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EBMT > SEC Filings for EBMT > Form 10-K on 19-Sep-2013All Recent SEC Filings

Show all filings for EAGLE BANCORP MONTANA, INC.

Form 10-K for EAGLE BANCORP MONTANA, INC.


19-Sep-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion and analysis of the financial condition and results of operations of Eagle is intended to help investors understand our company and our operations. The financial review is provided as a supplement to, and should be read in conjunction with the Consolidated Financial Statements and the related Notes included elsewhere in this report.

Overview

Historically, our principal business has consisted of attracting deposits from the general public and the business community and making loans secured by various types of collateral, including real estate and other consumer assets. We are significantly affected by prevailing economic conditions, particularly interest rates, as well as government policies concerning, among other things, monetary and fiscal affairs, housing and financial institutions and regulations regarding lending and other operations, privacy and consumer disclosure. Attracting and maintaining deposits is influenced by a number of factors, including interest rates paid on competing investments offered by other financial and non-financial institutions, account maturities, fee structures, and levels of personal income and savings. Lending activities are affected by the demand for funds and thus are influenced by interest rates, the number and quality of lenders and regional economic conditions. Sources of funds for lending activities include deposits, borrowings, repayments on loans, cash flows from maturities of investment securities and income provided from operations.


Our earnings depend primarily on our level of net interest income, which is the difference between interest earned on our interest-earning assets, consisting primarily of loans, mortgage-backed securities and other investment securities, and the interest paid on interest-bearing liabilities, consisting primarily of deposits, borrowed funds, and trust-preferred securities. Net interest income is a function of our interest rate spread, which is the difference between the average yield earned on our interest-earning assets and the average rate paid on our interest- bearing liabilities, as well as a function of the average balance of interest-earning assets compared to interest-bearing liabilities. Also contributing to our earnings is noninterest income, which consists primarily of service charges and fees on loan and deposit products and services, net gains and losses on sale of assets, and mortgage loan service fees. Net interest income and noninterest income are offset by provisions for loan losses, general administrative and other expenses, including salaries and employee benefits and occupancy and equipment costs, as well as by state and federal income tax expense.

American Federal Savings Bank has a strong mortgage lending focus, with the majority of its loan originations in single-family residential mortgages, which has enabled it to successfully market home equity loans, as well as a wide range of shorter term consumer loans for various personal needs (automobiles, recreational vehicles, etc.). In recent years we have also focused on adding commercial loans to our portfolio, both real estate and non-real estate. We have made significant progress in this initiative. As of June 30, 2013, commercial real estate and land loans and commercial business loans represented 34.32% and 10.04% of the total loan portfolio, respectively. The purpose of this diversification is to mitigate our dependence on the mortgage market, as well as to improve our ability to manage our interest rate spread. With the acquisition of the Sterling Bank branches, the investment portfolio grew substantially during the current fiscal year. As such, management is also focused on decreasing the investment portfolio as a percentage of total assets and offset this with growth in the loan portfolio. American Federal Savings Bank's management recognizes that fee income will also enable it to be less dependent on specialized lending and it now maintains a significant loan serviced portfolio, which provides a steady source of fee income. As of June 30, 2013, we had mortgage servicing rights, net of $3.19 million compared to $2.22 million as of June 30, 2012. The gain on sale of loans also provides significant fee income in periods of high mortgage loan origination volumes. Fee income is also supplemented with fees generated from our deposit accounts. American Federal Savings Bank has a high percentage of non-maturity deposits, such as checking accounts and savings accounts, which allows management flexibility in managing its spread. Non-maturity deposits do not automatically reprice as interest rates rise, as do certificates of deposit.

For the past three years, management's focus has been on improving our core earnings. Core earnings can be described as income before taxes, with the exclusion of gain on sale of loans and adjustments to the market value of our loans serviced portfolio. Management believes that we will need to continue to focus on increasing net interest margin, other areas of fee income, and control operating expenses to achieve earnings growth going forward. Management's strategy of growing the loan portfolio and deposit base is expected to help achieve these goals: loans typically earn higher rates of return than investments; a larger deposit base will yield higher fee income; increasing the asset base will reduce the relative impact of fixed operating costs. The biggest challenge to management's strategy is funding the growth of our balance sheet in an efficient manner. Though deposit growth this last year was robust, it may become more difficult to maintain due to significant competition and possible reduced customer demand for deposits as customers may shift into other asset classes.

Other than in limited circumstances for certain high-credit-quality customers, we do not offer "interest only" mortgage loans on one- to four-family residential properties (where the borrower pays interest but no principal for an initial period, after which the loan converts to a fully amortizing loan). We also do not offer loans that provide for negative amortization of principal, such as "Option ARM" loans, where the borrower can pay less than the interest owed on their loan, resulting in an increased principal balance during the life of the loan. We do not offer "subprime loans" (loans that generally target borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (traditionally defined as loans having less than full documentation).

The level and movement of interest rates impacts the Bank's earnings as well. For the 2013 fiscal year the short end of the yield curve was fairly static as the Federal Open Market Committee maintained the fed funds rate at a target of 0 to 25 basis points while the long end of the curve moved upward.

From time to time the Bank has considered growth through mergers or acquisition as an alternative to its strategy of organic growth. In this connection, on June 29, 2012, the Bank entered into a definitive agreement with Sterling Savings Bank, a Washington state-chartered bank, to acquire Sterling's banking operations in the state of Montana, including seven branch locations, certain deposit liabilities, loans and other assets and liabilities associated with such branch locations. As a result of this acquisition, which closed on November 30, 2012, the Bank acquired approximately $182.5 million in additional assets, including approximately $41.3 million of pass-rated performing loans and assumed $181.6 million in new deposits. The Bank expects that the increase in its branch network as a result of the Sterling branch acquisition will substantially increase its loan origination volume and, due to the substantial increase in deposits, fee income. In addition, the acquisition of the branches is expected to increase certain of the Bank's expenses, including salaries and employee benefits and occupancy and equipment expense. The Bank received approximately $130.1 million in cash in the transaction, which may not be able to be immediately used to fund loans. While a substantial amount of the cash has been invested in securities, it may require additional time to deploy all of the proceeds to fund loans. The Company anticipates that the Sterling acquisition will be accretive to earnings per share in the first year after the acquisition. However, the size of the acquisition may cause integration challenges that could delay or reduce the expected benefits of the acquisition.


The branch acquisition complements the Bank's existing growth strategy by expanding into the southern Montana market and more than doubling the Bank's retail branch network from six to 13 locations. Of the seven acquired branches six are in new markets for the Bank, including two in Missoula, one in Billings, and one each in Hamilton, Livingston and Big Timber. The seventh is in Bozeman where the Bank already has a presence. After the acquisition, the Bank became the sixth largest Montana-based banking institution.

In addition, the transaction also strengthens the Bank's mortgage origination franchise and adds a wealth management business headquartered in Bozeman, Montana. The addition of Sterling's Montana mortgage banking unit will double the Bank's mortgage banking business. This increase in the mortgage banking business and the addition of a wealth management business is expected to increase the Bank's noninterest income and further the Bank's strategy to increase fee income to complement its margin.

RECENT ACCOUNTING PRONOUNCEMENTS

In September 2011, the FASB issued Accounting Standards Update No. 2011-08, Intangibles - Goodwill and Other (Topic 350) - Testing Goodwill for Impairment (ASU 2011-08), to allow entities to use a qualitative approach to test goodwill for impairment. ASU 2011-08 permits an entity to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, it is necessary to perform the currently prescribed two-step goodwill impairment test. Otherwise, the two step goodwill impairment test is not required. ASU 2011-08 is effective for us in fiscal 2013 and earlier adoption is permitted. Upon completion of the acquisition 7 branches from another bank the Company has recorded goodwill and has adopted the provisions of this pronouncement.

In February 2013, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this update require entities to report significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles to be reclassified in its entirety to net income. For all other amounts an entity is required to cross-reference other disclosures that provide additional detail about these amounts. The amendments are effective during the interim and annual periods beginning after December 15, 2012. The Company adopted this guidance and it did not have a significant impact on the consolidated financial statements.

Critical Accounting Policies

Certain accounting policies are important to the understanding of our financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances, including, but without limitation, changes in interest rates, performance of the economy, financial condition of borrowers and laws and regulations. The following are the accounting policies we believe are critical.

Allowance for Loan Losses. We recognize that losses will be experienced on loans and that the risk of loss will vary with, among other things, the type of loan, the creditworthiness of the borrower, general economic conditions and the quality of the collateral for the loan. We maintain an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance for loan losses represents management's estimate of probable losses based on all available information. The allowance for loan losses is based on management's evaluation of the collectability of the loan portfolio, including past loan loss experience, known and inherent losses, information about specific borrower situations and estimated collateral values, and current economic conditions. The loan portfolio and other credit exposures are regularly reviewed by management in its determination of the allowance for loan losses. The methodology for assessing the appropriateness of the allowance includes a review of historical losses, internal data including delinquencies among others, industry data, and economic conditions.


As an integral part of their examination process, the Office of the Comptroller of the Currency will periodically review our allowance for loan losses and may require us to make additional provisions for estimated losses based upon judgments different from those of management. In establishing the allowance for loan losses, loss factors are applied to various pools of outstanding loans. Loss factors are derived using our historical loss experience and may be adjusted for factors that affect the collectability of the portfolio as of the evaluation date. Commercial business loans that are criticized are evaluated individually to determine the required allowance for loan losses and to evaluate the potential impairment of such loans under FASB ASC 310 Receivables. Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of loans deteriorate as a result of the factors discussed previously. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations. The allowance is based on information known at the time of the review. Changes in factors underlying the assessment could have a material impact on the amount of the allowance that is necessary and the amount of provision to be charged against earnings. Such changes could impact future results.

Valuation of Investment Securities. Substantially all of our investment securities are classified as available-for-sale and recorded at current fair value. Unrealized gains or losses, net of deferred taxes, are reported in other comprehensive income as a separate component of stockholders' equity. In general, fair value is based upon quoted market prices of identical assets, when available. If quoted market prices are not available, fair value is based upon valuation models that use cash flow, security structure and other observable information. Where sufficient data is not available to produce a fair valuation, fair value is based on broker quotes for similar assets. Broker quotes may be adjusted to ensure that financial instruments are recorded at fair value. Adjustments may include unobservable parameters, among other things. No adjustments were made to any broker quotes received by us.

We conduct a quarterly review and evaluation of our investment securities to determine if any declines in fair value are other than temporary. In making this determination, we consider the period of time the securities were in a loss position, the percentage decline in comparison to the securities' amortized cost, the financial condition of the issuer, if applicable, and the delinquency or default rates of underlying collateral. We consider our intent to sell the investment securities and the likelihood that we will not have to sell the investment securities before recovery of their cost basis. If impairment exists, credit related impairment losses are recorded in earnings while noncredit related impairment losses are recorded in accumulated other comprehensive income.

Deferred Income Taxes. We use the asset and liability method of accounting for income taxes as prescribed in FASB ASC 740 Income Taxes. Using this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. We exercise significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets. These judgments require us to make projections of future taxable income. The judgments and estimates we make in determining our deferred tax assets, which are inherently subjective, are reviewed on an ongoing basis as regulatory and business factors change. A reduction in estimated future taxable income could require us to record a valuation allowance. Changes in levels of valuation allowances could result in increased income tax expense, and could negatively affect earnings.

FINANCIAL CONDITION

Introduction.
Growth in a number of the categories referenced herein was significantly impacted by the acquisition of the Sterling Bank branches in November of 2012. Total assets increased $183.24 million, or 55.98%, to $510.53 million at June 30, 2013, from $327.30 million at June 30, 2012. Total liabilities increased by $187.65 million, or 68.57%, to $461.30 million at June 30, 2013, from $273.65 million at June 30, 2012. The loan portfolio increased $40.84 million during the year. Total deposits increased $197.76 million. Noninterest checking increased $29.55 million or 126.13%, to $52.97 million at June 30, 2013, and money market accounts increased $56.87, or 199.63%. Interest bearing checking accounts increased $19.75 million, or 42.82%, to $65.88 million at June 30, 2013. Certificates of deposits increased $76.13 million, or 93.58%, to $157.49 million at June 30, 2013. All of these increases were principally from the acquisition of the Sterling Bank branches previously noted.


Balance Sheet Details.
Loans receivable increased $40.84 million, or 23.49% to $214.68 million from $173.84 million. Though loan originations were relatively strong, much of the loan origination volume was in 30 and 15 year fixed rate one- to four-family residential mortgages which were primarily sold in the secondary market. We sold $228.92 million in loans during fiscal year 2013, an increase of $129.41 million from $99.51 million sold in fiscal year 2012. The amount of loans sold in fiscal year 2013 was exceptionally high, particularly in the second half of the fiscal year, as the Bank had fully integrated the mortgage lending operations of the Sterling Bank Montana home loan operations. Likewise significant refinance volume of one- to four-family residential mortgages continued due to the historical low mortgage interest rates. Origination activity in all loan categories, increased in the current fiscal year. Commercial real estate and land loan originations increased $7.40 million during the year, and residential mortgage loan originations increased $132.76 million. The available-for-sale investment portfolio increased $129.89 million, or 145.26%, to $218.96 million at June 30, 2013 from $89.28 million at June 30, 2012. The investment category with the largest increase was municipal securities, which increased $42.38 million. Premises and equipment increased $3.38 million, which was primarily due to the purchase of the Sterling Bank Montana branches as noted previously. This was partially offset by depreciation expense.

Total deposits increased by $197.76 million, notwithstanding lower rates on deposits. The growth was attributable to the acquisition of the Sterling Bank Montana branches and consumers seeking additional safety and protection afforded by increased federal deposit insurance. Of that increase, certificates of deposit increased $76.13 million, to $157.49 million at June 30, 2013 from $81.36 million at June 30, 2012. The Bank had no brokered deposits as of June 30, 2013. Interest-earning checking accounts increased $19.75 million and noninterest checking increased $29.55 million. Money market accounts increased $56.87 million and savings accounts increased $15.46 million. In addition to the Sterling Bank Montana branch acquisition, a portion of the deposit growth the Bank has experienced over the last three fiscal years has likely been the result of investor interest in principal protection during the financial crisis and ensuing economic downturn. As such, as the financial crisis subsides, we believe deposit growth could be more difficult to achieve on a long-term basis due to significant competition among financial institutions in our markets. Advances from the FHLB and other borrowings decreased to $34.86 million at year-end 2013 from $42.70 million at year-end 2012, a decrease of $7.84 million and is largely attributable to the availability of retail funding from deposits.

Total shareholders' equity was $49.23 million at June 30, 2013, a decrease of $4.42 million over the comparable period. This decrease was due to earnings offset by dividends paid and decreases in net accumulated other comprehensive gain.


Analysis of Net Interest Income

The Bank's earnings have historically depended primarily upon net interest income, which is the difference between interest income earned on loans and investments and interest paid on deposits and any borrowed funds. It is the single largest component of Eagle's operating income. Net interest income is affected by (i) the difference between rates of interest earned on loans and investments and rates paid on interest-bearing deposits and borrowings (the "interest rate spread") and (ii) the relative amounts of loans and investments and interest-bearing deposits and borrowings.

The following tables set forth average balance sheets, average yields and costs, and certain other information at and for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.

                                                For the twelve months ended June 30,
                                          2013                                         2012
                                                       (Dollars in thousands)
                          Average       Interest                      Average       Interest
                           Daily           and          Yield/         Daily           and          Yield/
                          Balance       Dividends       Cost(3)       Balance       Dividends       Cost(3)
Assets:
 Interest-earning
assets:
   FHLB stock            $   1,972     $         -          0.00 %   $   2,003     $         -          0.00 %
   Loans receivable,
net                        208,638          11,200          5.37 %     188,502          10,884          5.77 %
   Investment
securities                 167,118           3,568          2.14 %      97,976           3,192          3.26 %
   Interest-bearing
deposits with banks         11,359              30          0.24 %       8,693              20          0.20 %
Total
interest-earning
assets                     389,087          14,798          3.80 %     297,174          14,096          4.74 %
Noninterest-earning
assets                      42,978                                      33,987
Total assets             $ 432,065                                   $ 331,161

Liabilities and
Equity:
 Interest-bearing
liabilities:
   Deposit accounts:
    Money market         $  63,138     $        87          0.14 %   $  27,936     $        37          0.13 %
    Savings                 48,058              37          0.08 %      38,344              39          0.10 %
    Checking                55,305              28          0.05 %      43,863              24          0.05 %
    Certificates of
deposit                    125,327           1,046          0.83 %      82,317             974          1.18 %
   Advances from FHLB
& subordinated debt         38,781           1,049          2.70 %      58,806           2,091          3.55 %
Total
interest-bearing
liabilities                330,609           2,247          0.68 %     251,266           3,165          1.26 %
Non-interest checking       42,305                                      22,030
Other
noninterest-bearing
liabilities                  5,365                                       4,190
Total liabilities          378,279                                     277,486

Total equity                53,786                                      53,675

Total liabilities and
equity                   $ 432,065                                   $ 331,161
Net interest income/interest rate
spread(1)                              $    12,551          3.12 %                 $    10,931          3.48 %

Net interest
margin(2)                                                   3.23 %                                      3.68 %
Total interest-earning assets to
interest-bearing liabilities                              117.69 %                                    118.27 %

Interest rate spread represents the difference between the average yield on
(1) interest-earning assets and the average rate on interest-bearing liabilities.
(2) Net interest margin represents income before the provision for loan losses divided by average interest-earning assets.
(3) For purposes of this table, tax exempt income is not calculated on a tax equivalent basis.


Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: (1) changes in volume multiplied by the old rate; (2) changes in rate, which are changes in rate multiplied by the old volume; and (3) changes not solely attributable to rate or volume, which have been allocated proportionately to the change due to volume and the change due to rate.

                                                  For the Years Ended June 30,
                                                       Increase (Decrease)
                                                         (In thousands)
                                     2013 vs 2012                               2012 vs 2011
                                       Due to                                      Due to
                         Volume         Rate           Net          Volume          Rate           Net
Interest earning
assets:
. . .
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