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OPOF > SEC Filings for OPOF > Form 10-K on 29-Mar-2013All Recent SEC Filings

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Form 10-K for OLD POINT FINANCIAL CORP


29-Mar-2013

Annual Report


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

The following discussion is intended to assist readers in understanding and evaluating the financial condition, changes in financial condition and the results of operations of the Company, consisting of the parent company (the Parent) and its wholly-owned subsidiaries, the Bank and Trust. This discussion should be read in conjunction with the Consolidated Financial Statements and other financial information contained elsewhere in this report.

Caution About Forward-Looking Statements In addition to historical information, this report may contain forward-looking statements. For this purpose, any statement that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, the net interest margin, liquidity, the loan portfolio and expected trends in the quality of the loan portfolio, the allowance and provision for loan losses, the securities portfolio, interest rate sensitivity, asset quality, levels of net loan charge-offs and nonperforming assets, noninterest expense (and components of noninterest expense), lease expense, the cost of expanding a current office building, noninterest income (and components of noninterest income), income taxes, intentions regarding the Company's FHLB advance, expected impact of efforts to restructure the balance sheet, expected yields on the loan and securities portfolios, market risk, business and growth strategies, investment strategy and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. These statements can also be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to, changes in interest rates, general economic conditions, the effects of the sequestration on the Company's service area, the quality or composition of the loan or investment portfolios, the effects of management's investment strategy, the adequacy of the Company's credit quality review processes, the level of nonperforming assets and charge-offs, the local real estate market, volatility and disruption in national and international financial markets, government intervention in the U.S. financial system, FDIC premiums and/or assessments, penalties paid if the Company were to prepay its FHLB advance, demand for loan products, levels of noninterest income and expense, deposit flows, competition, adequacy of the allowance for loan losses and changes in accounting principles, policies and guidelines. The Company could also be adversely affected by monetary and fiscal policies of the U.S. Government, as well as any regulations or programs implemented pursuant to the Dodd-Frank Act or other legislation and policies of the Comptroller, U.S. Treasury and the Federal Reserve Board.

The Company has experienced losses due to the current economic climate. Dramatic declines in the residential and commercial real estate market in the past few years have resulted in significant write-downs of asset values by the Company as well as by other financial institutions in the U.S. Concerns about future economic conditions and financial markets generally have reduced the availability of funding to certain financial institutions, leading to a tightening of credit and reduction of business activity.

In July 2010, the President signed into law the Dodd-Frank Act, which implements far-reaching changes across the financial regulatory landscape. It is not clear what other impacts the Dodd-Frank Act, regulations promulgated thereunder and other regulatory initiatives of the Treasury and other bank regulatory agencies will have on the financial markets and the financial services industry.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements. Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made. In addition, past results of operations are not necessarily indicative of future results.

Executive Overview
Description of Operations
Headquartered in Hampton, Virginia, the Company is the parent company of Trust and the Bank. Trust is a wealth management services provider. The Bank offers a complete line of consumer, mortgage and business banking services, including loan, deposit, and cash management services to individual and business customers. The Bank is an independent community bank. The Bank has 21 branches throughout the Hampton Roads localities of Chesapeake, Hampton, Isle of Wight County, Newport News, Norfolk, Virginia Beach, Williamsburg/James City County and York County.

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Index

Management Initiatives in 2012
In 2012, management intended to improve asset quality, grow the loan portfolio, expand the Company's fee based revenue and concentrate on improving Company efficiency. Management succeeded in three of the four initiatives. Management was able to improve asset quality as is evident by a $4.9 million reduction in net charge-offs when comparing charge-offs for 2012 to those of 2011, and a $2.8 million reduction in foreclosed assets at December 31, 2012 as compared to December 31, 2011. In addition, there was an $11.0 million reduction in risk rated loans in the Other Assets Especially Mentioned and Substandard categories when comparing December 31, 2012 to December 31, 2011. Details of the improvement of asset quality can be found in Note 4 of the Notes to Consolidated Financial Statements included in item 8, "Financial Statements and Supplementary Data" of this report on Form 10-K. In addition, fee based revenue was higher for the year ended December 31, 2012 as compared to 2011. To improve efficiency, the Company reduced total employees from 334 on December 31, 2011 to 319 on December 31, 2012 by attrition and an early retirement program. Although the retirement program increased expense in 2012, the program is expected to result in reduced salary expense beginning in 2013.

As in 2010 and in 2011, loan growth did not occur in 2012. Management believes that the decline in the loan portfolio in 2012 was the result of several factors, including an attractive refinance market, efforts by management to improve asset quality, and the continued reduced level of quality loan demand in the Company's primary service area. In 2012, management focused on slowing the decline in certain real estate mortgage loans by working with Old Point Mortgage, LLC, to refinance existing loans to keep them in the Company's portfolio and where possible to add loans to the Company's portfolio by refinancing loans originally made by other lenders. If the Company's loan portfolio continues to decline, the Company expects that excess liquidity will continue to be invested in marketable securities, which would likely result in a continued overall reduction in net interest income and the net interest margin, because loans typically yield higher returns than the Company's investment portfolio.

Primary Financial Data for 2012
The Company earned $4.2 million in 2012, as compared to net income of $3.3 million in 2011, an increase of $897 thousand or 27.26%. The increase in net income was due to an increase in realized gains on available-for-sale securities, from $787 thousand in 2011 to $2.3 million in 2012. A $1.3 million reduction in the provision for loan losses when comparing 2011 and 2012 also contributed to the increase in net income. Decreases in loans and charge-offs between the two periods allowed management to reduce the provision for loan losses in 2012. Net loans charged off for the year ended December 31, 2012 were 57.60% lower than net charge-offs for the year ended December 31, 2011.

Assets as of December 31, 2012 were $907.5 million, an increase of $58.0 million or 6.83% compared to assets as of December 31, 2011. This growth in assets was driven by increased deposits; low-cost deposits in particular grew $49.0 million. As quality loan demand has decreased in recent years, the Company has invested excess funds in securities that can be readily liquidated when loan demand recovers. Between December 31, 2011 and December 31, 2012, securities available-for-sale and cash and cash equivalents increased $110.3 million.

Critical Accounting Estimates
The accounting and reporting policies of the Company are in accordance with U.S. generally accepted accounting principles (GAAP) and conform to general practices within the banking industry. The Company's financial position and results of operations are affected by management's application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company's consolidated financial position and/or results of operations. The accounting policy that required management's most difficult, subjective or complex judgments is the Company's allowance for loan losses, which is described below.

Allowance for Loan Losses
The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on three basic principles of accounting which require: (i) that losses be accrued when they are probable of occurring and estimable, (ii) that losses be accrued based on the differences between the loan balances and the value of collateral, present value of future cash flows or values that are observable in the secondary market and (iii) that adequate documentation exist to support the allowance for loan losses estimate.

The Company's allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. Management's estimate is based on certain observable, historical data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; discounted cash flow analysis; loan volumes; geographic, borrower and industry concentrations; the findings of internal credit quality assessments and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

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Index

Authoritative accounting literature requires that the impairment of loans that have been separately identified for evaluation be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting literature, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

Reserves for commercial loans are determined by applying estimated loss factors to the portfolio based on management's evaluation and risk grading of the commercial loan portfolio. Reserves are provided for noncommercial loan categories using estimated loss factors applied to the total outstanding loan balance of each loan category. Specific reserves are determined on a loan-by-loan basis based on management's evaluation of the Company's exposure for each credit, given the current payment status of the loan and the net market value of any underlying collateral.

While management uses the best information available to establish the allowance for loan losses, future adjustment to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

Income Taxes
The Company recognizes expense for federal income and state bank franchise taxes payable as well as deferred federal income taxes for estimated future tax effects of temporary differences between the tax basis of assets and liabilities and amounts reported in the Consolidated Financial Statements. Income and franchise tax returns are subject to audit by the Internal Revenue Service (IRS) and state taxing authorities. Income and franchise tax expense for current and prior periods is subject to adjustment based on the outcome of such audits. The Company believes it has adequately provided for all taxes payable.

Earnings Summary
Net income was $4.2 million, or $0.84 per diluted share, in 2012 compared to $3.3 million, or $0.66 per diluted share, in 2011. During 2012, the Company decreased its loan loss provision to $2.4 million as compared to $3.7 million in 2011. The decrease to the loan loss provision was mainly a result of the reduction in nonperforming assets. Another benefit from the improvement in nonperforming assets during 2012 was the reduction of foreclosed assets expenses which decreased $97 thousand when comparing 2012 to 2011. In addition, loss on write-down/sale of foreclosed assets in 2012 decreased by $636 thousand compared to 2011.

Net Interest Income
The principal source of earnings for the Company is net interest income. Net interest income is the difference between interest and fees generated by earning assets and interest expense paid to fund them. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. The net interest margin is calculated by dividing tax equivalent net interest income by average earning assets. Net interest income, on a fully tax-equivalent basis, was $27.2 million in 2012, down $2.5 million from 2011 and down $3.9 million from 2010. The net interest margin was 3.40% in 2012 as compared to 3.81% in 2011 and 3.63% in 2010.

When comparing 2012 to 2011, the following changes were noted. Tax equivalent interest income decreased $3.4 million, or 9.37%. Average earning assets increased $21.5 million, or 2.76%. Total average loans decreased $66.3 million, or 12.18%, while average investment securities increased $81.6 million, or 39.44%. The yield on earning assets decreased by 55 basis points due to decreasing yields in the loan portfolio. The Company's securities portfolio increased in 2012 as demand for the Company's loan products dropped and the Company invested excess funds in securities. The Company intends to continue investing excess funds in securities until quality loan demand increases. Management expects that the Company's loan yields will continue to decline, due to intense competition for quality loans and rate reductions on loans currently held in the portfolio. To partially offset this anticipated decline in loan yields, management has placed an increased focus on prudently increasing the yields on the Company's securities portfolio. Because loans typically yield higher returns than the Company's securities portfolio, however, a continued shift in the Company's asset mix towards investment securities would likely result in a continued overall reduction in net interest income and the net interest margin.

Interest expense decreased $941 thousand, or 14.01% in 2012 as compared to 2011, while average interest-bearing liabilities decreased $13.3 million, or 2.14%. The cost of interest-bearing liabilities decreased 13 basis points due to the low interest rate environment. Management expects that the reduction of the Company's interest expense will continue to slow in the future, because the majority of the higher cost time deposits have repriced to current, lower market rates.

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Index

The following table shows an analysis of average earning assets, interest-bearing liabilities and rates and yields. Nonaccrual loans are included in loans outstanding.

                                                                                  TABLE I
                                                          AVERAGE BALANCE SHEETS, NET INTEREST INCOME* AND RATES*

Years ended December 31,                                      2012                                        2011                                        2010
                                                            Interest                                    Interest                                    Interest
                                              Average       Income/         Yield/        Average       Income/         Yield/        Average       Income/         Yield/
                                              Balance       Expense          Rate         Balance       Expense          Rate         Balance       Expense          Rate
                                                                                                 (dollars in thousands)
ASSETS

Loans                                        $ 478,220     $   26,565           5.55 %   $ 544,523     $   32,176           5.91 %   $ 621,550     $   37,142           5.98 %
Investment securities:
Taxable                                        263,532          5,238           1.99 %     203,198          3,884           1.91 %     186,992          3,419           1.83 %
Tax-exempt                                      25,053          1,032           4.12 %       3,763            238           6.32 %       5,579            406           7.28 %
Total investment securities                    288,585          6,270           2.17 %     206,961          4,122           1.99 %     192,571          3,825           1.99 %
Interest-bearing due from banks                 28,460             56           0.20 %       9,819             22           0.22 %       1,156              3           0.26 %
Federal funds sold                               1,780              2           0.11 %      13,622             21           0.15 %      35,608             75           0.21 %
Other investments                                3,967            100           2.52 %       4,599             62           1.35 %       4,939             44           0.89 %
Total earning assets                           801,012         32,993           4.12 %     779,524         36,403           4.67 %     855,824         41,089           4.80 %
Reserve for loan losses                         (7,771 )                                   (10,349 )                                   (11,064 )
                                               793,241                                     769,175                                     844,760

Cash and due from banks                          8,589                                      13,227                                      12,486
Bank premises and equipment, net                30,728                                      29,896                                      30,051
Other assets                                    36,878                                      41,551                                      37,412

Total assets                                 $ 869,436                                   $ 853,849                                   $ 924,709

LIABILITIES AND STOCKHOLDERS' EQUITY

Time and savings deposits:
Interest-bearing transaction accounts        $  11,600     $        7           0.06 %   $  11,512     $        7           0.06 %   $  11,031     $        7           0.06 %
Money market deposit accounts                  180,106            322           0.18 %     169,951            352           0.21 %     159,934            359           0.22 %
Savings accounts                                53,054             53           0.10 %      48,252             49           0.10 %      45,281             47           0.10 %
Time deposits, $100,000 or more                131,020          1,613           1.23 %     126,711          1,862           1.47 %     182,983          2,647           1.45 %
Other time deposits                            172,230          2,238           1.30 %     180,162          2,634           1.46 %     161,399          3,977           2.46 %

Total time and savings deposits                548,010          4,233           0.77 %     536,588          4,904           0.91 %     560,628          7,037           1.26 %
Federal funds purchased, repurchase
agreements and other borrowings                 29,917             45           0.15 %      50,196            106           0.21 %     104,859            545           0.52 %
Federal Home Loan Bank advances                 30,574          1,496           4.89 %      35,000          1,705           4.87 %      47,620          2,400           5.04 %

Total interest-bearing liabilities             608,501          5,774           0.95 %     621,784          6,715           1.08 %     713,107          9,982           1.40 %
Demand deposits                                170,792                                     147,069                                     126,829
Other liabilities                                2,231                                       1,674                                       2,260

Total liabilities                              781,524                                     770,527                                     842,196
Stockholders' equity                            87,912                                      83,322                                      82,513

Total liabilities and stockholders' equity   $ 869,436                                   $ 853,849                                   $ 924,709

Net interest margin                                        $   27,219           3.40 %                 $   29,688           3.81 %                 $   31,107           3.63 %

* Computed on a fully taxable equivalent basis using a 34% rate.

The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities and changes in interest rates.

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Index

                                                                                         TABLE II
                                                                                 VOLUME AND RATE ANALYSIS*
                                                                                      (in thousands)

                                                    2012 vs. 2011                             2011 vs. 2010                             2010 vs. 2009
                                                 Increase (Decrease)                       Increase (Decrease)                       Increase (Decrease)
                                                 Due to Changes in:                        Due to Changes in:                        Due to Changes in:

                                         Volume         Rate          Total        Volume         Rate          Total        Volume         Rate          Total
EARNING ASSETS:
Loans                                   $  (3,918 )   $  (1,693 )   $  (5,611 )   $  (4,603 )   $    (363 )   $  (4,966 )   $    (727 )   $    (299 )   $  (1,026 )
Investment securities:
Taxable                                     1,153           201         1,354           296           169           465         1,496          (643 )         853
Tax-exempt                                  1,347          (553 )         794          (132 )         (36 )        (168 )        (413 )           4          (409 )
Total investment securities                 2,500          (352 )       2,148           164           133           297         1,083          (639 )         444

Federal funds sold                            (18 )          (1 )         (19 )         (46 )          (8 )         (54 )          22            (1 )          21
Other investments **                          105           (33 )          72            64           (27 )          37          (270 )        (104 )        (374 )
Total earning assets                       (1,331 )      (2,079 )      (3,410 )      (4,421 )        (265 )      (4,686 )         108        (1,043 )        (935 )

INTEREST-BEARING LIABILITIES:
Interest-bearing transaction accounts           0             0             0             0             0             0             1            (1 )           0
Money market deposit accounts                  21           (51 )         (30 )          22           (29 )          (7 )          51             7            58
Savings accounts                                5            (1 )           4             3            (1 )           2             5           (11 )          (6 )
Time deposits, $100,000 or more                63          (312 )        (249 )        (814 )          29          (785 )          (4 )      (1,092 )      (1,096 )
Other time deposits                          (116 )        (280 )        (396 )         462        (1,805 )      (1,343 )         335        (2,566 )      (2,231 )
Total time and savings deposits               (27 )        (644 )        (671 )        (327 )      (1,806 )      (2,133 )         388        (3,663 )      (3,275 )
Federal funds purchased, repurchase
agreements and other borrowings               (43 )         (18 )         (61 )        (284 )        (155 )        (439 )         184          (205 )         (21 )
Federal Home Loan Bank advances              (216 )           7          (209 )        (636 )         (59 )        (695 )        (979 )         (66 )      (1,045 )
Total interest-bearing liabilities           (286 )        (655 )        (941 )      (1,247 )      (2,020 )      (3,267 )        (407 )      (3,934 )      (4,341 )

Change in net interest income           $  (1,045 )   $  (1,424 )   $  (2,469 )   $  (3,174 )   $   1,755     $  (1,419 )   $     515     $   2,891     $   3,406

* Computed on a fully tax-equivalent basis using a 34% rate. ** Other investments include interest-bearing balances due from banks.

Interest Sensitivity
An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. This gap can be managed by repricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies governing asset generation and pricing, funding sources . . .

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