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

Show all filings for FIRST COMMONWEALTH FINANCIAL CORP /PA/

Form 10-K for FIRST COMMONWEALTH FINANCIAL CORP /PA/


3-Mar-2014

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis represents an overview of the financial condition and the results of operations of First Commonwealth and its subsidiaries, FCB, First Commonwealth Insurance Agency, Inc. ("FCIA") and First Commonwealth Financial Advisors, Inc. ("FCFA"), as of and for the years ended December 31, 2013, 2012 and 2011. The purpose of this discussion is to focus on information concerning our financial condition and results of operations that is not readily apparent from the Consolidated Financial Statements. In order to obtain a clear understanding of this discussion, you should refer to the Consolidated Financial Statements, the notes thereto and other financial information presented in this Annual Report.

Company Overview
First Commonwealth provides a diversified array of consumer and commercial banking services through our bank subsidiary, FCB. We also provide trust and wealth management services through FCFA and insurance products through FCIA. At December 31, 2013, FCB operated 110 community banking offices throughout western Pennsylvania and one loan production office in downtown Pittsburgh, Pennsylvania.
Our consumer services include Internet, mobile and telephone banking, an automated teller machine network, personal checking accounts, interest-earning checking accounts, savings accounts, insured money market accounts, debit cards, investment certificates, fixed and variable rate certificates of deposit, secured and unsecured installment loans, construction and real estate loans, safe deposit facilities, credit lines with overdraft checking protection and IRA accounts. Commercial banking services include commercial lending, small and high-volume business checking accounts, on-line account management services, ACH origination, payroll direct deposit, commercial cash management services and repurchase agreements. We also provide a variety of trust and asset management services and a full complement of auto, home and business insurance as well as term life insurance. We offer annuities, mutual funds, stock and bond brokerage services through an arrangement with a broker-dealer and insurance brokers. Most of our commercial customers are small and mid-sized businesses in central and western Pennsylvania.
As a financial institution with a focus on traditional banking activities, we earn the majority of our revenue through net interest income, which is the difference between interest earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon balance sheet growth and maintaining or increasing our net interest margin, which is net interest income (on a fully taxable-equivalent basis) as a percentage of our average interest-earning assets. We also generate revenue through fees earned on various services and products that we offer to our customers and through sales of assets, such as loans, investments or properties. These revenue sources are offset by provisions for credit losses on loans, loss on sale or other-than-temporary impairments on investment securities, operating expenses and income taxes.
General economic conditions also affect our business by impacting our customers' need for financing, thus affecting loan growth, and impacting the credit strength of existing and potential borrowers.

Critical Accounting Policies and Significant Accounting Estimates First Commonwealth's accounting and reporting policies conform to accounting principles generally accepted in the United States of America ("GAAP") and predominant practice in the banking industry. The preparation of financial statements in accordance with GAAP requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. Over time, these estimates, assumptions and judgments may prove to be inaccurate or vary from actual results and may significantly affect our reported results and financial position for the period presented or in future periods. We currently view the determination of the allowance for credit losses, fair value of financial instruments, goodwill and other intangible assets, and income taxes to be critical because they are highly dependent on subjective or complex judgments, assumptions and estimates made by management.
Allowance for Credit Losses
We account for the credit risk associated with our lending activities through the allowance and provision for credit losses. The allowance represents management's best estimate of probable losses that are inherent in our existing loan portfolio as of the balance sheet date. The provision is a periodic charge to earnings in an amount necessary to maintain the allowance at a level that is appropriate based on management's assessment of probable estimated losses. Management determines and reviews with the Board of Directors the adequacy of the allowance on a quarterly basis in accordance with the methodology described below.


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Individual loans are selected for review in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 310, "Receivables." These are generally large balance commercial loans and commercial mortgages that are rated less than "satisfactory" based on our internal credit-rating process.

We assess whether the loans identified for review in step one are "impaired," which means that it is probable that all amounts will not be collected according to the contractual terms of the loan agreement, which generally represents loans that management has placed on nonaccrual status.

For impaired loans we calculate the estimated fair value of the loans that are selected for review based on observable market prices, discounted cash flows or the value of the underlying collateral and record an allowance if needed.

We then select pools of homogenous smaller balance loans having similar risk characteristics as well as unimpaired larger commercial loans for evaluation collectively under the provisions of FASB ASC Topic 450, "Contingencies." These smaller balance loans generally include residential mortgages, consumer loans, installment loans and some commercial loans.

FASB ASC Topic 450 loans are segmented into groups with similar characteristics and an allowance for credit losses is allocated to each segment based on recent loss history and other relevant information.

We then review the results to determine the appropriate balance of the allowance for credit losses. This review includes consideration of additional factors, such as the mix of loans in the portfolio, the balance of the allowance relative to total loans and nonperforming assets, trends in the overall risk profile in the portfolio, trends in delinquencies and nonaccrual loans, and local and national economic information and industry data, including trends in the industries we believe are higher risk.

There are many factors affecting the allowance for credit losses; some are quantitative while others require qualitative judgment. These factors require the use of estimates related to the amount and timing of expected future cash flows, appraised values on impaired loans, estimated losses for each loan category based on historical loss experience by category using an eight to twenty quarter average, and consideration of current economic trends and conditions, all of which may be susceptible to significant judgment and change. To the extent that actual outcomes differ from estimates, additional provisions for credit losses could be required that could adversely affect our earnings or financial position in future periods. The loan portfolio represents the largest asset category on our Consolidated Statements of Financial Condition. Fair Values of Financial Instruments
FASB ASC Topic 820, "Fair Value Measurements and Disclosures," establishes a framework for measuring fair value. In accordance with FASB ASC Topic 820, First Commonwealth groups financial assets and financial liabilities measured at fair value in three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. Level 1 valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities. Level 2 valuations are for instruments that trade in less active dealer or broker markets and incorporates values obtained for identical or comparable instruments. Level 3 valuations are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to each instrument.
Level 2 investment securities are valued by a recognized third party pricing service using observable inputs. Management validates the market values provided by the third party service by having another recognized pricing service price 100% of securities on an annual basis and a random sample of securities each quarter, monthly monitoring of variances from prior period pricing and on a monthly basis evaluating pricing changes compared to expectations based on changes in the financial markets.
Level 3 investments include pooled trust preferred collateralized debt obligations. The fair values of these investments are determined by a specialized third party valuation service. Management validates the fair value of the pooled trust preferred collateralized debt obligations by monitoring the performance of the underlying collateral, discussing the discount rate, cash flow assumptions and general market trends with the specialized third party and by confirming changes in the underlying collateral to the trustee and underwriter reports. Management's monitoring of the underlying collateral includes deferrals of interest payments, payment defaults, cures of previously deferred interest payments, any regulatory filings or actions and general news related to the underlying collateral. Management also evaluates fair value changes compared to expectations based on changes in the interest rates used in determining the discount rate and general financial markets.
Methodologies and estimates used by management when determining the fair value for pooled trust preferred collateralized debt obligations and testing those securities for other-than-temporary impairment are discussed in detail in Management's


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Discussion and Analysis of Financial Condition and Results of Operations and in Note 9 "Impairment of Investment Securities" and Note 19 "Fair Values of Assets
and Liabilities" of Notes to the Consolidated Financial Statements. Goodwill and Other Intangible Assets
We consider our accounting policies related to goodwill and other intangible assets to be critical because the assumptions or judgment used in determining the fair value of assets and liabilities acquired in past acquisitions are subjective and complex. As a result, changes in these assumptions or judgment could have a significant impact on our financial condition or results of operations.
The fair value of acquired assets and liabilities, including the resulting goodwill, was based either on quoted market prices or provided by other third-party sources, when available. When third-party information was not available, estimates were made in good faith by management primarily through the use of internal cash flow modeling techniques. The assumptions that were used in the cash flow modeling were subjective and are susceptible to significant changes.
Goodwill and other intangible assets with indefinite useful lives are tested for impairment at least annually and written down and charged to results of operations only in periods in which the recorded value is more than the estimated fair value. Intangible assets that have finite useful lives will continue to be amortized over their useful lives and are periodically evaluated for impairment.
As of December 31, 2013, goodwill and other intangible assets were not considered impaired; however, changing economic conditions that may adversely affect our performance and stock price could result in impairment, which could adversely affect earnings in future periods. Our Step 1 goodwill impairment analysis as of November 30, 2013, determined that the fair value of our goodwill exceeded its carrying value by approximately 30%. An assessment of qualitative factors was completed as of December 31, 2013 and indicated that it is more likely than not that our fair value exceeded its carrying value. Income Taxes
We estimate income tax expense based on amounts expected to be owed to the tax jurisdictions where we conduct business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year.
Deferred income tax assets and liabilities are determined using the asset and liability method and are reported in the Consolidated Statements of Financial Condition. Under 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. Management assesses all available positive and negative evidence on a quarterly basis to estimate if sufficient future taxable income will be generated to utilize the existing deferred tax assets. The amount of future taxable income used in management's valuation is based upon management approved forecasts, evaluation of historical earnings levels, proven ability to raise capital to support growth or during times of economic stress and consideration of prudent and feasible potential tax strategies. If future events differ from our current forecasts, a valuation allowance may be required, which could have a material impact on our financial condition and results of operations.
Accrued taxes represent the net estimated amount due to taxing jurisdictions and are reported in other liabilities in the Consolidated Statements of Financial Condition. Management evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance. These changes, when they occur, can affect deferred taxes and accrued taxes, as well as the current period's income tax expense and can be significant to our operating results.

Results of Operations-2013 Compared to 2012 Net Income
Net income for 2013 was $41.5 million, or $0.43 per diluted share, as compared to net income of $42.0 million, or $0.40 per diluted share, in 2012. Net income in 2013 was positively impacted by improvements in the credit quality of our loan portfolio as losses on the sale or write-down of assets decreased $6.3 million and collection and repossession expenses decreased $1.9 million. Additionally, operational losses decreased $3.3 million during 2013. Offsetting these positives were $2.6 million in technology related conversion expenses, $1.2 million in net securities losses and a $4.3 million decrease in net interest income.


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Our return on average equity was 5.7% and return on average assets was 0.68% for 2013, compared to 5.5% and 0.71%, respectively, for 2012.
Average diluted shares for the year 2013 were 7% less than the comparable period in 2012 primarily due to the common stock buyback programs that were authorized during 2013 and 2012.
Net Interest Income
Net interest income, which is our primary source of revenue, is the difference between interest income from earning assets (loans and securities) and interest expense paid on liabilities (deposits, short-term borrowings and long-term debt). The amount of net interest income is affected by both changes in the level of interest rates and the amount and composition of interest-earning assets and interest-bearing liabilities. The net interest margin is expressed as the percentage of net interest income, on a fully taxable equivalent basis, to average interest-earning assets. To compare the tax exempt asset yields to taxable yields, amounts are adjusted to the pretaxable equivalent amounts based on the marginal corporate federal income tax rate of 35%. The taxable equivalent adjustment to net interest income for 2013 was $4.1 million compared to $4.4 million in 2012. Net interest income comprises a majority of our operating revenue (net interest income before the provision plus noninterest income) at 75% and 74% for the years ended December 31, 2013 and 2012, respectively. Net interest income, on a fully taxable equivalent basis, was $188.7 million for the year-ended December 31, 2013, a $4.6 million, or 2%, decrease compared to $193.3 million for the same period in 2012. The net interest margin, on a fully taxable equivalent basis decreased 22 basis points, or 6%, to 3.39% in 2013 from 3.61% in 2012. The net interest margin is affected by both changes in the level of interest rates and the amount and composition of interest-earning assets and interest-bearing liabilities.
The low interest rate environment and resulting decline in rates earned on interest-earning assets challenged the net interest margin during the year-ended December 31, 2013. Yields and spreads on new loan volumes continued to experience competitive pricing pressures in 2013, specifically home equity and indirect loans. Also contributing to lower yields on earning assets is the runoff of existing assets which are earning higher interest rates than new volumes as well as growth in the investment portfolio. Growth in earning assets has helped to offset the spread compression as average earning assets for the year-ended December 31, 2013 increased $210.5 million, or 4%, compared to the comparable period in 2012. However, approximately 58% of the growth in earning assets relates to the investment portfolio, which is earning approximately 180 basis points less than the rate earned on growth in the loan portfolio. Investment portfolio purchases during 2013 have been primarily in the mortgage-related assets with approximate durations of 36-48 months. The majority of these investments have monthly principal payments which provide for reinvestment opportunities as interest rates rise. It is expected that the challenges to the net interest margin will continue as $2.9 billion in interest-sensitive assets either reprice or mature over the next twelve months. The taxable equivalent yield on interest-earning assets was 3.79% for the year-ended December 31, 2013, a decrease of 39 basis points from the 4.18% yield for the same period in 2012. This decline can be attributed to the repricing of our variable rate assets in a declining interest rate environment as well as lower interest rates available on new investments and loans. Reductions in the cost of interest-bearing liabilities partially offset the impact of lower yields on interest-earning assets. The cost of interest-bearing liabilities was 0.48% for the year-ended December 31, 2013, compared to 0.70% for the same period in 2012.
Comparing the year-ended December 31, 2013 with the same period in 2012, changes in interest rates negatively impacted net interest income by $10.3 million. The lower yield on interest-earning assets adversely impacted net interest income by $20.4 million, while the decline in the cost of interest-bearing liabilities had a positive impact of $10.1 million. We have been able to partially mitigate the impact of lower interest rates and the effect on net interest income through improving the mix of deposits and borrowed funds, disciplined pricing strategies, loan growth and increasing our investment volumes within established interest rate risk management guidelines. As part of these strategies, on April 1, 2013, the Company redeemed $32.5 million in issued and outstanding 9.50% mandatorily redeemable capital securities issued by First Commonwealth Capital Trust I and replaced these capital securities with lower cost funding alternatives.
While decreases in interest rates and yields compressed the net interest margin, increases in average interest-earning assets and a lower cost of funds tempered the effect on net interest income. Changes in the volumes of interest-earning assets and interest-bearing liabilities positively impacted net interest income by $5.7 million in the year-ended December 31, 2013 compared to the same period in 2012. Higher levels of interest-earning assets resulted in an increase of $7.4 million in interest income, while volume changes primarily attributed to short-term and long-term borrowings increased interest expense by $1.7 million. Positively affecting net interest income was a $41.1 million increase in average net free funds at December 31, 2013 as compared to December 31, 2012. Average net free funds are the excess of noninterest-bearing demand deposits, other noninterest-bearing liabilities and shareholders' equity over noninterest-earning assets. The largest component of the increase in


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net free funds was a $66.1 million increase in average noninterest-bearing demand deposits as a result of marketing promotions aimed at attracting new and retaining existing customers. Additionally, higher costing time deposits continue to mature and reprice to lower costing certificates or other deposit alternatives. Average time deposits for the year-ended December 31, 2013 increased $16.9 million million, or 1%, compared to the comparable period in 2012, while the average rate paid on time deposits decreased 42 basis points. The positive change in deposit mix is expected to continue as $750.7 million in certificates of deposits either mature or reprice over the next twelve months. The following table reconciles interest income in the Consolidated Statements of Income to net interest income adjusted to a fully taxable equivalent basis for the periods presented:

                                                        For the Years Ended December 31,
                                                       2013               2012           2011
                                                             (dollars in thousands)
Interest income per Consolidated Statements of
Income                                          $    206,358          $  219,075     $  231,545
Adjustment to fully taxable equivalent basis           4,081               4,392          5,500
Interest income adjusted to fully taxable
equivalent basis (non-GAAP)                          210,439             223,467        237,045
Interest expense                                      21,707              30,146         41,678
Net interest income adjusted to fully taxable
equivalent basis (non-GAAP)                     $    188,732          $  193,321     $  195,367


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The following table provides information regarding the average balances and yields and rates on interest-earning assets and interest-bearing liabilities for the periods ended December 31:

                                                                       Average Balance Sheets and Net Interest Analysis
                                               2013                                          2012                                          2011
                               Average         Income /       Yield or       Average         Income /       Yield or       Average         Income /       Yield or
                               Balance        Expense (a)       Rate         Balance        Expense (a)       Rate         Balance        Expense (a)       Rate
                                                                                    (dollars in thousands)
Assets
Interest-earning assets:
Interest-bearing deposits
with banks                  $     3,355     $           7        0.21 %   $     4,329     $           6        0.14 %   $    26,477     $          64        0.24 %
Tax-free investment
securities (e)                       83                 6        7.40             271                18        6.85           4,852               328        6.76
Taxable investment
securities                    1,300,538            30,218        2.32       1,179,169            31,799        2.70       1,043,798            33,812        3.24
Loans, net of unearned
income (b)(c)                 4,255,593           180,208        4.23       4,165,292           191,644        4.60       4,061,822           202,841        4.99
Total interest-earning
assets                        5,559,569           210,439        3.79       5,349,061           223,467        4.18       5,136,949           237,045        4.61
Noninterest-earning assets:
Cash                             71,930                                        75,044                                        75,071
Allowance for credit losses     (62,800 )                                     (65,279 )                                     (76,814 )
Other assets                    563,283                                       581,321                                       593,248
Total noninterest-earning
assets                          572,413                                       591,086                                       591,505
Total Assets                $ 6,131,982                                   $ 5,940,147                                   $ 5,728,454
Liabilities and
Shareholders' Equity
Interest-bearing
liabilities:
Interest-bearing demand
deposits (d)                $   670,524     $         236        0.04 %   $   645,970     $         286        0.04 %   $   607,756     $         515        0.08 %
Savings deposits (d)          1,942,323             2,962        0.15       1,921,417             4,233        0.22       1,877,321             7,252        0.39
Time deposits                 1,154,984            12,398        1.07       1,138,112            16,935        1.49       1,343,281            25,729        1.92
Short-term borrowings           478,388             1,262        0.26         402,196             1,070        0.27         182,864               728        0.40
Long-term debt                  233,483             4,849        2.08         202,598             7,622        3.76         184,185             7,454        4.05
Total interest-bearing
liabilities                   4,479,702            21,707        0.48       4,310,293            30,146        0.70       4,195,407            41,678        0.99
Noninterest-bearing
liabilities and
shareholders' equity:
Noninterest-bearing demand
deposits (d)                    876,111                                       810,041                                       720,005
Other liabilities                48,335                                        50,859                                        49,163
Shareholders' equity            727,834                                       768,954                                       763,879
. . .
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