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CSBQ > SEC Filings for CSBQ > Form 10-Q on 14-Aug-2013All Recent SEC Filings

Show all filings for CORNERSTONE BANCSHARES INC | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for CORNERSTONE BANCSHARES INC


14-Aug-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee. The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia. The Bank's business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.

The following is a discussion of Cornerstone's financial condition at June 30, 2013 and December 31, 2012 and our results of operations for the three and six months ended June 30, 2013 and 2012. The purpose of this discussion is to focus on information about Cornerstone's financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone's consolidated financial statements and the related notes included elsewhere herein.

Critical Accounting Policies

Cornerstone's accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, Presentation of Financial Information to the consolidated financial statements and are integral to understanding the MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that Cornerstone reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

Allowance for Loan Losses

The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan losses and reduced through loan charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance.

Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone's net income as a result of the change in the provision for loan losses. Refer to Notes 1 and 4 in the notes to Cornerstone's consolidated financial statements for a discussion of Cornerstone's methodology of establishing the allowance.

Estimates of Fair Value

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Cornerstone's available for sale securities and cash surrender value of life insurance are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. Cornerstone uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that Cornerstone make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate Cornerstone's assessments regarding assumptions that market participants would use in pricing the asset or the liability.

Changes in fair value could materially impact our financial results. Refer to Note 6, "Fair Value Disclosures," in the notes to Cornerstone's consolidated financial statements for a discussion of the methodology in calculating fair value.

Income Taxes

Cornerstone is subject to various taxing jurisdictions where Cornerstone conducts business. Cornerstone estimates income tax expense based on amounts expected to be owed to these jurisdictions. Cornerstone evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in Cornerstone's consolidated balance sheets. Cornerstone assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management's evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 9, "Income Taxes," in the notes to Cornerstone's consolidated financial statements set forth in its Annual Report on Form 10-K for the year ended December 31, 2012 for more information.

Review of Financial Performance

As of June 30, 2013, Cornerstone had total consolidated assets of approximately $435 million, total loans of approximately $276 million, total securities of approximately $100 million, total deposits of approximately $339 million and stockholders' equity of approximately $40 million. Net income for the three and six month period ended June 30, 2013 totaled $396,031 and $848,159 respectively.

Results of Operations

Net income for the three months ended June 30, 2013 was $396,031 or $0.00 basic earnings per common share, compared to a net income of $310,585 or $0.00 basic earnings per common share, for the same period in 2012. Net income for the six months ended June 30, 2013 was $848,159 or $0.01 basic earnings per common share, compared to a net income of $667,102 or $0.01 basic earnings per common share, for the same period in 2012.

The following table presents our results for the three and six months ended June 30, 2013 compared to the three and six months ended June 30, 2012 (amounts in thousands).

                                                  2013-2012                                             2013-2012
                            Three months           Percent         Dollar          Six months            Percent         Dollar
                           ended June 30,         Increase         Amount        ended June 30,         Increase         Amount
                          2013        2012       (Decrease)        Change       2013        2012       (Decrease)        Change
Interest income          $ 4,576     $ 4,817           (5.00 )%   $   (241 )   $ 9,179     $ 9,443           (2.80 )%   $   (264 )
Interest expense             919       1,217          (24.49 )%       (298 )     1,881       2,531          (25.68 )%       (650 )
Net interest income
before provision for
loan loss                  3,657       3,600            1.58 %          57       7,298       6,912            5.58 %         386

Provision for loan
loss                           -           -               -             -         300           -               -           300
Net interest income
after provision for
loan loss                  3,657       3,600            1.58 %          57       6,998       6,912            1.24 %          86

Total noninterest
income                       697         252          176.59 %         445       1,053         519          102.89 %         534
Total noninterest
expense                    3,702       3,423            8.15 %         279       6,678       6,497            2.79 %         181

Income before income
taxes                        652         429           51.98 %         223       1,373         934           47.00 %         439

Provision for income
taxes                        256         118          116.95 %         138         525         267           96.63 %         258

Net income               $   396     $   311           27.33 %    $     85     $   848     $   667           27.14 %    $    181

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended June 30, 2013, net interest income before the provision for loan loss increased approximately $57 thousand or 1.58 percent over the same period of 2012. For the six months ended June 30, 2013, net interest income before the provision for loan loss increased $386 thousand or 5.58 percent.

Cornerstone's interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities) was 3.60 percent compared to 3.70 percent for the three month periods ended June 30, 2013 and 2012, respectively. The interest rate spread on a tax equivalent basis was 3.62 percent compared to 3.56 percent for the six month periods ended June 30, 2013 and 2012, respectively.

The net interest margin on a tax equivalent basis was 3.77 percent and 3.87 percent for the three months ending June 30, 2013 and 2012, respectively. The net interest margin on a tax equivalent basis was 3.79 percent and 3.73 percent for the six months ending June 30, 2013 and 2012, respectively.

Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

[[Image Removed]] The Bank's net interest income as of June 30, 2013 has been positively impacted by a reduction in cost of funds. The cost of funds reduction was the result of a decrease in interest rates paid by the Bank and a change in the deposit mix with customers choosing to place deposits in transactional accounts rather than certificates of deposit. The Bank's cost of funds was approximately $900 thousand for the three months ended June 30, 2013 compared to $1.2 million during the same time period in 2012.

[[Image Removed]] The Bank's loan portfolio yield decreased to 6.00 percent for the three months ended June 30, 2013 compared to 6.39 percent for the three months ended June 30, 2012. Management believes the interest rates on loans will continue to decrease as the Bank attempts to increase its outstanding loan balances in a very competitive market. If management is successful in increasing the amount of outstanding loans, the resulting change in asset mix would increase the Bank's total interest income.

[[Image Removed]] For the three month period ended June 30, 2013, the Bank's investment portfolio yielded 2.13 percent compared to 2.91 percent for the same time period in 2012. The decrease in the investment portfolio yield was due to the liquidation of approximately $5 million municipal securities during the second quarter of 2013 combined with an increase in variable interest rate mortgage-backed securities.

[[Image Removed]] The Bank's net interest margin for the three month period ending June 30, 2012 compared to June 30, 2013 decreased by 10 basis points. The primary reason for the decline resulted from the decrease in loan and security yield. The Bank expects the net interest margin to slightly improve as the Bank continues to reduce its cost of funds.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management's evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. Cornerstone did not record additional loan loss expense during the second quarter of 2013. For the year, Cornerstone has recorded $300,000 on provision for loan losses. The primary reason for the lack of provision expense during the second quarter of 2013 is the amount of loan loss recoveries that were recorded from previous loans that were charged-off.

Noninterest Income-Items reported as noninterest income include service charges on checking accounts, insufficient funds charges, automated clearing house ("ACH") processing fees and the Bank's secondary mortgage department earnings. Increases in income derived from service charges and ACH fees are primarily a function of the Bank's growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.

The following table presents the components of noninterest income for the three and six months ended June 30, 2013 and 2012 (dollars in thousands):

                                                                  2013-2012                                    2013-2012
                                      Three months ended           Percent           Six months ended           Percent
                                           June 30,               Increase               June 30,              Increase
                                     2013            2012        (Decrease)          2013          2012       (Decrease)
Service charges on deposit
accounts                           $     201       $     207           (2.90 )%   $      390      $   404           (3.47 )%
Net gains on sale of securities          425               -               -             425            -               -
Net gains / (losses) on sale of
loans and other assets                    52              26          100.00 %           202           76          165.79 %
Other noninterest income                  19              19            0.00 %            36           39           (7.69 )%
Total noninterest income           $     697       $     252          176.59 %    $    1,053      $   519          102.89 %

Significant matters relating to the changes in noninterest income are presented below:

[[Image Removed]] The Bank has experienced a decrease in its service charges on deposit accounts during 2013 due to a continued reduction in customer overdraft charges.

[[Image Removed]] The Bank realized a $425 thousand security gain on the liquidation of approximately $5 million in municipal bond securities during the second quarter of 2013. The Bank chose to liquidate the securities to offset increased foreclosed asset expense during the quarter.

Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense, depository insurance, net foreclosed assets expense and other operating expense.

The following table presents the components of noninterest expense for the three and six months ended June 30, 2013 and 2012 (dollars in thousands).

                                                                2013-2012                                  2013-2012
                                     Three months ended          Percent          Six months ended          Percent
                                          June 30,              Increase              June 30,             Increase
                                      2013          2012       (Decrease)         2013         2012       (Decrease)
Salaries and employee benefits     $    1,623      $ 1,570            3.38 %    $   3,220     $ 3,161            1.87 %
Occupancy and equipment expense           340          348           (2.30 )%         678         684           (0.88 )%
Foreclosed asset expense, net             798          481           65.90 %          927         631           46.91 %
FDIC depository insurance                 161          207          (22.22 )%         321         419          (21.52 )%
Other operating expense                   780          818           (4.65 )%       1,532       1,612           (4.96 )%
Total noninterest expense          $    3,702      $ 3,424            8.12 %    $   6,678     $ 6,497            2.79 %

Significant matters relating to the changes to noninterest expense are presented below:

[[Image Removed]] Cornerstone's employee expense increased slightly when comparing both the three and six months ended June 30, 2012 and June 30, 2013. The increase is primarily attributable to an increase in the Bank's employee performance incentive compensation accrual. Management has elected to maintain consistent salary levels as the Bank continues to improve its earnings. The incentive compensation is distributed to employees during the fourth quarter of each year if the Bank achieves certain annual performance goals.

[[Image Removed]] As of June 30, 2013, the Bank had incurred approximately $798 thousand in foreclosed assets expense. The expense consists of asset write-downs based upon current appraisals, carrying cost and losses on the sale of foreclosed assets. Management, in its financial reporting, nets the foreclosed assets expense and write-downs against the revenue generated from income producing real estate. As of December 31, 2012, the Bank had recorded approximately $1.1 million in net foreclosed asset expense. Management anticipates foreclosed asset expense will be slightly higher than the amount recorded during 2012 as the Bank continues to dispose of these assets.

[[Image Removed]] Depository insurance during the second quarter decreased from approximately $207 thousand as of June 30, 2012 to approximately $161 thousand as of June 30, 2013. Management anticipates the FDIC expense to reduce further as the Bank's regulatory status improves.

[[Image Removed]] The Bank has been able to reduce other operating expense for the three and six months ended June 30, 2012 and June 30, 2013. Management has reviewed its operating cost structure each year to determine if costs can be reduced further.

Financial Condition

Overview-Cornerstone's consolidated assets totaled approximately $443 million as of December 31, 2012. As of June 30, 2013, total consolidated assets had decreased approximately $8.1 million or 1.8 percent to approximately $435 million.

Liabilities as of June 30, 2013 and December 31, 2012 totaled approximately $395 million and $403 million, respectively.

Stockholders' equity as of June 30, 2013 and December 31, 2012 totaled approximately $40 million and $41 million, respectively.

Securities-The Bank's investment portfolio, primarily consisting of Ginnie Mae Agency, mortgage-backed securities and municipal securities, amounted to approximately $100 million as of June 30, 2013 compared to approximately $76 million as of December 31, 2012. The primary purposes of the Bank's investment portfolio are to provide liquidity, satisfy pledging requirements and collateralize the Bank's repurchase accounts.

Loans-The composition of loans at June 30, 2013 and at December 31, 2012 of each classification to total loans are summarized in the following table (dollars in thousands):

                                    June 30,       December 31,
                                      2013             2012
Commercial real estate-mortgage:
Owner-occupied                      $  60,725     $       58,425
All other                              67,416             66,747
Consumer real estate-mortgage          67,345             71,195
Construction and land development      36,185             38,557
Commercial and industrial              42,374             40,140
Consumer and other                      2,018              1,927
Total loans                           276,063            276,991
Less: Allowance for loan losses        (5,095 )           (6,141 )

Loans, net                          $ 270,968     $      270,850

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone's assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio, quarterly, to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Bank performs prudent credit underwriting, no assurances can be given that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

[[Image Removed]] During the second quarter of 2013, the Bank did not record a provision expense to the loan loss allowance. Management believes that it has established an allowance for loan losses that adequately accounts for the Bank's identified loan impairment. However, additional provision to the loan loss allowance may be needed in future quarters as the Bank works its problem assets through the collection cycle.

The following is a summary of changes in the allowance for loan losses for the six months ended June 30, 2013 and for the year ended December 31, 2012 and the ratio of the allowance for loan losses to total loans as of the end of each period (amounts in thousands):

                                       June 30,       December 31,
                                         2013             2012
Balance, beginning of period          $    6,141     $        7,400
Loans charged-off                         (2,461 )           (2,869 )
Recoveries of loans previously
charged-off                                1,115              1,180
Provision for loan losses                    300                430
Balance, end of period                $    5,095     $        6,141

Total loans                           $  276,063     $      276,991

Ratio of allowance for loan losses
to loans outstanding at the end of
the period                                  1.85 %             2.22 %

Ratio of net charge-offs to total
loans outstanding for the period            0.49 %             0.61 %

Non-Performing Assets-The specific economic and credit risks associated with the Bank's loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

The Bank attempts to reduce these economic and credit risks by adherence to a lending policy approved by the Bank's board of directors. The Bank's lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards. The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated loans, non-accrual loans, foreclosures and repossessed property as non-performing assets. The Bank's policy is to categorize a loan on non-accrual status when payment of principal or interest is contractually ninety (90) or more days past due. At the time the loan is categorized as non-accrual the interest previously accrued but not collected may be reversed and charged against current earnings.

The following table summarizes Cornerstone's non-performing assets at each quarter end from September 30, 2012 to June 30, 2013 (amounts in thousands):

                                         June 30,       March 31,       December 31,       September 30,
                                           2013           2013              2012               2012
Non-accrual loans                       $    6,883     $     6,364     $        6,005     $         7,971
Foreclosed assets                           18,867          21,159             20,332              22,376
Total non-performing assets             $   25,750     $    27,523     $       26,337     $        30,347

30-89 days past due loans               $    5,111     $     4,023     $        6,594     $         3,819
Total loans outstanding                 $  276,063     $   272,550     $      276,991     $       273,820
Allowance for loan losses                    5,095           5,669              6,141               5,280

Ratio of non-performing loans to
total loans outstanding at the end of
the period                                    2.49 %          2.33 %             2.17 %              2.91 %

Ratio of non-performing assets to
total allowance for loan losses at
the end of the period                       505.40 %         485.0 %           428.87 %            574.75 %

[[Image Removed]] The Bank's non-accrual loans have remained consistent over the last four quarters. Management has attempted to proactively resolve loans that have been classified as non-accrual when possible. Management anticipates that non-accrual balances will start to decline as the Bank continues to see a decline in the rate of loans being downgraded and management continues to proactively address these loans.

[[Image Removed]] The Bank was able to reduce its foreclosed asset balances during the second quarter of 2013. Furthermore, the Bank has approximately $2.9 million in foreclosed assets under contract to liquidate in the third or fourth quarter of 2013. Management has made the reduction of foreclosed assets a priority of the Bank. The foreclosed asset reduction would result in reduced expenses, reallocation of human resources to revenue generating positions and improvements in the Bank's regulatory assessment.

[[Image Removed]] The Bank has maintained a consistent ratio of non-performing loans to total loans outstanding and ratio of non-performing assets to total allowance for loan losses over the last four . . .

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