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CNOB > SEC Filings for CNOB > Form 10-K on 5-Mar-2014All Recent SEC Filings

Show all filings for CONNECTONE BANCORP, INC.

Form 10-K for CONNECTONE BANCORP, INC.


5-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Some of the statements in this document discuss future expectations, contain projections or results of operations or financial conditions or state other "forward-looking" information. Those statements are subject to known and unknown risk; uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. We based the forward-looking statements on various factors and using numerous assumptions. Important factors that may cause actual results to differ from those contemplated by forward-looking statements include those disclosed under Item 1A-Risk Factors as well as the following factors:

the success or failure of our efforts to implement our business strategy;

the effect of changing economic conditions and, in particular, changes in interest rates;

changes in government regulations, tax rates and similar matters;

our ability to attract and retain quality employees; and

other risks which may be described in our future filings with the SEC

We do not promise to update forward-looking information to reflect actual results or changes in assumptions or other factors that could affect those statements.

Critical Accounting Policies and Estimates

"Management's Discussion and Analysis of Financial Condition and Results of Operations," is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to our audited consolidated financial statements contains a summary of our significant accounting policies. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses involves a higher degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. This critical policy and its application are periodically reviewed with the Audit Committee and our Board of Directors.

The allowance for loan losses is based upon management's evaluation of the adequacy of the allowance, including an assessment of known and probable incurred losses included in the portfolio, including giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available, the level of the allowance for loan losses remains an estimate which is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of our loans are secured by real estate in the State of New Jersey. Accordingly, the collectability of a substantial portion of the carrying value of our loan portfolio is susceptible to changes in local market conditions and may be adversely affected by declines in real estate values, or if the Central or Northern areas of New Jersey experience an adverse economic shock. Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond our control.


Overview and Strategy

We serve as a holding company for the Bank, which is our primary asset and only operating subsidiary. We follow a business plan that emphasizes the delivery of customized banking services in our market area to customers who desire a high level of personalized service and responsiveness. The Bank conducts a traditional banking business, making commercial loans, consumer loans and residential and commercial real estate loans. In addition, the Bank offers various non-deposit products through non-proprietary relationships with third party vendors. The Bank relies upon deposits as the primary funding source for its assets. The Bank offers traditional deposit products.

Many of our customer relationships start with referrals from existing customers. We then seek to cross sell our products to customers to grow the customer relationship. For example, we will frequently offer an interest rate concession on credit products for customers that maintain a non-interest bearing deposit account at the Bank. This strategy has lowered our funding costs and helped slow the growth of our interest expense even as we have substantially increased our total deposits. It has also helped fuel our significant loan growth. We believe that the Bank's significant growth and increasing profitability demonstrate the need for and success of our brand of banking.

Our results of operations depend primarily on our net interest income, which is the difference between the interest earned on our interest-earning assets and the interest paid on funds borrowed to support those assets, primarily deposits. Net interest margin is the difference between the weighted average rate received on interest-earning assets and the weighted average rate paid to fund those interest-earning assets, which is also affected by the average level of interest-earning assets as compared with that of interest-bearing liabilities. Net income is also affected by the amount of non-interest income and non-interest expenses.

Operating Results Overview

Net income for the year ended December 31, 2013 was $10.3 million, an increase of $1.8 million, or 22.0%, compared to net income of $8.4 million for 2012. Net income available to common shareholders for the year ended December 31, 2013 was $10.3 million, an increase of $2.2 million, or 27.3%, compared to net income available to common shareholders of $8.1 million for 2012. Diluted earnings per share were $2.09 for 2013, a 20.5% decrease from $2.63 for 2012. Diluted earnings per share for 2013 reflect the Company's February 2013 initial public offering and issuance of 1.8 million shares of common stock. Diluted earnings per share for 2012 reflect preferred dividends of $0.4 million. All shares of preferred were converted into common in 2012 and had no impact on 2013 results.

The increase in net income from 2012 to 2013 was primarily attributable to significant increases in net interest income due to the Company's rapid growth in loans and deposits, and in its customer base. Partially offsetting the revenue increases were higher noninterest expenses, largely staff-related, commensurate with the Company's growing infrastructure. Credit costs have kept pace with both loan growth and a changing mix in the loan portfolio, while benefitting from overall sound credit quality.

Net income for the year ended December 31, 2012 was $8.4 million, an increase of $1.7 million, or 26.3%, compared to net income of $6.7 million for 2011. Net income available to common shareholders for the year ended December 31, 2012 was $8.1 million, an increase of $2.0 million, or 33.0%, compared to net income available to common shareholders of $6.1 million for 2011. Diluted earnings per share were $2.63 for 2012, a 20.6% increase from $2.18 for 2011. Net income available to common shareholders and diluted earnings per share for 2012 were impacted by three series of convertible preferred stock issued at various times between 2009 and 2012. During 2012, all three series of preferred stock were converted into common shares and, as of December 31, 2012, stockholders' equity was comprised solely of common equity.

The increases in net income, net income available to common shareholders, and diluted earnings per share from 2011 to 2012 was primarily attributable to significant increases in net interest income due to the Company's rapid growth in loans and deposits, and in its customer base. Partially offsetting the revenue increases were higher noninterest expenses, largely staff-related, commensurate


with the Company's growing infrastructure. Credit costs have kept pace with both loan growth and a changing mix in the loan portfolio, while benefitting from overall sound credit quality.

Net Interest Income

Fully taxable equivalent net interest income for 2013 totaled $40.8 million, an increase of $6.3 million, or 18.4%, from 2012. The increase in net interest income was primarily due to an increase in average interest-earning assets, which grew by 28.6% to $1.1 billion, and was partially offset by a 33 basis points contraction in the net interest margin, from 4.20% in 2012 to 3.87% in 2013. Average total loans increased by 31.2% to $1.0 billion in 2013 from $743.2 million in 2012. Management expects net interest income to continue to expand as a result of continued strong loan growth, and margin compression to moderate throughout 2014 as our loan portfolio fully re-prices.

Fully taxable equivalent net interest income for 2012 totaled $34.5 million, an increase of $7.0 million, or 25.5%, from 2011. The increase in net interest income was primarily due to an increase in average interest-earning assets, principally loans, which increased by 29.6% to $743.2 million in 2012 from $573.6 million in 2011. The net interest margin remained relatively stable at 4.20% in 2012 as compared to 4.21% for the prior year period, as reduced yields on our loan portfolio resulting from the persistently low interest rate environment were offset by a lower cost of funds and a higher level of loan prepayment fees.


Average Balance Sheets

The following table sets forth certain information relating to our average
assets and liabilities for the years ended December 31, 2013, 2012 and 2011 and
reflect the average yield on assets and average cost of liabilities for the
periods indicated. Such yields are derived by dividing income or expense by the
average balance of assets or liabilities, respectively, for the periods shown.


                                                                                                                 For the Years Ended December 31,
                                                                  2013                                                           2012                                                         2011
                                             Average                                    Average             Average                                  Average             Average                                  Average
                                             Balance                Interest              Rate              Balance               Interest             Rate              Balance               Interest             Rate
                                                                                                                      (dollars in thousands)
Interest earning assets:
Investment securities(1)(2)             $        28,425           $        811             2.85 %        $      31,009          $      1,079            3.48 %        $      43,980          $      1,505            3.42 %
Loans receivable(3)(4)                          975,217                 46,405             4.76 %              743,178                39,625            5.33 %              573,648                32,113            5.60 %
Federal funds sold and
interest-earning deposits with
banks                                            51,894                    103             0.20 %               46,902                    83            0.18 %               35,339                    58            0.16 %

Total interest-earning assets                 1,055,536                 47,319             4.48 %              821,089                40,787            4.97 %              652,967                33,676            5.16 %
Allowance for loan losses                       (14,267 )                                                      (11,196 )                                                     (8,651 )
Non-interest earning assets                      25,607                                                         21,558                                                       20,976

Total assets                            $     1,066,876                                                  $     831,451                                                $     665,292

Interest-bearing liabilities:
Savings, NOW, Money Market,
Interest Checking                       $       332,513                    987             0.30 %        $     313,475                 1,397            0.45 %        $     270,374                 2,356            0.87 %
Time deposits                                   329,765                  3,811             1.16 %              229,150                 3,380            1.48 %              160,580                 2,532            1.58 %

Total interest-bearing deposits                 662,278                  4,798             0.72 %              542,625                 4,777            0.88 %              430,954                 4,888            1.13 %
Borrowings                                       91,949                  1,489             1.62 %               77,473                 1,349            1.74 %               68,217                 1,121            1.64 %
Capital lease obligation                          3,150                    189             6.00 %                3,224                   193            5.99 %                3,293                   198            6.01 %

Total interest-bearing liabilities              757,377                  6,476             0.86 %              623,322                 6,319            1.01 %              502,464                 6,207            1.24 %
Noninterest-bearing deposits                    191,233                                                        138,155                                                      106,174
Other liabilities                                 3,631                                                          4,345                                                        2,970
Stockholders' equity                            114,635                                                         65,629                                                       53,684

Total liabilities and
stockholders' equity                    $     1,066,876                                                  $     831,451                                                $     665,292

Net interest income/interest rate
spread(5)                                                         $     40,843             3.63 %                               $     34,468            3.95 %                               $     27,469            3.92 %
Tax equivalent effect                                                      (16 )                                                           -                                                            -

Net interest income as reported                                   $     40,827                                                  $     34,468                                                 $     27,469
Net interest margin(6)                                                                     3.87 %                                                       4.20 %                                                       4.21 %


(1) Average balances are calculated on amortized cost.

(2) Interest income is presented on a tax equivalent basis using 35 percent federal tax rate.

(3) Includes loan fee income.

(4) Loans receivable include non-accrual loans.

(5) Represents difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.

(6) Represents net interest income on a fully taxable equivalent basis divided by average total interest-earning assets.


Rate/Volume Analysis

The following table presents, by category, the major factors that contributed to
the changes in net interest income. Changes due to both volume and rate have
been allocated in proportion to the relationship of the dollar amount change in
each.


                                                      For the Year Ended                                      For the Year Ended
                                                 December 31, 2013 versus 2012                          December 31, 2012 versus 2011
                                                      Increase (Decrease)                                    Increase (Decrease)
                                                   Due to Change in Average                                Due to Change in Average
                                          Volume              Rate               Net             Volume              Rate               Net
Interest Income:
Investment securities                  $      (85 )       $     (183 )       $    (268 )       $    (452 )       $       26         $    (426 )
Loan receivable                            10,342             (3,562 )           6,780             8,953             (1,441 )           7,512
Federal funds sold and interest-                -                  -                 -                 -                  -                 -
earning deposits with banks                     9                 11                20                20                  5                25

Total interest income                  $   10,266         $   (3,734 )       $   6,532         $   8,521         $   (1,410 )       $   7,111

Interest Expense:
Savings, NOW, Money Market,
Interest Checking                      $       91         $     (501 )       $    (410 )       $     464         $   (1,423 )       $    (959 )
Time deposits                                 850               (419 )             431               999               (151 )             848
Borrowings                                    224                (84 )             140               158                 70               228
Capital lease obligation                       (4 )                0                (4 )              (4 )               (1 )              (5 )

Total interest expense                 $    1,161         $   (1,004 )       $     157         $   1,617         $   (1,505 )       $     112

Net interest income                    $    9,105         $   (2,730 )       $   6,375         $   6,904         $       95         $   6,999

Provision for Loan Losses

In determining the provision for loan losses, management considers national and local economic trends and conditions; trends in the portfolio including orientation to specific loan types or industries; experience, ability and depth of lending management in relation to the complexity of the portfolio; effects of changes in lending policies, trends in volume and terms of loans; levels and trends in delinquencies, impaired loans and net charge-offs and the results of independent third party loan and lease review.

For the year ended December 31, 2013, the provision for loan losses was $4.6 million, an increase of $0.6 million, compared to the provision for loan losses of $4.0 million for the same period in 2012. The increase is substantially attributable to the increased loan growth in 2013 versus 2012.

For the year ended December 31, 2012, the provision for loan losses was $4.0 million, an increase of $1.6 million, compared to the provision for loan losses of $2.4 million for the same period in 2011. The increase is substantially attributable to the increased loan growth in 2012 versus 2011.

Non-Interest Income

The Company's non-interest income consists primarily of service charges on deposit accounts, gains on sale of residential mortgages, card (ATM, credit and debit cards) income, fees from a title insurance agency in which the Bank is a 49% owner and income in bank owned life insurance (BOLI).

Non-interest income represents a relatively small portion of the Bank's total revenue as management has historically made a strategic decision to de-emphasize fee income, focusing instead on customer growth and retention. Non-interest income totaled $1.2 million for the year ended December 31, 2013, versus $1.1 million for the year ended December 31, 2012. The increase in non-interest income is attributable to BOLI income in 2013, while growth in service and card-related fees were essentially offset by declines in gains on sale of residential mortgage loans. Non-interest income


amounted to $1.1 for 2011. Card income grew by approximately $80,000 in 2012 versus 2011, while 2011 included $96,000 in securities gains.

Non-Interest Expense

Non-interest expense for the full-year 2013 increased by $3.2 million, or 18.1%, to $20.7 million from $17.5 million in 2012. The largest factor contributing to the increases in total non-interest expense was salaries and employee benefits expense, which increased by $1.9 million to $10.3 million for the full year 2013 from $8.4 million in 2012. The increases were primarily due an increase in the number of full-time equivalent employees and higher incentive-based compensation. Also contributing to higher non-interest expenses were increased costs associated with being a publicly traded entity, higher legal fees, and a general increase in other operating expenses related to a significantly increased volume of business.

Non-interest expense for the full-year 2012 increased by $2.4 million, or 16.1%, to $17.5 million from $15.1 million in 2011. The largest factor contributing to the year-over-year increase was salaries and employee benefits expense, which increased by $1.4 million to $8.4 million in 2012 from $6.9 million in 2011; this increase was primarily a result of increased staffing levels, particularly at the executive and senior management level. Also contributing to the increase were data processing expenses ($260,000), advertising and promotion expenses ($133,000) and other expenses ($574,000). The increases in these categories were all primarily related to the Company's increased volume of business.

Management continues to focus efforts on supporting growth primarily by adding to staff, investing in technology, and by enhancing risk controls. At the same time, management seeks to contain costs whenever prudent. Our success in this regard is evident in our continued low efficiency ratio, a widely-followed metric in the banking industry which measures operating expenses as a percentage of net revenue. The ratio is computed by dividing total noninterest expense by the sum of net interest income and noninterest income less securities gains/(losses). The Company's efficiency ratio was 49.1% for 2013 and 2012. The Company's efficiency ratio was 52.9% in 2011.

Income Taxes

Income tax expense was $6.5 million for the full-year 2013 versus $5.7 million for the full-year 2012. The effective tax rates were 38.9% for the full-year of 2013, versus 40.4% full-year of 2012. Effective tax rates for 2013 reflect a reorganized operating structure effective October 1, 2013. The Company's effective tax rate is projected to be approximately 36% in future periods, although is likely to fluctuate depending upon future levels of taxable and non-taxable revenue.

Income tax expense was $5.7 million for the full-year 2012 versus $4.5 million for the full-year 2011. The effective tax rate was approximately 40% for all periods presented representing the combined federal and state statutory tax rates for a New Jersey corporation, and reflecting no tax-advantaged investments such as municipal securities or bank owned life insurance.

Financial Condition Overview

At December 31, 2013, total assets were $1.2 billion, a $313.3 million increase from December 31, 2012. The increase in total assets was due primarily to a $303.0 million increase, to $1.2 billion, in loans receivable. The growth in assets was funded by a $196.5 million increase in deposits, a $58.0 million increase in Federal Home Loan Bank borrowings, $10.3 million in retained earnings, and $47.7 million in net proceeds from the Company's first quarter 2013 initial public equity offering.

Loan Portfolio

The Bank's lending activities are generally oriented to small-to-medium sized businesses, high net worth individuals, professional practices and consumer and retail customers living and working in the Bank's market area of Hudson, Bergen and Monmouth Counties, New Jersey. The Bank has not made loans to borrowers outside of the United States. The Bank believes that its strategy of high-


quality customer service, competitive rate structures and selective marketing have enabled it to gain market entry.

Commercial loans are loans made for business purposes and are primarily secured by collateral such as cash balances with the Bank, marketable securities held by or under the control of the Bank, business assets including accounts receivable, taxi medallions, inventory and equipment and liens on commercial and residential real estate. Commercial construction loans are loans to finance the construction of commercial or residential properties secured by first liens on such properties. Commercial real estate loans include loans secured by first liens on completed commercial properties, including multi- family properties, to purchase or refinance such properties. Residential mortgages include loans secured by first liens on residential real estate, and are generally made to existing customers of the Bank to purchase or refinance primary and secondary residences. Home equity loans and lines of credit include loans secured by first or second liens on residential real estate for primary or secondary residences. Consumer loans are made to individuals who qualify for auto loans, cash reserve, credit cards and installment loans.

During 2013 and 2012, loan portfolio growth was positively impacted in several ways including (i) an increase in demand for small business lines of credit, and business term loans as economic conditions have stabilized and begun to improve,
(ii) industry consolidation and lending restrictions involving larger competitors allowing the Bank to gain market share, (iii) an increase in refinancing strategies employed by borrowers during the current low rate environment, and (iv) the Bank's success in attracting highly experienced commercial loan officers with substantial local market knowledge.

Gross loans at December 31, 2013 totaled $1,153.1 million, an increase of $303.8 million, or 35.8%, over gross loans at December 31, 2012 of $829.3 million. The biggest component of our loan portfolio at December 31, 2013 and December 31, 2012 was commercial real estate loans. Our commercial real estate loans at December 31, 2013 were $769.1 million, an increase of $219.9 million, or 40.0%, over commercial real estate loans at December 31, 2012 of $549.2 million. Our commercial loans were $203.7 million at December 31, 2013, an increase of $56.2 million, or 38.1%, over commercial loans at December 31, 2012 of $203.7 million. Our commercial construction loans at December 31, 2013 were $59.8 million, an . . .

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