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EVBN > SEC Filings for EVBN > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for EVANS BANCORP INC

Form 10-K for EVANS BANCORP INC


3-Mar-2014

Annual Report


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

OVERVIEW

This discussion is intended to compare the performance of the Company for the years ended December 31, 2013, 2012 and 2011. The review of the information presented should be read in conjunction with Part I, Item 1: "Business" and Part II, Item 6: "Selected Financial Data" and Item 8: "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K.

The Company is a financial holding company registered under the BHCA. The Company currently conducts its business through its two direct wholly-owned subsidiaries: the Bank and the Bank's subsidiaries, ENL and ENHC; and ENFS and its subsidiary, TEA. The Company does not engage in any other substantial business. Unless the context otherwise requires, the term "Company" refers collectively to Evans Bancorp, Inc. and its subsidiaries.

Summary

In 2013, the Company experienced continued strong earnings results moderated slightly by a significantly higher provision for loan and lease losses. The Company's stated public intentions are to continue to grow to increase market share and achieve scale while improving profitability and returning value to shareholders. Net income in 2013 was $7.9 million, a 3.4% decrease from 2012 net income of $8.1 million, but above the 2011 net income of $6.1 million. The Company's provision for loan and lease losses increased $1.6 million from ($0.1) million in 2012 to $1.5 million in 2013. As the leasing portfolio declined and existing leases continued to perform, the benefit from additional releases in the provision for lease losses in the current year had been exhausted, resulting in a benefit to provision of $0.3 million, as compared to a $0.9 million benefit in 2012. The Company's total criticized commercial loans increased $10.6 million from $20.2 million as of December 31, 2012 to $30.8 million at December 31, 2013. The ratio of non-performing loans and leases to total loans and leases also increased from 1.41% at December 31, 2012 to 2.12% as of December 31, 2013. Additionally, the Company recognized $0.6 million in provision for loan losses in 2013 related to the termination of the FDIC loss sharing agreement. These factors, combined with loan growth in 2013, resulted in a provision for loan and lease losses for the year of $1.6 million. Overall, the provision for loan and lease losses for the Company has returned to a more historic level in 2013.

In 2013, two non-routine events occurred. The Company and the FDIC agreed in the third quarter of 2013 to terminate the loss sharing agreement with the FDIC as described under Footnote 3 - "Loans and Leases" below, which eliminated the FDIC guarantees on acquired loan losses. Upon termination of the loss sharing agreement, the Company recognized $0.6 million in provision for loan and lease losses, with an offsetting gain on the termination in non-interest income of $0.7 million. Secondly, the Company entered into a historic tax credit investment in 2013 for a community based project. In the third quarter of 2013, the Company recorded a loss on the tax credit investment of $1.6 million into non-interest income, but realized a $1.8 million tax benefit in the Company's income tax provision.

As for the Company's core performance, 2013 was marked by solid growth in commercial loans and deposits in the face of the continued headwinds of a sluggish economy and a very competitive local market in Western New York. The Company experienced large loan growth in the fourth quarter of 2013, in contrast to some large pay-offs in the fourth quarter of 2012, resulting in a year-over-year increase in total gross loans of $64.1 million, or 11.0% as of December 31, 2013, and an increase in average total gross loans and leases of $16.8 million, or 2.8%, in 2013 when compared with 2012. The growth in average loans and leases combined with rate cuts on interest-bearing deposits in 2013 helped drive a 2.0% increase in net interest income, despite a 10 basis point decrease in net interest margin to 3.74% as the low interest rate environment continued to put pressure on the Company's net interest margin. To continue to support the Company's high organic growth rates and increasing regulatory requirements, management has focused on retaining and attracting talented individuals, resulting in an increase in non-interest expenses. Non-interest income decreased 5.2% in 2013 when compared with 2012, driven by the two non-routine events described above. Excluding the one-time gain on termination of the FDIC loss sharing agreement and loss on historic tax credit, non-interest income increased $0.2 million, or 1.4%, from the prior year.

Strategy

To sustain future growth and to meet the Company's financial objectives, the Company has defined a number of strategies. Six of the more important strategies are:

Continuing to differentiate through proactively building and maintaining customer relationships;


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Continuing growth of non-interest income through financial services revenues, employee benefits insurance and retirement programs sales, and cash management;

Continuing to develop opportunities with a segmented market approach to develop a more diversified portfolio and strengthen presence with community investment initiatives;

Leveraging our resources and capabilities to continuously improve operational efficiency and to utilize technology effectively;

Maintaining a balanced risk appetite within a risk management framework that drives shareholder value.

The Company's strategies are designed to direct tactical investment decisions supporting its financial objectives. While the Company intends to focus its efforts on the pursuit of these strategies, there can be no assurance that the Company will successfully implement these strategies or that the strategies will produce the desired results. The Company's most significant revenue source continues to be net interest income, defined as total interest income less interest expense. Net interest income accounted for approximately 70% of total revenue in 2013. To produce net interest income and consistent earnings growth over the long-term, the Company must generate loan and deposit growth at acceptable margins within its market area. To generate and grow loans and deposits, the Company must focus on a number of areas including, but not limited to, opportunistic branch expansion, sales practices, customer and employee satisfaction and retention, competition, evolving customer behavior, technology, product innovation, interest rates, credit performance of its customers and vendor relationships.

The Company also considers non-interest income important to its continued financial success. Fee income generation is partly related to the Company's loan and deposit operations, such as deposit service charges, as well as to its financial products, such as commercial and personal insurance sold through TEA. Improved performance in non-interest income can help increase capital ratios because most of the non-interest income is generated without recording assets on the balance sheet. The Company has and will continue to face challenges in increasing its non-interest income as the regulatory environment changes.

While the Company reviews and manages all customer units, it has focused increased efforts on targeted segments in its community such as (1) smaller businesses with smaller credit needs but rich in deposits and other services;
(2) middle market commercial businesses; (3) commercial real estate lending; and
(4) retail customers. The overarching goal is to cross-sell between our insurance, financial services and banking lines of business to deepen our relationships with all of our customers. The Company believes that these efforts resulted in growth in the commercial loan portfolio and core deposits during fiscal 2013 and 2012.

The Bank opened a new branch office in Williamsville, NY in October 2012. With all new and existing branches, the Company has strived to provide a personal touch to customer service and is committed to maintaining a local community based philosophy. The Bank has emphasized hiring local branch and lending personnel with strong ties to the specific local communities it enters and serves.

The Bank serves its market through 14 banking offices in Western New York, located in Amherst, Buffalo, Clarence, Derby, Evans, Forestville, Hamburg, Lancaster, North Boston, Tonawanda, West Seneca, and Williamsville. The Company's principal source of funding is through deposits, which it reinvests in the community in the form of loans and investments. Deposits are insured up to the maximum permitted by the Insurance Fund of the FDIC. The Bank is regulated by the OCC.

APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

The Company's Consolidated Financial Statements are prepared in accordance with U.S. generally accepted accounting principles ("GAAP") and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the Company's Consolidated Financial Statements and Notes. These estimates, assumptions and judgments are based on information available as of the date of the Consolidated Financial Statements. Accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments, and as such, have a greater possibility of producing results that could be materially different than originally reported.

The most significant accounting policies followed by the Company are presented in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. These policies, along with the disclosures presented in the other Notes to the Company's Consolidated Financial Statements contained in this Annual Report on Form 10-K and in this financial review, provide information on how significant assets and liabilities are valued in the Company's Consolidated Financial Statements and how those values are determined.


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Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan and lease losses and valuation of goodwill to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new information becomes available.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses represents management's estimate of probable losses in the Bank's loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgment on the part of management and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the Company's consolidated balance sheets.

On a quarterly basis, management of the Bank meets to review and determine the adequacy of the allowance for loan and lease losses. In making this determination, the Bank's management analyzes the ultimate collectability of the loans and leases in its portfolio by incorporating feedback provided by the Bank's internal loan and lease staff, an independent internal loan and lease review function and information provided by examinations performed by regulatory agencies.

The analysis of the allowance for loan and lease losses is composed of two components: specific credit allocation and general portfolio allocation. The specific credit allocation includes a detailed review of each impaired loan and allocation is made based on this analysis. Factors may include the appraisal value of the collateral, the age of the appraisal, the type of collateral, the performance of the loan to date, the performance of the borrower's business based on financial statements, and legal judgments involving the borrower. The Company has an appraisal policy in which appraisals are obtained upon a loan being downgraded on the Company's internal loan rating scale to a 5 (special mention) or a 6 (substandard) depending on the amount of the loan, the type of loan and the type of collateral. All impaired loans are either graded a 6 or 7 on the internal loan rating scale. Subsequent to the downgrade, if the loan remains outstanding and impaired for at least one year more, management may require another follow-up appraisal. Between receipts of updated appraisals, if necessary, management may perform an internal valuation based on any known changing conditions in the marketplace such as sales of similar properties, a change in the condition of the collateral, or feedback from local appraisers. The general portfolio allocation consists of an assigned reserve percentage based on the historical loss experience and other quantitative and qualitative factors of the loan or lease category.

The general portfolio allocation is segmented into pools of loans with similar characteristics. Separate pools of loans include loans pooled by loan grade and by portfolio segment. Loans graded a 5 or worse ("criticized loans") that exceed a material balance threshold are evaluated by the Company's credit department to determine if the collateral for the loan is worth less than the loan. All of these "shortfalls" are added together and divided by the respective loan pool to calculate the quantitative factor applied to the respective pool as this represents a potential loss exposure. These loans are not considered individually impaired because the cash flow of the customer and the payment history of the loan suggest that it is not probable that the Company will be unable to collect the full amount of principal and interest as contracted and are thus still accruing interest.

Loans that are graded 4 or better ("non-criticized loans") are reserved in separate loan pools in the general portfolio allocation. A weighted average 5-year historical charge-off ratio by portfolio segment is calculated and applied against these loan pools.

For both the criticized and non-criticized loan pools in the general portfolio allocation, additional qualitative factors are applied. The qualitative factors applied to the general portfolio allocation reflect management's evaluation of various conditions. The conditions evaluated include the following: industry and regional conditions; seasoning of the loan and lease portfolio and changes in the composition of and growth in the loan and lease portfolio; the strength and duration of the business cycle; existing general economic and business conditions in the lending areas; credit quality trends in non-


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accruing loans and leases; timing of the identification of downgrades; historical loan and lease charge-off experience; and the results of bank regulatory examinations. Due to the nature of the loans, the criticized loan pools carry significantly higher qualitative factors than the non-criticized pools.

Direct financing leases are segregated from the rest of the loan portfolio in determining the appropriate allowance for that portfolio segment. The Company performs a migration analysis for non-accruing leases based on historical loss data. Management periodically updates this analysis by examining the non-accruing lease portfolio at different points in time and studying what percentage of the non-accruing portfolio ends up being charged off. All of the remaining leases not in non-accrual are allocated a reserve based on several factors including: delinquency and non-accrual trends, charge-off trends, and national economic conditions.

For further discussion on the allowance for loan and lease losses, please see Note 1 and Note 3 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

Goodwill and Intangible Assets

The amount of goodwill reflected in the Company's Consolidated Financial Statements is required to be tested by management for impairment on at least an annual basis. The test for impairment of goodwill in an identified reporting unit is considered a critical accounting estimate because it requires judgment on the part of management and the use of estimates related to the growth assumptions and market multiples used in the valuation model. As of December 31, 2013, TEA had $8.1 million in goodwill. The banking and ENL reporting units do not have any goodwill. All of the goodwill at TEA stems from the acquisition of various insurances agencies, not the purchase of diverse companies in which goodwill was subjectively allocated to different reporting units. Therefore, total market capitalization reconciliation was not performed because not all of the reporting units had goodwill. As a result, such an analysis would not be meaningful.

Management valued TEA, the reporting unit with goodwill, using cash flow modeling and earnings multiple techniques. When using the cash flow models, management considered historical information, the operating budget for 2014, economic and insurance market cycles, and strategic goals in projecting net income and cash flows for the next five years. The fair value calculated substantially exceeded the book value of TEA. The value based on a multiple to earnings before interest, taxes, depreciation, and amortization ("EBITDA") was higher, a result of conservative growth assumptions used by the Company in the cash flow model as well as an implied control premium in the multiple. The multiple used was based on historical industry data and consistent with the previous year's assumption.

While the fair values determined in the impairment tests were substantially higher than the carrying value for TEA, the risk of a future impairment charge still exists. Management used growth rates that are achievable over the long run through both soft and hard insurance cycles. A soft insurance market has persisted for several years, resulting in a modest increase in revenue of 3.5% in 2013 compared with 2012. A worsening of the soft insurance market over the long term could result in lower than projected revenue and profitability growth rates and result in depressed pricing multiples in the acquisition marketplace. Further softening of the insurance market is the biggest risk to the Company's valuation model.

For further discussion of the Company's accounting for goodwill and other intangible assets, see Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS

Note 1 to the Company's Consolidated Financial Statements included in Item 8 of
this Annual Report on Form 10-K discusses new accounting policies adopted by the Company during fiscal 2013. Below is an accounting policy recently issued or proposed but not yet required to be adopted. To the extent management believes the adoption of new accounting standards materially affects the Company's financial condition, results of operations, or liquidity, the impacts are discussed below.

Accounting Standards Update ("ASU") 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The objective of this ASU is to eliminate diversity in practice for presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The main provision states that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. This ASU is effective for fiscal years and interim periods within those years, beginning after December 15, 2013 and did not have a material impact on the Company's financial statements.


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ASU 2014-04, Reclassification of Collateralized Mortgage Loans upon a Troubled Debt Restructuring. The objective of this proposed ASU is to clarify when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, such that all or a portion of the loan should be derecognized and the real estate property recognized. The main provisions would also require additional disclosures regarding the amount of foreclosed residential real estate property held by the creditor and the recorded investments of consumer mortgage loans that are in the process of foreclosure at each interim and annual reporting period. This ASU is effective for fiscal years and interim periods within those years, beginning after December 15, 2014.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2013 AND DECEMBER 31,
2012

Net Income

Net income of $7.9 million in 2013 consisted of $6.6 million related to the Company's banking activities and $1.3 million in net income related to the Company's insurance agency activities. The total net income of $7.9 million was a 3.4% decrease from $8.1 million in 2012. Earnings per diluted share for 2013 of $1.85 showed a decrease of 5.2% from $1.95 per diluted share for 2012.

Net Interest Income

Net interest income, the difference between interest income and fee income on earning assets, such as loans and securities, and interest expense on deposits and borrowings, provides the primary basis for the Company's results of operations.

Net interest income is dependent on the amounts and yields earned on interest earning assets as compared to the amounts of and rates paid on interest bearing liabilities.


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AVERAGE BALANCE SHEET INFORMATION

The following table presents the significant categories of the assets and liabilities of the Bank, interest income and interest expense, and the corresponding yields earned and rates paid in 2013, 2012 and 2011. The assets and liabilities are presented as daily averages. The average loan balances include both performing and non-performing loans. Interest income on loans does not include interest on loans for which the Bank has ceased to accrue interest. Securities are stated at fair value. Interest and yield are not presented on a tax-equivalent basis.

                                       2013                                      2012                                      2011
                         Average        Interest                   Average        Interest                   Average       Interest
                       Outstanding      Earned/       Yield/     Outstanding       Earned/      Yield/     Outstanding      Earned/      Yield/
                         Balance          Paid         Rate        Balance          Paid         Rate        Balance         Paid         Rate
                              (dollars in thousands)                    (dollars in thousands)                    (dollars in thousands)
ASSETS
Interest-earning
assets:
Loans and leases,
net                    $   596,783      $  29,546     4.95  %    $   579,586       $ 30,300     5.23  %    $   535,526      $ 29,140      5.44  %
Taxable securities          63,890          1,666     2.61  %         67,679          1,870     2.76  %         62,269         2,115      3.40  %
Tax-exempt
securities                  35,255          1,060     3.01  %         34,104          1,153     3.38  %         37,201         1,434      3.85  %
Interest bearing
deposits
at banks                    62,286            132     0.21  %         42,817             53     0.12  %         16,395            26      0.16  %

Total
interest-earning
assets                     758,214      $  32,404     4.27  %        724,186       $ 33,376     4.61  %        651,391      $ 32,715      5.02  %

Non
interest-earning
assets:

Cash and due from
banks                       14,481                                    11,634                                    14,223
Premises and
equipment, net              11,250                                    10,748                                    10,607
Other assets                36,702                                    36,009                                    35,760

Total Assets           $   820,647                               $   782,577                               $   711,981

LIABILITIES & STOCKHOLDERS' EQUITY
Interest-bearing
liabilities:
NOW                    $    67,548      $     357     0.53  %    $    59,811       $    615     1.03  %    $    44,639      $    548      1.23  %
Regular savings            357,098          1,097     0.31  %        341,739          1,931     0.57  %        280,606         2,019      0.72  %
Muni-vest savings           26,052             60     0.23  %         24,937             79     0.32  %         27,272           131      0.48  %
Time deposits              111,165          1,782     1.60  %        109,508          1,921     1.75  %        131,171         2,923      2.23  %
Other borrowed
funds                       11,617            407     3.50  %         20,161            681     3.38  %         23,287           760      3.26  %
Junior subordinated
debentures                  11,330            325     2.87  %         11,331            348     3.07  %         11,330           331      2.92  %
Securities sold
under
agreement to
repurchase                  14,767             29     0.20  %         10,009             22     0.22  %          6,679            15      0.22  %

Total
interest-bearing
liabilities                599,577      $   4,057     0.68  %        577,496       $  5,597     0.97  %        524,984      $  6,727      1.28  %

Noninterest-bearing
liabilities:
Demand deposits            131,041                                   119,805                                   108,522
Other                       11,955                                    12,381                                    11,829
Total liabilities      $   742,573                               $   709,682                               $   645,335

Stockholders'
equity                      78,074                                    72,895                                    66,646

Total Liabilities
and Equity             $   820,647                               $   782,577                               $   711,981

. . .
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