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COFS > SEC Filings for COFS > Form 10-Q on 15-May-2013All Recent SEC Filings

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Form 10-Q for CHOICEONE FINANCIAL SERVICES INC


15-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. ("ChoiceOne" or the "Registrant") and its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and the Bank's wholly-owned subsidiary, ChoiceOne Insurance Agencies, Inc. This discussion should be read in conjunction with the consolidated financial statements and related notes.

FORWARD-LOOKING STATEMENTS

This discussion and other sections of this quarterly report contain forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and ChoiceOne itself. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," "may," "could," variations of such words and similar expressions are intended to identify such forward-looking statements. Management's determination of the provision and allowance for loan losses, the carrying value of goodwill and loan servicing rights, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary) and management's assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Company's Annual Report on Form 10-K; changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit availability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

RESULTS OF OPERATIONS

Summary

Net income for the first quarter of 2013 was $1,235,000, which represented an increase of $220,000 or 22% compared to the same period in 2012. A reduction in the provision for loan losses was partially offset by higher noninterest expense in the first quarter of 2013 compared to the same period in the prior year. Basic and diluted earnings per common share were $0.37 for the first quarter of 2013, compared to $0.31 for the same quarter in 2012. The return on average assets and return on average shareholders' equity percentages were 0.98% and 8.10%, respectively, for the first quarter of 2013, compared to 0.81% and 6.97%, respectively, for the same period in 2012.

Dividends

Cash dividends of $429,000 or $0.13 per share were declared in the first quarter of 2013, compared to $395,000 or $0.12 per share in the first quarter of 2012. The cash dividend payout percentage was 35% for the first three months of 2013, compared to 39% in the same period a year ago.

Interest Income and Expense

Tables 1 and 2 on the following pages provide information regarding interest income and expense for the three-month periods ended March 31, 2013 and 2012. Table 1 documents ChoiceOne's average balances and interest income and expense, as well as the average rates earned or paid on assets and liabilities. Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. These tables are referred to in the discussion of interest income, interest expense and net interest income.

Table 1 - Average Balances and Tax-Equivalent Interest Rates



(Dollars in thousands)                               Three Months Ended March 31,
                                              2013                                   2012
                                Average                                Average
                                Balance      Interest      Rate        Balance      Interest      Rate
Assets:
Loans (1)                     $ 311,724     $  4,008        5.14 %   $ 313,566     $  4,350        5.55 %
Taxable securities (2) (3)       92,499          463        2.00        85,155          503        2.36
Nontaxable securities (1)
(2)                              41,468          522        5.04        33,908          484        5.71
Other                             4,729            2        0.17         9,836            5        0.20
 Interest-earning assets        450,420        4,995        4.43       442,465        5,342        4.83
Noninterest-earning assets       52,950                                 56,119
Total assets                  $ 503,370                              $ 498,584

Liabilities and
Shareholders' Equity:
Interest-bearing demand
deposits                      $ 133,236           69        0.21 %   $ 136,416          118        0.35 %
Savings deposits                 65,271           11        0.07        47,213            9        0.08
Certificates of deposit         128,248          296        0.92       145,991          485        1.33
Advances from Federal Home
Loan Bank                           418            4        3.83         8,444           76        3.60
Other                            17,196            9        0.21        21,235           68        1.28
Interest-bearing
liabilities                     344,369          389        0.45       359,299          756        0.84
Noninterest-bearing demand
deposits                         94,297                                 77,151
Other noninterest-bearing
liabilities                       3,688                                  3,892
Total liabilities               442,354                                440,342
Shareholders' equity             61,016                                 58,242
Total liabilities and
shareholders' equity          $ 503,370                              $ 498,584

Net interest income
(tax-equivalent basis) -
interest spread                                4,606        3.98 %                    4,586        3.99 %
Tax-equivalent adjustment
(1)                                             (179 )                                 (167 )
Net interest income                         $  4,427                               $  4,419
Net interest income as a
percentage of earning
assets (tax-equivalent
basis)                                                      4.09 %                                 4.15 %

(1) Adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 34% for the periods presented.
(2) Includes the effect of unrealized gains or losses on securities.
(3) Taxable securities include dividend income from Federal Home Loan Bank and Federal Reserve Bank stock.

Table 2 - Changes in Tax-Equivalent Net Interest Income



                                                       Three Months Ended March 31,
(Dollars in thousands)                                        2013 Over 2012
                                                        Total          Volume       Rate
Increase (decrease) in interest income (1)
Loans (2)                                          $     (342 )     $     (25 )   $ (317 )
Taxable securities                                        (40 )           207       (247 )
Nontaxable securities (2)                                  38             323       (285 )
Other                                                      (3 )            (2 )       (1 )
Net change in tax-equivalent income                      (347 )           503       (850 )

Increase (decrease) in interest expense (1)
Interest-bearing demand deposits                          (49 )            (3 )      (46 )
Savings deposits                                            2               8         (6 )
Certificates of deposit                                  (189 )           (54 )     (135 )
Advances from Federal Home Loan Bank                      (72 )          (103 )       31
Other                                                     (59 )           (11 )      (48 )
Net change in interest expense                           (367 )          (163 )     (204 )
Net change in tax-equivalent net interest income   $       20       $     666     $ (646 )

(1) The volume variance is computed as the change in volume (average balance) multiplied by the previous year's interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year's volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
(2) Interest on nontaxable investment securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 34% for the periods presented.

Net Interest Income

The presentation of net interest income on a tax-equivalent basis is not in accordance with generally accepted accounting principles ("GAAP"), but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine net interest income on a tax-equivalent basis were $179,000 and $167,000 for the three months ended March 31, 2013 and 2012, respectively. These adjustments were computed using a 34% federal income tax rate.

As shown in Tables 1 and 2, tax-equivalent net interest income increased $20,000 in the first three months of 2013 compared to the same period in 2012. The combination of growth in average interest-earning assets and a decline in average interest-bearing liabilities caused net interest income to increase $666,000 in the first quarter of 2013 compared to the same quarter in the prior year. A reduction of 1 basis point in the net interest spread from 3.99% in the first quarter of 2012 to 3.98% in the same quarter in 2013 resulted in a $646,000 decrease in net interest income.

The average balance of loans decreased $1.8 million in the first quarter of 2013 compared to the same period in 2012. Average commercial and industrial and commercial real estate loans were $6.1 million lower in the first quarter of 2013 than in the same quarter of 2012. These decreases were partially offset by a $2.3 million increase in the average balance of consumer loans and $2.0 million increase in the average balance of residential real estate loans in the first quarter of 2013 compared to the same quarter in the prior year. The decrease in the average loans balance combined with a 41 basis point decrease in the average rate earned caused tax-equivalent interest income from loans to decline $342,000 in the first quarter of 2013 compared to the same period in the prior year. The average balance of total securities grew $14.9 million in the first three months of 2013 compared to the same period in 2012. Additional securities were purchased in 2012 and in the first quarter of 2013 due to the declining balance in loans and to provide earning asset growth. The growth in securities, partially offset by the effect of lower interest rates earned, caused interest income to decrease $2,000 in the first quarter of 2013 compared to the same quarter in 2012.

The average balance of interest-bearing demand deposits decreased $3.2 million in the first three months of 2013 compared to the same period in 2012. The effect of the lower average balance and a 14 basis point decline in the average rate paid caused interest expense to decrease $49,000 in the first quarter of 2013 compared to the same quarter in 2012. The average balance of savings deposits increased $18.1 million in the first quarter of 2013 compared to the same quarter in the prior year. The impact of the savings deposit growth was offset slightly by a 1 basis point drop in the average rate paid, resulting in an increase in interest expense of $2,000 in the first three months of 2013 compared to the same period in 2012. The average balance of certificates of deposit was down $17.8 million in the first quarter of 2013 compared to the same period in 2012. The average balance of local certificates was $13.4 million lower while the average balance of nonlocal certificates was $4.4 million lower in the first quarter of 2013 than in the same period in 2012. The decline in certificates of deposit plus a 41 basis point reduction in the average rate paid on certificates caused interest expense to fall $189,000 in the first quarter of 2013 compared to the same period in 2012. A combination of an $8.0 million decrease in the average balance of Federal Home Loan Bank advances offset by a 23 basis point increase in the average rate paid caused interest expense to decline $72,000 in the first quarter of 2013 compared to the same quarter in 2012. A decrease of $4.0 million in the average balance of other interest-bearing liabilities in the first quarter of 2013 compared to the first quarter of 2012 plus the effect of a 107 basis point decrease in the average rate paid caused a $59,000 decrease in interest expense.

ChoiceOne's net interest income spread was 3.98% in the first quarter of 2013, compared to 3.99% for the first quarter of 2012. The decline in the interest spread was due to a 40 basis point decrease in the average rate earned on interest earning assets in the first quarter of 2013 compared to the same quarter in 2012, which was partially offset by a 39 basis point decrease in the average rate paid on interest-bearing liabilities. The reduction in the average rate earned on interest-earning assets was caused by relatively low general market rates which affected new loan originations and securities purchases in 2012 and the first quarter of 2013. Interest rates on loans are also being impacted by rate pressure from some of ChoiceOne's competing financial institutions. The lower rate paid on interest-bearing liabilities resulted from repricing of local deposits as general market interest rates remained low during 2012 and the first quarter of 2013.

Provision and Allowance for Loan Losses

The allowance for loan losses grew $29,000 from December 31, 2012 to March 31, 2013. The provision for loan losses was $300,000 in the first quarter of 2013, compared to $825,000 in the same period in 2012. Nonperforming loans were $6.9 million as of March 31, 2013, compared to $6.8 million as of December 31, 2012. The allowance for loan losses was 1.88% of total loans at March 31, 2013, compared to 1.88% at December 31, 2012 and 1.74% at March 31, 2012.

Charge-offs and recoveries for respective loan categories for the three months ended March 31 were as follows:

(Dollars in thousands)                   2013                               2012
                              Charge-offs       Recoveries       Charge-offs       Recoveries
Agricultural                $           -     $          1     $           -     $          1
Commercial and industrial              21               37                20               20
Consumer                               97               52                71               66
Real estate, commercial                98               10               187               10
Real estate, residential              164                9               584               63
                            $         380     $        109     $         862     $        160

Net charge-offs in the first quarter of 2013 were $271,000, compared to $702,000 in the first quarter of 2012. Net charge-offs on an annualized basis as a percentage of average loans were 0.35% in the first three months of 2013 compared to 0.90% for the same period in the prior year. Management is aware that the economic climate in Michigan will continue to affect business and personal borrowers. Management has worked and intends to continue to work with delinquent borrowers in an attempt to lessen the negative impact to ChoiceOne. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur throughout 2013, the provision and allowance for loan losses will be reviewed by the Bank's management and adjusted as necessary.

Noninterest Income

Total noninterest income increased $3,000 in the first quarter of 2013 compared to the same period in 2012. An increase of $58,000 in customer service charges resulted from growth in overdraft and debit card income. Growth of $119,000 in gains on sales of loans came from increased residential mortgage refinancing activity which supported $13.6 million of loan sales in the first quarter of 2013, compared to $11.5 million in the first quarter of 2012. A decrease of $146,000 in gains on sales of securities resulted from less sales activity in the first three months of 2013 than in the same period of the prior year. The change in losses on sales and write-downs of other assets was primarily due to a $77,000 decrease in write-downs of other real estate owned in the first quarter of 2013 compared to the same period in 2012. Earnings on life insurance policies included $135,000 in the first quarter of 2012 from a death benefit received.

Noninterest Expense

Total noninterest expense increased $147,000 or 4% in the first quarter of 2013 compared to the same period in 2012. The increase of $147,000 in salaries and benefits in the first quarter of 2013 compared to the same period in the prior year resulted from higher salaries, incentive bonus accruals, commission expense from mortgage loan originations, and health insurance costs. Growth of $58,000 in data processing expense resulted from higher ATM and electronic banking expenses. Professional fees were $52,000 lower in the first three months of 2013 than in the same period in 2012 due to lower legal fees related to nonperforming loans.

Income Tax Expense

Income tax expense was $426,000 in the first quarter of 2013 compared to $257,000 for the same quarter in 2012. The effective tax rate was 25.6% for 2013 and 20.2% for 2012. The increase in the effective tax rate in 2013 compared to 2012 was primarily due to nontaxable income from a life insurance death benefit received in the first quarter of 2012.

FINANCIAL CONDITION

Securities

The securities available for sale portfolio decreased $0.8 million from December 31, 2012 to March 31, 2013. Various securities totaling $6.2 million were purchased in the first three months of 2013 to replace maturities, principal repayments, and calls within the securities portfolio. Approximately $4.2 million in various securities were called or matured since the end of 2012. Principal repayments on securities totaled $1.4 million in the first three months of 2013. Approximately $1.3 million of securities were sold in the first quarter of 2013 for a net gain of $23,000.

Loans

The loan portfolio (excluding loans held for sale) grew $1.6 million from December 31, 2012 to March 31, 2013. Commercial real estate loans increased $3.1 million and commercial and industrial loans increased $1.3 million since the end of 2012. Agricultural loans, consumer loans, and residential mortgage loans declined $1.8 million, $0.2 million, and $0.8 million, respectively, in the first quarter of 2013. Much of the decrease in agricultural loans in the first quarter of 2013 resulted from seasonal pay-downs on lines of credit.

Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. The total balance of loans classified as impaired increased from $5.9 million as of December 31, 2012 to $8.3 million as of March 31, 2013. Residential real estate loans classified as impaired grew $1.2 million and commercial real estate loans classified as impaired grew by $0.6 million in the first quarter.

As part of its review of the loan portfolio, management also monitors the various nonperforming loans. Nonperforming loans are comprised of: (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or loans past due 90 days or more, which are considered troubled debt restructurings.

The balances of these nonperforming loans were as follows:

    (Dollars in thousands)
                                                     March 31,      December 31,
                                                       2013             2012
    Loans accounted for on a nonaccrual basis       $     1,729     $       2,331
    Accruing loans contractually past due 90 days
    or more as to principal or interest payments            512                30
    Loans considered troubled debt restructurings         4,623             4,405
    Total                                           $     6,864     $       6,766

At March 31, 2013, nonaccrual loans included $784,000 in commercial real estate loans, $631,000 in residential real estate loans, $187,000 in commercial and industrial loans, and $114,000 in agricultural loans. At December 31, 2012, nonaccrual loans included $1,230,000 in commercial real estate loans, $754,000 in residential real estate loans, $220,000 in commercial and industrial loans, and $94,000 in agricultural loans. The decrease in nonaccrual loans was due to payments received and charge-offs. Management believes the allowance allocated to its nonperforming loans is sufficient at March 31, 2013.

Other Real Estate Owned

The balance of other real estate owned ("OREO") increased $58,000 from December 31, 2012 to March 31, 2013. A total of $365,000 of loans were transferred into OREO during the first quarter of 2013 while sales of properties or payments upon them or write-downs of the value of other real estate properties were $307,000 for the same time period. Due to the current state of the Michigan economy, management believes there will be continuing transfers from loans into OREO during the remainder of 2013. The OREO balance may also be affected by troubled debt restructurings in future quarters as loans can be restructured as an alternative to foreclosure. Management is continuing to work with borrowers in an attempt to mitigate potential losses for ChoiceOne.

Deposits and Borrowings

Total deposits increased $1.5 million from December 31, 2012 to March 31, 2013. Since the end of 2012, money market account balances have risen $16.0 million and savings deposits have grown $4.8 million. Decreases in local certificates of deposit, noninterest-bearing checking accounts, and interest-bearing checking accounts of $8.3 million, $6.2 million, and $4.8 million, respectively were experienced in the first quarter of 2013.

A decline of $1.2 million in repurchase agreements in the first quarter of 2013 was due to normal fluctuations in funds provided by bank customers. Certain securities are sold under agreements to repurchase them the following day or over a certain fixed term. Management plans to continue this practice as a low-cost source of funding. Federal Home Loan Bank advances decreased $7,000 in the first quarter of 2013 due to payments on an amortizing advance.

Shareholders' Equity

Total shareholders' equity increased $740,000 from December 31, 2012 to March 31, 2013. Growth in equity resulted from current year's net income, an increase in accumulated other comprehensive income, and proceeds from issuances of ChoiceOne stock, offset by cash dividends paid.

Following is information regarding the Bank's compliance with regulatory capital requirements:

                                                                                Total
                                                                                Risk-
(Dollars in thousands)                    Leverage            Tier 1            Based
                                           Capital           Capital           Capital
Capital balances at March 31, 2013      $      42,789      $     42,789      $     46,808
Required regulatory capital to be
considered "well capitalized"                  24,233            20,355            33,925
Capital in excess of "well
capitalized" minimum                           18,556            22,434            12,883
Capital ratios at March 31, 2013                 8.83 %           12.61 %           13.80 %
Regulatory capital ratios - minimum
requirement to be considered "well
capitalized"                                     5.00 %            6.00 %           10.00 %

Management reviews the capital levels of ChoiceOne and the Bank on a regular basis. The Board of Directors (the "Board") and management believe that the capital levels as of March 31, 2013 are adequate for the foreseeable future. The Board's determination of appropriate cash dividends for future periods will be based on market conditions and ChoiceOne's requirements for cash and capital.

Liquidity

Net cash provided from operating activities was $0.8 million for the three months ended March 31, 2013 compared to $3.1 million provided in the same period a year ago. The primary reason for the decrease was a $1.9 million net decrease in net activity of sold loans. Net cash used in investing activities was $1.9 million for the first quarter of 2013 compared to $0.8 million in the same period in 2012. The effect of loan growth in the first quarter of 2013 compared to a decline in loans in the first quarter of 2012 was offset by less net purchases of securities in 2013 than in 2012. Net cash provided from financing activities was a negative $0.1 million in the quarter ended March 31, 2013, compared to $6.2 million in the same period in the prior year. The decrease resulted from less deposit growth in 2013 than in 2012, partially offset by a smaller decrease in repurchase agreements.

Management believes that the current level of liquidity is sufficient to meet the Bank's normal operating needs. This belief is based upon the availability of deposits from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds purchased from correspondent banks, and advances available from the Federal Home Loan Bank. The Bank also has a secured line of credit available from the Federal Reserve Bank.

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