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MBRG > SEC Filings for MBRG > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for MIDDLEBURG FINANCIAL CORP

Form 10-K for MIDDLEBURG FINANCIAL CORP


14-Mar-2014

Annual Report


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

The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of the Company. This discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and Notes to Consolidated Financial Statements. It should also be read in conjunction with the "Caution About Forward Looking Statements" section at the end of this discussion.

Overview

The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc. and a majority owned subsidiary, Southern Trust Mortgage,
LLC. Middleburg Bank is a community bank serving the Virginia counties of Prince William, Loudoun, Fairfax, Fauquier, the Town of Williamsburg and the City of Richmond with twelve financial service centers and one limited service facility. Middleburg Investment Group is a non-bank holding company with one wholly owned subsidiary, Middleburg Trust Company. Middleburg Trust Company is a trust company headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank's facilities. Southern Trust Mortgage is a regional mortgage company headquartered in Virginia Beach, Virginia and maintains offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.

The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. Middleburg Bank's cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses or potential other-than-temporary impairment of securities. Middleburg Investment Group's subsidiary, Middleburg Trust Company, generates fee income by providing investment management and trust services to its clients. Investment management and trust fees are generally based upon the value of assets under management, and, therefore can be significantly affected by fluctuations in the values of securities caused by changes in the capital markets. Southern Trust Mortgage generates fees from the origination and sale of mortgages loans. Southern Trust Mortgage also maintains a real estate construction portfolio and receives interest and fee income from these loans, which, net of interest expense, is included in net interest income.

At December 31, 2013, total assets were $1.2 billion, a decrease of 0.73% or $9.0 million compared to December 31, 2012. Total gross loans increased $19.0 million from $709.5 million at December 31, 2012 to $728.5 million at December 31, 2013. Total deposits increased $496,000 or 0.05% to $982.4 million at December 31, 2013 from $981.9 million at December 31, 2012. Lower cost deposits, including demand checking, interest checking and savings increased $24.6 million or 3.6% from December 31, 2012 to $714.5 million at December 31, 2013. Higher cost time deposits decreased 8.2% or $24.1 million from December 31, 2012 to $267.9 million at December 31, 2013. The net interest margin, a non-GAAP measure more fully described in the "Results of Operations" section below, decreased from 3.47% for the year ended December 31, 2012 to 3.40% for the year ended December 31, 2013. The decrease is primarily attributed to the 28 basis point decrease, on a tax equivalent basis, in the yield on total earning assets, offset by the 23 basis point decrease in the cost of total interest bearing liabilities. The provision for loan losses decreased by $3.3 million for the year ended December 31, 2013 to $109,000 compared to $3.4 million for the same period in 2012. Total non-interest income decreased by $4.9 million for the year ended December 31, 2013, compared to 2012. The decrease is largely due to the decline in gains on the sale of loans by the Company's mortgage banking subsidiary, Southern Trust Mortgage. Non-interest expense in 2013 decreased $218,000 from 2012. The Company remains well capitalized as evidenced by all regulatory capital ratios exceeding the regulatory minimums.

The Company is not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on the registrant's liquidity, capital resources or results of operations.

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to some degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.


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Presented below is discussion of those accounting policies that management believes are the most important ("Critical Accounting Policies") to the portrayal and understanding of Middleburg Financial Corporation's financial condition and results of operations. The Critical Accounting Policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting standards. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, troubled debt restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics.

For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans losses. This estimate of losses is compared to the allowance for loan losses of Middleburg Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the consolidated financial statements.

Goodwill and Intangibles

With the adoption of Accounting Standards Update 2011-08, "Intangible-Goodwill and Other-Testing Goodwill for Impairment", the Company 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 each applicable reporting unit is less than its carrying amount. If the likelihood of impairment is more than 50%, the Company must perform a test for impairment and may be required to record impairment charges. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit is greater than zero and its fair value exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; thus, the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill shall be its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is recognized.


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Management estimates fair value utilizing multiple methodologies which include discounted cash flows, comparable companies, third-party sale and assets under management analysis. Determining the fair value of the Company's reporting units requires management to make judgments and assumptions related to various items, including estimates of future operating results, allocations of indirect expenses, and discount rates. Management believes its estimates and assumptions are reasonable; however, the fair value of each reporting unit could be different in the future if actual results or market conditions differ from the estimates and assumptions used.

The Company's forecasted cash flows for its reporting units assume a stable economic environment and consistent long-term growth in loan originations and assets under management over the projected periods. Additionally, expenses are assumed to be consistently correlated with projected asset and revenue growth over the time periods projected. Although we believe the key assumptions underlying the financial forecasts to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond the control of the Company. Accordingly, there can be no assurance that the forecasted results will be realized and variations from the forecast may be material. If weak economic conditions continue or worsen for a prolonged period of time, or if the reporting unit loses key personnel, the fair value of the reporting unit may be adversely affected which may result in impairment of goodwill or other intangible assets in the future. Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company's financial condition and results of operations.

Middleburg Investment Group has intangible assets in the form of certain customer relationships that were acquired in 2002. We amortize those intangible assets on a straight line basis over their estimated useful life.

Other-Than-Temporary Impairment (OTTI) for 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.

Results of Operations

The Company had net income for 2013 of $6.2 million, a decrease of $332,000 or 5.1% from 2012. For 2013, the earnings per diluted share was $0.87 compared to earnings per diluted share of $0.92 for 2012.

Return on average assets ("ROA") measures how effectively the Company employs its assets to produce net income. The ROA for the Company was 0.51%, 0.54% and 0.44% for the years ended December 31, 2013, 2012 and 2011, respectively. Return on average equity ("ROE"), another measure of earnings performance, indicates the amount of net income earned in relation to the total average equity capital invested. ROE was 5.4%, 5.9% and 4.9% for the years ended December 31, 2013, 2012 and 2011, respectively.

The following table reflects an analysis of the Company's net interest income using the daily average balances of the Company's assets and liabilities as of December 31.


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                                                                  Years Ended December 31,
                                   2013                                     2012                                     2011
(Dollars in          Average       Income/      Yield/        Average       Income/      Yield/        Average       Income/      Yield/
thousands)           Balance       Expense     Rate (2)       Balance       Expense     Rate (2)       Balance       Expense     Rate (2)
Assets:
Securities:
Taxable           $   268,954     $  6,337        2.36 %   $   262,991     $  6,601        2.51 %   $   231,893     $  6,771        2.92 %
Tax-exempt (1)         66,396        3,870        5.83 %        62,363        3,642        5.84 %        56,793        3,580        6.30 %
Total securities  $   335,350     $ 10,207        3.04 %   $   325,354     $ 10,243        3.15 %   $   288,686     $ 10,351        3.59 %
Loans:
Taxable           $   755,913     $ 35,224        4.66 %   $   755,790     $ 37,890        5.01 %   $   720,633     $ 39,392        5.47 %
Tax-exempt (1)            679           37        5.45 %           135            8        5.93 %             -            -           -
Total loans (3)   $   756,592     $ 35,261        4.66 %   $   755,925     $ 37,898        5.01 %   $   720,633     $ 39,392        5.47 %
Interest-bearing
deposits with
other
institutions           56,436          132        0.23 %        54,237          124        0.23 %        43,469          110        0.25 %
Total earning
assets            $ 1,148,378     $ 45,600        3.97 %   $ 1,135,516     $ 48,265        4.25 %   $ 1,052,788     $ 49,853        4.74 %
Less: allowances
for loan losses       (13,643 )                                (14,830 )                                (14,835 )
Total non-earning
assets                 80,813                                   84,279                                   87,410
Total assets      $ 1,215,548                              $ 1,204,965                              $ 1,125,363
Liabilities:
Interest-bearing
deposits:
Checking          $   324,171     $    852        0.26 %   $   322,715     $  1,271        0.39 %   $   294,660     $  1,883        0.64 %
Regular savings       110,210          243        0.22 %       105,768          350        0.33 %        96,725          683        0.71 %
Money market
savings                75,899          171        0.23 %        64,517          204        0.32 %        59,356          353        0.59 %
Time deposits:
$100,000 and over     139,018        1,671        1.20 %       143,687        2,200        1.53 %       136,526        2,419        1.77 %
Under $100,000        140,230        1,974        1.41 %       165,703        2,891        1.74 %       172,815        3,529        2.04 %
Total
interest-bearing
deposits          $   789,528     $  4,911        0.62 %   $   802,390     $  6,916        0.86 %   $   760,082     $  8,867        1.17 %
Short-term
borrowings              3,565          123        3.45 %         8,725          392        4.49 %         9,555          318        3.33 %
Securities sold
under agreements
to repurchase          35,536          325        0.91 %        34,177          332        0.97 %        33,162          293        0.88 %
FHLB borrowings
and subordinated
debt                   86,767        1,208        1.39 %        83,654        1,184        1.42 %        81,300        1,213        1.49 %
Federal funds
purchased                   -            -           -               -            -           -              42            -           -
Total
interest-bearing
liabilities       $   915,396     $  6,567        0.72 %   $   928,947     $  8,824        0.95 %   $   884,141     $ 10,691        1.21 %
Non-interest
bearing
liabilities
Demand deposits       175,942                                  156,057                                  130,565
Other liabilities       7,356                                    6,503                                    6,628
Total liabilities $ 1,098,694                              $ 1,091,507                              $ 1,021,334
Non-controlling
interest in
consolidated
Subsidiary              2,824                                    2,828                                    2,241
Shareholders'
equity                114,030                                  110,630                                  101,788
Total liabilities
and Shareholders'
equity            $ 1,215,548                              $ 1,204,965                              $ 1,125,363
Net interest
income (1)                        $ 39,033                                 $ 39,441                                 $ 39,162
Interest rate
spread                                            3.25 %                                   3.30 %                                   3.53 %
Interest expense
as a percent of
average earning
assets                                            0.57 %                                   0.78 %                                   1.02 %
Net interest
margin                                            3.40 %                                   3.47 %                                   3.72 %

(1) Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%.

(2) All yields and rates have been annualized on a 365 day year for 2013 and 2011 and a 366 day year for 2012.

(3) Total average loans include loans on non-accrual status.


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Net Interest Income

Net interest income represents the principal source of earnings of the Company. Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets. Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income was $37.7 million for the year ended December 31, 2013. This is a decrease of 1.3% and 0.63% over net interest income of $38.2 million and $37.9 million reported for 2012 and 2011, respectively. The net interest margin of 3.40% for 2013 decreased 7 basis points compared to 3.47% for 2012 and decreased 32 basis points compared to 3.72% for 2011. The net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. The tax rate utilized in calculating the tax benefit for each of the reported periods is 34%. The reconciliation of tax equivalent net interest income, which is not a measurement under accounting principles generally accepted in the United States, to net interest income is reflected in the table below.

                                                       For the Year Ended December 31,
(Dollars in thousands)                                2013            2012           2011
GAAP measures:
Interest Income - Loans                          $     35,248     $   37,895     $   39,392
Interest Income - Investments & Other                   9,024          9,128          9,244
Interest Expense - Deposits                             4,911          6,916          8,867
Interest Expense - Other Borrowings                     1,656          1,908          1,824
Total Net Interest Income                        $     37,705     $   38,199     $   37,945
Plus:
Non-GAAP measures:
Tax Benefit Realized on:
Non-taxable interest income - municipal
securities                                       $      1,315     $    1,239     $    1,217
Non-taxable interest income - loans                        13              3              -
Total Tax Benefit Realized on Non-Taxable
Interest Income                                  $      1,328     $    1,242     $    1,217
Total Tax Equivalent Net Interest Income         $     39,033     $   39,441     $   39,162

The decrease in net interest income for 2013 compared to 2012 and 2011 primarily resulted from lower interest income as a result of declining yields on loans and securities. This decrease was partially offset by a reduction in funding costs. Interest income and fees from loans and investments decreased 5.9% and 9.0% compared to 2012 and 2011, respectively. The cost of interest bearing liabilities in 2013 decreased to 0.72%, a decline of 23 basis points and 49 basis points relative to 2012 and 2011, respectively.

The yield on the loan portfolio decreased 35 basis points for 2013 to 4.66% compared to 5.01% for 2012 and decreased 81 basis points compared to 5.47% for 2011 as a result of lower yields on newly originated loans as well as a reduction in rates for existing loans that the Company refinanced. On average, the loan portfolio increased $667,000 or 0.09% from the year ended December 31, 2012 and increased $36.0 million or 5.0% compared to 2011. Interest income from loans, on a tax-equivalent basis, decreased $2.6 million or 7.0% from the year ended December 31, 2012 and decreased $4.1 million or 10.5% compared to 2011. The average balance in the securities portfolio increased $10.0 million and $47.0 million compared to 2012 and 2011, respectively. The tax-equivalent yield on the securities was 3.04% at December 31, 2013, a decrease of 11 basis points and 55 basis points compared to 2012 and 2011, respectively.

The average balance of interest bearing deposit accounts (interest bearing checking, savings and money market accounts) increased to $510.3 million at December 31, 2013, from $493.0 million at December 31, 2012 and $450.7 million at December 31, 2011. These increases were the result of strong growth in both business and retail deposit accounts. The average balances in total time deposits decreased $30.1 million compared to 2012 and decreased $30.1 million compared to 2011. The cost of total interest bearing deposits decreased 24 basis points compared to 2012 and decreased 55 basis points compared to 2011. The decline in the cost of total interest bearing deposits is the result of reductions in rates for retail deposits during 2013.

During 2013, the Company decreased its average short-term borrowings by $5.2 million from the year ended December 31, 2012 and $6.0 million from the year ended 2011. The Company increased its average FHLB borrowings by $3.1 million compared to the year ended December 31, 2012 and increased $5.5 million compared to 2011. Total interest expense for 2013 was $6.6 million, a decrease of $2.3 million and $4.1 million compared to 2012 and 2011, respectively. The cost of interest-bearing liabilities decreased 23 basis points from the year ended December 31, 2012, and decreased 49 basis points from 2011 primarily due to


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reductions in rates for retail deposits as well as a reduction in wholesale borrowings, including brokered certificates of deposit that matured or were called by the Company in 2013.

Management believes that the net interest margin could be relatively unchanged during 2014. Based on conservative internal interest rate risk models and the assumption of a sustained low rate environment, the Company expects net interest income to trend downward slightly throughout the next 12 months as loan related assets reprice and the decline in funding costs slows. It is anticipated that targeted growth in earning assets and liability repricing opportunities will help mitigate the impact to the Company's net interest margin. The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.

The following table analyzes changes in net interest income attributable to . . .

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