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SOMH > SEC Filings for SOMH > Form 10-Q on 14-May-2013All Recent SEC Filings

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Form 10-Q for SOMERSET HILLS BANCORP


14-May-2013

Quarterly Report


Item 2. 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 included in the Company's Annual Report Form 10-K filed for the year ended December 31, 2012.

CRITICAL ACCOUNTING POLICIES

Disclosure of the Company's significant accounting policies is included in Note 1 to the consolidated financial statements of the Company for the year ended December 31, 2012 included in its Annual Report Form 10-K filed under the Securities Exchange Act of 1934. Some of these policies are particularly sensitive, requiring significant judgments, estimates and assumptions to be made by management. Management believes the Company's 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 the Board of Directors of the Company. The allowance for loan losses is based upon management's evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available, the level of the allowance for loan losses remains an estimate, which is subject to significant judgment and short- term change. Various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of the Company's loans are secured by real estate in the state of New Jersey. Accordingly, the collectability of a substantial portion of the carrying value of the Company's loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the Company's market area experience an adverse economic shock. Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond the Company's control. Additional information is contained on pages 18 and 19 of this Form 10-Q for the provision and allowance for loan losses.

RESULTS OF OPERATIONS

Overview

For the three months ended March 31, 2013, net income declined 51.0% to $402,000, or $0.07 per diluted share, from $820,000, or $0.15 per diluted share, for the same period in 2012. First quarter 2013 results include $419,000 of pretax expenses related to the pending merger with Lakeland Bancorp, Inc. ("Lakeland") and amount to $352,000, or $0.07 per diluted share, on an after-tax basis. Net income in the first quarter of 2013 excluding merger-related expenses declined by 8.0% from the same quarter of 2012. Excluding merger-related expenses, net income per diluted share for the first quarter of 2013 declined by 6.7% from the first quarter of 2012. The declines in net income and diluted earnings per share not attributable to merger-related expenses were due to lower net interest income (resulting from a narrowing of the net interest margin) and decreased non-interest income (largely from lower mortgage banking income), partly offset by lower non-interest expenses. At March 31, 2013, total assets were $355.9 million, a decrease of $13.0 million from $368.9 million at year-end 2012. The decrease was primarily due to a $12.2 million decline in cash and cash equivalents and a $4.4 million decline in loans held for sale that was partially offset by a $3.5 million increase in total loans. Total deposits at March 31, 2013 amounted to $307.5 million, representing a $12.6 million decrease from year-end 2012. The decrease in deposit balances at March 31, 2013 from year-end 2012 largely represents a seasonal variance and does not reflect the Bank's recent trend in deposits (see "Comparative Average Balance Sheets" below).

Net Interest Income

Fully taxable equivalent ("FTE") net interest income for the first quarter of 2013 was $2.8 million, a decrease of $319,000 or 10.1%, from $3.1 million earned in the first quarter of 2012. The decline in net interest income during 2013 was attributable to a 47 basis-point narrowing in first quarter net interest margin to 3.37% from 3.84% in the first quarter of 2012, partly offset by a 3.2% increase in average interest-earning assets to $340.2 million in 2013 from $329.6 million in 2012. The decline in the first quarter 2013 net interest margin was largely due to a $30.6 million decline in average securities to $23.1 million from $53.7 million in the first quarter of 2012 that led to a $29.9 million increase in average interest bearing deposits with banks to $70.2 million in the 2013 quarter from $40.3 million in the first quarter of 2012. The Company's balance sheet and interest sensitivity has become more liquid and asset sensitive in recent quarters due to less than robust loan demand coupled with a lack of attractive yields on shorter duration investment securities. The growth in average interest earning assets resulted from an $11.0 million increase in average loans to $243.5 million during the first quarter of 2013 versus $232.5 million in the same quarter of 2012.

- 20 -

The following tables present a summary of the Company's interest-earning assets and their average yields, and interest-bearing liabilities and their average costs and stockholders' equity for the three months ended March 31, 2013 and 2012. The average balances are derived from average daily balances. The average balance of loans includes non-accrual loans, and associated yields include loan fees, which are considered an adjustment to yields.

                       Comparative Average Balance Sheets



                                                           Three Months Ended March 31,
                                               2013                                             2012
                                          Interest       Average Rates                     Interest       Average Rates
                            Average       Income/           Earned/          Average       Income/           Earned/
                            Balance       Expense            Paid            Balance       Expense            Paid
                                                              (dollars in thousands)
Assets
Interest bearing
deposits at other banks    $  70,216     $       45                0.26 %   $  40,281     $       26                0.26 %
Loans                        243,463          2,766                4.61 %     232,507          2,996                5.18 %
Loans held for sale            2,673             27                4.12 %       2,327             30                5.13 %
Investment securities         23,072            215                3.79 %      53,719            440                3.30 %
Restricted stock                 743              9                4.92 %         784             10                4.91 %
Total interest earning
assets                       340,167          3,062                3.65 %     329,618          3,502                4.27 %

Non-interest earning
assets                        23,622                                           24,139
Allowance for loan
losses                        (3,183 )                                         (3,008 )
Total Assets               $ 360,606                                        $ 350,749

Liabilities and Equity

Interest bearing demand
deposits                   $ 166,810             37                0.09 %   $ 153,769             70                0.18 %
Savings                        8,032              2                0.10 %       7,520              2                0.11 %
Money Market                  20,656              5                0.10 %      25,936             13                0.21 %
Certificates of deposits      33,647            144                1.73 %      40,561            205                2.03 %
FHLB advances/other
borrowings                     5,511             47                3.42 %       7,500             66                3.52 %
Total interest bearing
liabilities                  234,656            235                0.41 %     235,286            356                0.61 %

Non-Interest Bearing
Liabilities:
Non-interest bearing
deposits                      82,986                                           73,259
Other liabilities                980                                            1,247

Total Liabilities            318,622                                          309,792
Stockholders' Equity          41,984                                           40,957

Total Liabilities and
Stockholders' Equity       $ 360,606                                        $ 350,749

Net Interest Income                      $    2,827                                       $    3,146
Net Interest Spread                                                3.24 %                                           3.66 %
Net Interest Margin                                                3.37 %                                           3.84 %

The data contained in the table has been adjusted to a tax equivalent basis, based on the Company's federal statutory rate of 34 percent. Management believes that this presentation provides comparability of net interest income and net interest margin arising from both taxable and tax-exempt sources and is consistent with industry practice and SEC rules.

Provision for Loan Losses

The first quarter provision for loan losses was $25,000 in 2013 versus $75,000 for 2012. The Company's asset quality metrics, such as nonaccrual loan, charge-off, and delinquency ratios remain sound relative to its competitive peer groups, and the relatively low level of loan loss provisioning during both 2013 and 2012 reflects very few new problem credits. Management regularly reviews the adequacy of its allowance and may provide for additional provisions in future periods due to increased general weakness in the economy or in our geographic trade area, deterioration or impairment of specific credits, or as management may deem necessary.

- 21 -

Non-Interest Income

Non-interest income decreased $32,000 or 5.8% to $519,000 in the first quarter of 2013 from $551,000 in the first quarter of 2012, primarily due to a $41,000 decline in gains on sales of residential loans at Sullivan Financial Services, Inc. ("Sullivan"), a wholly-owned mortgage banking subsidiary of the Bank, partially offset by a $9,000 increase in deposit service fees to $80,000 in the first quarter of 2013 from $71,000 in the first three months of 2012. A decline in Sullivan's origination volume was primarily responsible for the decline in mortgage banking income.

Non-Interest Expense

Non-interest expense increased 10.4% to $2.6 million for the first quarter of 2013 from $2.3 million for the same period of 2012. Included in non-interest expense in the first quarter of 2013 were merger?related expenses of $419,000. Excluding these merger-related expenses, adjusted non-interest expense decreased by $177,000 or 7.6% to $2.1 million for the three months of 2013 from $2.3 million in the first quarter of 2012. The decline in operating expenses was primarily due to decreases in personnel, office-related and other non-interest expenses. Management continues to proactively manage its expense containment efforts.

Income Taxes

The Company recorded first quarter income tax provisions of $317,000 for 2013 and $438,000 for 2012, representing effective tax rates of 44.1% and 34.8% for the first quarter of 2013 and 2012, respectively. The increase in the effective tax rates for the first three months of 2013 over the same period of 2012 was primarily due to the impact of the merger-related expenses. If both taxable income and the income tax provision for the first quarter of 2013 were adjusted to exclude the impact of merger-related costs, the adjusted effective tax rate would be 33.7%.

FINANCIAL CONDITION

March 31, 2013 Compared to December 31, 2012

At March 31, 2013, total assets were $355.9 million, a decrease of $13.0 million from $368.9 million at year-end 2012. The decrease was primarily due to a $12.2 million decline in cash and cash equivalents and a $4.4 million decline in loans held for sale that was partially offset by a $3.5 million increase in total loans. Total deposits at March 31, 2013 amounted to $307.5 million, representing a $12.6 million decrease from year-end 2012. The decrease in deposit balances at March 31, 2013 from year-end 2012 largely represents a seasonal variance and does not reflect the Bank's recent trend in deposits (see "Comparative Average Balance Sheets" above).

Our portfolio of investment securities available for sale decreased slightly, from $13.4 million at year-end 2012 to $13.0 million at March 31, 2013, while the Company's investment securities held to maturity increased by a comparable amount to $9.4 million at March 31, 2013 from $8.9 million at year-end 2012.

Since 2009, management has taken a cautious approach with regard to liquidity and interest rate risk by largely depositing net inflows into the Bank's Federal Reserve Bank account, which is currently earning 0.25% per annum. As a result, cash and cash equivalents have remained high by historical standards. Cash and cash equivalents totaled $70.5 million at March 31, 2013 and $82.7 million at December 31, 2012.

Total loans receivable at March 31, 2013 increased $3.5 million to $245.4 million from $241.9 million at year-end 2012. The changes in and composition of the loan portfolio, by category, as of March 31, 2013 compared to December 31, 2012 are as follows: commercial loans decreased $1.8 million to $30.4 million; construction, land and land development loans increased by $1.6 million to $3.5 million; commercial mortgage loans increased $4.5 million to $135.2 million; residential mortgage loans increased by $0.8 million to $40.6 million; and consumer loans decreased by $1.6 million to $35.5 million. At the end of the first quarter of 2013, the Bank's commercial loan pipeline of approved loans approximated $6.8 million.

- 22 -

The following schedule presents the components of loans, net of unearned income, for each period presented:

                                              March 31, 2013            December 31, 2012
                                           Amount       Percent        Amount       Percent
                                                        (dollars in thousands)
Commercial                                $  30,425         12.4 %   $   32,192         13.3 %
Construction, land and land development       3,473          1.4          1,902          0.8
Commercial mortgages                        135,214         55.1        130,733         54.1
Residential mortgages                        40,608         16.6         39,766         16.5
Consumer                                     35,494         14.5         37,088         15.3
Gross loans                                 245,214        100.0 %      241,681        100.0 %
Net deferred costs                              208                         230
Total loans                                 245,422                     241,911
Less: Allowance for loan losses               3,192                       3,158
Net loans                                 $ 242,230                  $  238,753

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, inventory and equipment and liens on commercial and residential real estate. Construction, land and land development loans include loans secured by first liens on commercial or residential properties to finance the construction or renovation of such properties. Commercial mortgages include loans secured by first liens on completed commercial 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. Consumer loans consist primarily of home equity loans secured by 1st or 2nd liens.

                                 ASSET QUALITY



The following table sets forth information concerning the Company's
non-performing assets and troubled debt restructurings ("TDRs") as of the dates
indicated:



                                                      March 31, 2013        December 31, 2012
                                                              (dollars in thousands)
Non-accrual loans                                    $            746      $               746
OREO                                                                -                        -
Total non-performing assets                          $            746      $               746
Troubled debt restructured loans                     $          2,255      $               340
Loans past due 90 days and still accruing            $            416      $               420

Non-accrual loans to total loans                                 0.30 %                   0.31 %
Non-performing assets to total assets                            0.21                     0.20
Allowance for loan losses to non-performing loans                 428                      423
Allowance for loan losses to total loans                         1.30                     1.31

Loans delinquent 30-89 days were $205,000 at March 31, 2013, compared to $216,000 at December 31, 2012.

As of March 31, 2013 and December 31, 2012, there were $3.3 million and $3.1 million in impaired loans, respectively. The amount of the allowance for loan losses allocated for impaired loans as of March 31, 2013 and December 31, 2012 was $129,000 and $165,000, respectively.

ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is maintained at a level considered adequate to provide for probable loan losses. The level of the allowance is based on management's evaluation of estimated losses in the portfolio, after consideration of risk characteristics of the loans and prevailing and anticipated economic conditions. Provisions are charged to expense and the allowance is reduced by charge-offs, net of recoveries, and is increased by the provision. Although management strives to maintain an allowance it deems adequate, future economic changes, deterioration of borrowers' creditworthiness, and the impact of examinations by regulatory agencies all could cause changes to the Company's allowance for loan losses.

At March 31, 2013, the allowance for loan losses was $3.2 million, an increase of $34,000 from year-end 2012. A net recovery of $9,000 was recorded during the first quarter of 2013. Net charge-offs totaled $56,000 during the first quarter of 2012. The allowance for loan losses as a percentage of loans receivable was 1.30% at March 31, 2013 and 1.31% at December 31, 2012.

- 23 -

The following table describes the activity in the allowance for loan losses account for the periods ended:

                                                     Three Months Ended March 31,
                                                       2013                2012
                                                            (in thousands)
Allowance for loan losses at beginning of period   $       3,158       $       2,982
Charge-offs                                                    -                 (67 )
Recoveries                                                     9                  11
Net charge-offs                                            3,167                 (56 )
Provision for loan losses                                     25                  75
Allowance for loan losses at end of period         $       3,192       $       3,001

INTEREST RATE SENSITIVITY ANALYSIS

The principal objective of the Company's asset and liability management function is to evaluate the interest-rate risk included in certain balance sheet accounts; determine the level of risk appropriate given the Company's business focus, operating environment, and capital and liquidity requirements; establish prudent asset concentration guidelines; and manage the risk consistent with Board approved guidelines. The Company seeks to reduce the vulnerability of its operations to changes in interest rates, and actions in this regard are taken under the guidance of the Asset/Liability Committee (the "ALCO"). The ALCO generally reviews the Company's liquidity, cash flow needs, maturities of investments, deposits and borrowings, and current market conditions and interest rates.

The Company currently utilizes net interest income simulation and economic value of portfolio equity ("EVPE") models to measure the potential impact to the Company of future changes in interest rates. As of March 31, 2013 and 2012, the results of the models were within guidelines prescribed by the Company's Board of Directors. If model results were to fall outside prescribed ranges, action would be required by the ALCO.

The net interest income simulation model, which is based on multiple assumptions, attempts to measure the change in net interest income over the next one-year period assuming certain changes in the general level of interest rates. In our model, which was run as of March 31, 2013, we estimated that a gradual (often referred to as "ramped") 200 basis-point increase in the general level of interest rates will increase our net interest income by 7.3%, while a ramped 200 basis-point decrease in interest rates will decrease net interest income by 2.6%. As of March 31, 2012, our model predicted that a 200 basis-point gradual increase in general interest rates would decrease net interest income by 1.3%, while a 200 basis-point decrease would decrease net interest income by 1.8%.

An EVPE analysis is also used to dynamically model the present value of asset and liability cash flows with rate shocks of up and down 200 basis points. The economic value of equity is likely to be different as interest rates change. The Company's estimated variance in EVPE as a percentage of assets as of March 31, 2013, was -0.62% with a rate shock of up 200 basis points, and -0.97% with a rate shock of down 200 basis points. At March 31, 2012, the variances were -1.89% assuming an up 200 basis points rate shock and +0.02% assuming a down 200 basis-point rate shock.

LIQUIDITY MANAGEMENT AND CAPITAL RATIOS

The Company's liquidity is a measure of its ability to fund loans, withdrawals or maturities of deposits, and other cash outflows in a cost-effective manner. The Company's principal sources of funds are deposits, scheduled amortization and prepayments of loan principal, maturities of investment securities, and funds provided by operations. While scheduled loan payments and maturing investments are relatively predictable sources of funds, deposit flow and loan prepayments are greatly influenced by general interest rates, economic conditions, and competition.

At March 31, 2013, the amount of liquid assets remained at a level management deemed adequate to ensure that, on a short- and long-term basis, contractual liabilities, depositors' withdrawal requirements, and other operational and customer credit needs could be satisfied. As of March 31, 2013, liquid assets (cash and cash equivalents and unencumbered investment securities) were $77.4 million, which represented 21.7% of total assets and 24.7% of total deposits and borrowings.

The Bank is a member of the Federal Home Loan Bank of New York and, based on available qualified collateral as of March 31, 2013, had the ability to borrow $86.9 million. The Bank also has a credit facility with the Federal Reserve Bank of New York for direct discount window borrowings that had, as of March 31, 2013, an approximate borrowing capacity based on pledged collateral of $8.7 million. In addition, the Bank has in place additional borrowing capacity of $18.5 million through correspondent banks. At March 31, 2013, the Bank had aggregate available and unused credit of $108.6 million, which represents the aforementioned facilities totaling $114.1 million net of $5.5 million in outstanding borrowings. At March 31, 2013, outstanding commitments for the Bank to extend credit and standby letters of credit were $84.4 million.

Total stockholders' equity declined $67,000 to $41.8 million at March 31, 2013 from year-end 2012. The decline in total stockholders' equity for the first three months of 2013 resulted primarily from the payment of $429,000 in cash dividends on common stock and an after-tax reduction of $53,000 in unrealized gains on available for sale securities, partially offset by net income of $402,000.

- 24 -

At March 31, 2013, the Bank exceeded each of the regulatory capital requirements applicable to it. The table below presents the capital ratios at March 31, 2013 and 2012, for the Bank, as well as the minimum regulatory requirements.

                                                                  Minimum                       For Classification
                                Actual                    Regulatory Requirement               as Well Capitalized
                          Amount       Ratio          Amount             Minimum Ratio         Amount         Ratio
                                                            (dollars in thousands)
March 31, 2013
Leverage Capital         $ 40,431        11.22 %   $      14,011                    4.00 %   $    17,514        5.00 %
Tier 1-Risk Based          40,431        15.04            10,754                    4.00          16,130        6.00
Total Risk-Based           43,623        16.23            21,508                    8.00          26,883       10.00

December 31, 2012
Leverage Capital         $ 40,437        11.04 %   $      14,656                    4.00 %   $    18,320        5.00 %
Tier 1-Risk Based          40,437        15.12            10,696                    4.00          16,044        6.00
Total Risk-Based           43,595        16.30            21,392                    8.00          26,740       10.00

The Company's ratio of equity capital to total assets was 11.74% as of March 31, 2013 and 11.34% as of December 31, 2012. As the Company has less than $500 million in consolidated assets, it is not subject to regulatory capital requirements at the consolidated holding company level.

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