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CFFI > SEC Filings for CFFI > Form 10-Q on 7-Nov-2013All Recent SEC Filings

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Form 10-Q for C & F FINANCIAL CORP


7-Nov-2013

Quarterly Report


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

Cautionary Statement Regarding Forward-Looking Statements

This report contains statements concerning the Corporation's expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute "forward-looking statements" as defined by federal securities laws and may include, but are not limited to, statements regarding profitability, liquidity, the Corporation's and each business segment's loan portfolio, allowance for loan losses, trends regarding the provision for loan losses, trends regarding net loan charge-offs and expected future charge-off activity, trends regarding levels of nonperforming assets and troubled debt restructurings and expenses associated with nonperforming assets, provision for indemnification losses, levels of noninterest income and expense, interest rates and yields, competitive trends in the Corporation's businesses and markets, the deposit portfolio including trends in deposit maturities and rates, interest rate sensitivity, market risk, regulatory developments, monetary policy implemented by the Federal Reserve including quantitative easing programs, capital requirements, growth strategy including the outcome of the pending business combination and financial and other goals. These statements may address issues that involve estimates and assumptions made by management and risks and uncertainties. Actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, changes in:

interest rates, such as the current volatility in yields on U.S. Treasury bonds and increases in mortgage rates
general business conditions, as well as conditions within the financial markets
general economic conditions, including unemployment levels
the legislative/regulatory climate, including the Dodd-Frank Act and regulations promulgated thereunder, the Consumer Financial Protection Bureau (CFPB) and the regulatory and enforcement activities of the CFPB and rules promulgated under the Basel III framework
monetary and fiscal policies of the U.S. Government, including policies of the Treasury and the Federal Reserve Board
the ability to achieve the operations and results expected after the CVB acquisition, including achieving anticipated costs savings, continued relationships with major customers and deposit retention
the value of securities held in the Corporation's investment portfolios
the quality or composition of the loan portfolios and the value of the collateral securing those loans
the commercial and residential real estate markets
the inventory level and pricing of used automobiles, including sales prices of repossessed vehicles
the level of net charge-offs on loans and the adequacy of our allowance for loan losses
demand in the secondary residential mortgage loan markets
the level of indemnification losses related to mortgage loans sold
demand for loan products
deposit flows
the strength of the Corporation's counterparties
competition from both banks and non-banks
demand for financial services in the Corporation's market area
the Corporation's expansion and technology initiatives
reliance on third parties for key services
accounting principles, policies and guidelines

These risks are exacerbated by the turbulence over the past several years in the global and United States financial markets. Continued weakness in the global and United States financial markets could further affect the Corporation's performance, both directly by affecting the Corporation's revenues and the value of its assets and liabilities, and indirectly by affecting the Corporation's counterparties and the economy in general. While there are some signs of improvement in the economic environment, there was a prolonged period of volatility and disruption in the markets, and unemployment has risen to, and remains at, high levels. There can be no assurance that these unprecedented developments will not continue to materially and adversely affect our business, financial condition and results of operations, as well as our ability to raise capital for liquidity and business purposes.

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutions. As a result, defaults by, or even rumors or questions about defaults by, one or more financial services institutions, or the financial services industry generally, could create another market-wide liquidity crisis similar to that experienced in late 2008 and early 2009 and could lead to losses or defaults by us or by other institutions. There is no assurance that any such losses would not materially adversely affect the Corporation's results of operations.

There can be no assurance that the actions taken by the federal government and regulatory agencies will alleviate the industry or economic factors that may adversely affect the Corporation's business and financial performance. Further, many aspects of the Dodd-Frank Act remain subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall effect on the Corporation's business and financial performance.

These risks and uncertainties, and the risks discussed in more detail in Item 1A, "Risk Factors" of the Corporation's Annual Report on Form 10-K for the year ended December 31, 2012 and in Part II, Item 1A, "Risk Factors" of the Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2013, should be considered in evaluating the forward-looking statements contained herein. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.


The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Corporation. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.

Allowance for Loan Losses: We establish the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower's ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available.

Allowance for Indemnifications: The allowance for indemnifications is established through charges to earnings in the form of a provision for indemnifications, which is included in other noninterest expenses. A loss is charged against the allowance for indemnifications under certain conditions when a purchaser of a loan (investor) sold by C&F Mortgage incurs a loss due to borrower misrepresentation, fraud, early default, or underwriting error. The allowance represents an amount that, in management's judgment, will be adequate to absorb any losses arising from indemnification requests. Management's judgment in determining the level of the allowance is based on the volume of loans sold, historical experience, current economic conditions and information provided by investors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

Impairment of Loans: We consider a loan impaired when it is probable that the Corporation will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due. We measure impairment on a loan-by-loan basis for commercial, construction and residential loans in excess of $500,000 by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. We maintain a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. Troubled debt restructurings (TDRs) are also considered impaired loans, even if the loan balance is less than $500,000. A TDR occurs when we agree to significantly modify the original terms of a loan due to the deterioration in the financial condition of the borrower.

Impairment of Securities: Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value.
Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that includes the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.


Other Real Estate Owned (OREO): Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of like properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Corporation may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further other-than-temporary deterioration in market conditions.

Goodwill: All of the Corporation's goodwill was recognized in connection with the Bank's acquisition of C&F Finance Company in September 2002. With the adoption of Accounting Standards Update 2011-08, Intangible-Goodwill and Other-Testing Goodwill for Impairment, in 2012, the Corporation is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, we determine that it is more likely than not that the fair value of C&F Finance Company is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Corporation must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Corporation's goodwill, major assumptions used in determining impairment are increases in future income, sales multiples in determining terminal value and the discount rate applied to future cash flows. As part of any impairment test, we will perform a sensitivity analysis by increasing the discount rate, lowering sales multiples and reducing increases in future income.

Retirement Plan: The Bank maintains a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Bank's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the interest crediting rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may affect pension assets, liabilities or expense.

Derivative Financial Instruments: The Corporation recognizes derivative financial instruments at fair value as either an other asset or other liability in the consolidated balance sheet. The Corporation's derivative financial instruments consist of (1) the fair value of interest rate lock commitments (IRLCs) on mortgage loans that will be held for sale and related forward sale commitments and (2) interest rate swaps that qualify as cash flow hedges of a portion of the Corporation's trust preferred capital notes. Because the IRLCs and forward sale commitments are not designated as hedging instruments, adjustments to reflect unrealized gains and losses resulting from changes in fair value of the Corporation's IRLCs and forward sales commitments and realized gains and losses upon ultimate sale of the loans are classified as noninterest income. The effective portion of the gain or loss on the Corporation's cash flow hedges is reported as a component of other comprehensive income, net of deferred taxes, and reclassified into earnings in the same period or periods during which the hedged transactions affect earnings. For more information concerning fair value measurements of these instruments, see Part I, Item 1, "Financial Statements" in this Quarterly Report on Form 10-Q under the heading "Note 7:
Fair Value of Assets and Liabilities."

Accounting for Income Taxes: Determining the Corporation's effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Corporation's tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

For further information concerning accounting policies, refer to Item 8, "Financial Statements and Supplementary Data," under the heading "Note 1:
Summary of Significant Accounting Policies" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2012.

OVERVIEW

Our primary financial goals are to maximize the Corporation's earnings and to deploy capital in profitable growth initiatives that will enhance long-term shareholder value. We track three primary financial performance measures in order to assess the level of success in achieving these goals: (i) return on average assets (ROA), (ii) return on average common equity (ROE), and
(iii) growth in earnings. In addition to these financial performance measures, we track the performance of the Corporation's three principal business activities: retail banking, mortgage banking, and consumer finance. We also actively manage our capital through growth and dividends, while considering the need to maintain a strong regulatory capital position.


On October 1, 2013, the Corporation completed its acquisition of Central Virginia Bankshares, Inc. (or CVB), the one-bank holding company for Central Virginia Bank. For more information on this acquisition, see Part I, Item I, "Financial Statements" in this Quarterly Report on Form 10-Q under the heading "Note 12: Subsequent Events" and the Corporation's Current Report on Form 8-K filed with the SEC on October 2, 2013.

Financial Performance Measures

Net income for the Corporation was $3.4 million for the three months ended September 30, 2013, compared with $4.5 million for the three months ended September 30, 2012. Net income for the Corporation was $11.6 million for the first nine months of 2013, compared with $12.5 million for the first nine months of 2012. Net income available to common shareholders was $3.4 million, or $0.97 per common share assuming dilution, for the three months ended September 30, 2013, compared with $4.5 million, or $1.36 per common share assuming dilution, for the three months ended September 30, 2012. Net income available to common shareholders was $11.6 million, or $3.37 per common share assuming dilution for the first nine months of 2013, compared with $12.2 million, or $3.69 per common share assuming dilution for the first nine months of 2012. The difference between reported net income and net income available to common shareholders for 2012 is a result of the Preferred Stock dividends and amortization of the Warrant related to the Corporation's participation in the CPP. In April 2012, the Corporation redeemed the remainder of the Preferred Stock issued in January 2009 under the CPP.

The Corporation's earnings for the third quarter and first nine months of 2013 were attributable to profitability at all three of its principal business segments. During the three and nine months ended September 30, 2013, the Consumer Finance segment continued to benefit from (1) sustained loan growth and
(2) the low funding costs on its variable-rate borrowings, which were offset in part by higher provisions for loan losses, lower loan yields and higher personnel costs. During the nine months ended September 30, 2013, the Mortgage Banking segment benefited from lower provisions for indemnification losses, as well as the effect of electing to use fair value accounting for loans held for sale and interest rate lock commitments, and for forward sales commitments that are used to hedge the effect of changes in interest rates on loans that are to be sold in the secondary market. However, the Mortgage Banking segment and the mortgage banking industry were negatively affected by interest rate volatility during the third quarter of 2013, which resulted in fewer loan applications, lower loan production and a loss on fair value adjustments. The Retail Banking segment benefited from the effects of (1) the continued low interest rate environment on the cost of deposits and the renewal rates on borrowings from the Federal Home Loan Bank, (2) improvements is asset quality resulting in lower provisions for loan losses and (3) increased activity-based interchange and overdraft fee income, which were offset in part by the decline in average loans and higher personnel costs.

The Corporation's ROE and ROA were 12.58 percent and 1.37 percent, respectively, on an annualized basis for the third quarter of 2013, compared with 18.48 percent and 1.88 percent, respectively, for the third quarter of 2012. For the first nine months of 2013, on an annualized basis, the Corporation's ROE and ROA were 14.52 percent and 1.56 percent, respectively, compared with 17.74 percent and 1.75 percent, respectively, for the first nine months of 2012. The decline in ROE and ROA for the third quarter and the first nine months of 2013, as compared to the same periods in 2012, resulted from capital and asset growth coupled with lower earnings during the comparative periods.

Principal Business Activities. An overview of the financial results for each of the Corporation's principal business segments is presented below. A more detailed discussion is included in "Results of Operations."

Retail Banking: C&F Bank reported net income of $791,000 for the third quarter of 2013, compared to a net income of $705,000 for the third quarter of 2012. For the first nine months of 2013, C&F Bank reported net income of $2.0 million, compared to a net income of $1.6 million for the first nine months of 2012. Factors contributing to the improved financial results for the three and nine months ended September 30, 2013 were the effects of the continued low interest rate environment on the cost of deposits and on the renewal rates on borrowings from the FHLB, a shift in deposit mix to lower rate non-term deposit accounts, the effects of improved credit quality on the loan loss provision and expenses associated with loan work-outs, lower expenses related to the holding costs of foreclosed properties and increased activity-based interchange and overdraft fee income. Partially offsetting these positive factors were: (1) a decrease in average loans to nonaffiliates resulting from weak loan demand in the current economic environment and intense competition for loans in our markets, (2) higher personnel costs associated with increased staff levels throughout the branch network and the addition of new personnel dedicated to growing C&F Bank's commercial and small business loan portfolios, (3) higher occupancy expenses associated with depreciation and maintenance of technology related to expanding the banking services offered to customers and improving operational efficiency and security, (4) higher data processing expenses related to check card processing and mobile banking products and services.

The Bank's nonperforming assets were $8.0 million at September 30, 2013, compared to $17.7 million at December 31, 2012. Nonperforming assets at September 30, 2013 included $4.2 million in nonaccrual loans, compared to $11.5 million at December 31, 2012, and $3.8 million in foreclosed properties, compared to $6.2 million at December 31, 2012. Troubled debt restructurings (TDRs) were $5.3 million at September 30, 2013, of which $2.6 million were included in nonaccrual loans, as compared to $16.5 million of TDRs at December 31, 2012, of which $9.8 million were included in nonaccrual loans. The decrease in nonaccrual loans and TDRs was primarily a result of (1) the sale of $10.9 million of notes related to one commercial relationship, $5.2 million of which was classified as nonaccrual at December 31, 2012 and (2) the pay-off of $3.0 million of TDRs related to one commercial relationship, which resulted in a $1.7 million decline in nonaccrual loans. The sale of $10.9 million of notes resulted in a $2.1 million charge-off, which was previously provided for in the allowance for loan losses and which contributed to the decline in the Bank's allowance for loan losses as a percentage of total loans to 2.88 percent at September 30, 2013 from 3.38 percent at December 31, 2012. Management believes it has provided adequate loan loss reserves for the Retail Banking segment's loans.


Mortgage Banking: C&F Mortgage Corporation reported net income of $302,000 for the third quarter of 2013, compared to $736,000 for the third quarter of 2012. For the first nine months of 2013, C&F Mortgage Corporation reported net income of $1.8 million compared to $1.5 million for the first nine months of 2012.

During the second quarter of 2013, the Mortgage Banking segment began selling a portion of loans originated for sale on a mandatory delivery basis, while continuing to sell the majority of its loans on a best efforts delivery basis. In accordance with Accounting Standards Codification Topic 820-Fair Value Measurement and Disclosures, we have elected to use fair value accounting for loans held for sale and interest rate lock commitments, as well as for forward loan sales commitments and hedging instruments that are used to reduce the effect of changes in interest rates on loans that are to be sold in the secondary market. Under fair value accounting, gains on loans sold in the secondary market are recognized as loans progress through the origination pipeline, as opposed to recognizing gains when the loans are sold, as was done in the past. The decline in pre-tax income for the third quarter of 2013 compared to the third quarter of 2012 included a negative fair value adjustment of $473,000; whereas, the increase in pre-tax income for the first nine months of 2013 compared to the same period of 2012 included a favorable fair value adjustment of $823,000, which included $1.1 million attributable to the implementation of fair value accounting in April 2013.

Net income at the Mortgage Banking segment for the three and nine months ended September 30, 2013, compared to the same periods in 2012, benefited from lower provisions for indemnification losses. Net income at the Mortgage Banking segment was negatively affected by (1) fluctuations in mortgage interest rates during the third quarter of 2013 which caused industry wide lower application volume and lower loan production for the three and nine months ended September 30, 2013, (2) lower net interest income resulting from the decline in loan production and (3) higher non-production based personnel costs associated with expansion into Virginia Beach, Virginia and with regulatory compliance. If volatility in mortgage interest rates continues, there may be a continuation of lower loan demand, particularly for refinancings, which could negatively affect earnings of the Mortgage Banking segment for the remainder of 2013 and possibly beyond.

Consumer Finance: C&F Finance Company reported net income of $2.4 million for the third quarter of 2013, compared with $3.2 million for the third quarter of 2012. For the first nine months of 2013, C&F Finance Company reported net income of $8.8 million, compared to $9.8 million for the first nine months of 2012. Average loans outstanding increased 7.08 percent and 9.74 percent, respectively, during the three and nine months ended September 30, 2013. Additionally, the Consumer Finance segment continued to benefit from the low funding costs related to its variable-rate borrowings. Offsetting these benefits were (1) increases in the segment's provision for loan losses resulting from higher loan charge-offs due to the continued uncertain economic environment, lower resale values on repossessed vehicles and borrowers' willingness to default on existing debt in response to credit easing by competitors, (2) a decline in average loan yields as a result of aggressive loan pricing strategies used by competitors attempting to grow market share in automobile financing and (3) higher personnel expenses . . .

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