefit increases. The increase in salaries and benefits from $10.2 million in 2010 to $12.0 million in 2011 are attributable to normal salary and benefit increases, an increase of 10 employees in the number of full time equivalent employees and an increase of $611 thousand in incentive compensation. Bonus compensation was $148 thousand greater in 2012 compared to 2011 and $611 thousand greater in 2011 compared to 2010. The 2012 and 2011 increases in bonus compensation were the result of a successful bank wide incentive program that incorporated individual goals and bank performance goals. The bonus compensation plan offered in 2012 and 2011 was similar to the plan offered in 2010. Occupancy expense increased $75 thousand in 2012 to $3.0 million and increased $29 thousand in 2011 to $3.0 million. The largest component of occupancy expense, depreciation, increased $89 thousand to $1.3 million in 2012, and decreased $30 thousand to $1.2 million in 2011. Other noninterest expenses increased from $8.8 million in 2010 to $9.7 million in 2011 and increased to $10.1 million in 2012. Repossession expenses, net of rental income, decreased $312 thousand in 2012 compared to 2011 to $1.7 million. The decrease was mostly associated with the net write-downs of other real estate properties owned decreasing from $1.2 million in 2011 to $991 thousand in 2012. FDIC insurance decreased $90 thousand in 2012 compared to 2011 due to changes provided by Dodd-Frank in the calculation the FDIC uses to assess premiums. Legal and professional fees decreased $81 thousand from 2011 to 2012, mainly from additional loan collection efforts in 2011. Advertising and marketing expenses incurred increased $36 thousand during 2012 compared to 2011. Taxes other than payroll, property and income increased $68 thousand in 2012 from 2011 to $843 thousand. The increase was due to a one-time tax credit the Company received in 2011 in the amount of $116 thousand. Amortization of core deposits related to the Peoples acquisition was $138 thousand in 2012, compared to $148 thousand in 2011. See Note 7 in the Company's Consolidated Financial Statements and Notes included in Item 8 for more detail of the goodwill and intangible assets.

The following table is a summary of noninterest income and expense for the three-year period indicated.

                                                 For the Year Ended Year Ended December 31
                                                               (in thousands)
                                                  2012              2011              2010
NON-INTEREST INCOME
Service Charges                              $        4,741    $        4,604    $        4,920
Loan Service Fee Income (Loss), net                     105               (66 )             119
Trust Department Income                                 663               637               633
Investment Securities Gains (Losses),net              1,835             1,164             2,082
Gains on Sale of Mortgage Loans                       2,325               982             1,054
Brokerage Income                                        240               156               156
Debit Card Interchange Income                         1,868             1,680             1,454
Other                                                    93               190               145
Total Non-interest Income                    $       11,870    $        9,347    $       10,566

NON-INTEREST EXPENSE
Salaries and Employee Benefits               $       12,584    $       11,953    $       10,245
Occupancy Expenses                                    3,033             2,958             2,929
Other                                                10,069             9,704             8,847
Total Non-interest Expense                   $       25,686    $       24,615    $       22,021

Net Non-interest Expense as a Percentage
of Average Assets                                      2.02 %            2.34 %            1.71 %


Income Taxes

As part of normal business, Kentucky Bank typically makes tax free loans to select municipalities in our market and invests in selected tax free securities, primarily in the Commonwealth of Kentucky. In making these investments, the Company considers the overall impact to managing our net interest margin, credit worthiness of the underlying issuer and the favorable impact on our tax position. For the year ended December 31, 2012, the Company averaged $79.5 million in tax free securities and $21.7 million in tax free loans. For the year ended December 31, 2011, the Company averaged $78.7 million in tax free . . .

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