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MCBK > SEC Filings for MCBK > Form 10-K on 28-Mar-2014All Recent SEC Filings

Show all filings for MADISON COUNTY FINANCIAL, INC.

Form 10-K for MADISON COUNTY FINANCIAL, INC.


28-Mar-2014

Annual Report


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

This section is intended to help potential investors understand the financial performance of Madison County Financial, Inc. and its subsidiaries through a discussion of the factors affecting our financial condition at December 31, 2013 and December 31, 2012 and our results of operations for the years ended December 31, 2013 and 2012. This section should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this Annual Report.

Overview

We have operated continuously in and around Madison, Nebraska, which is located in northeastern Nebraska, since our founding in 1888. Our principal business consists of attracting retail deposits from the general public in our market area and investing those deposits, together with funds generated from operations, and to a lesser extent borrowings, in agricultural real estate loans, one- to four-family residential real estate loans, agricultural and commercial non-real estate loans and commercial and multi-family real estate loans. To a much lesser extent, we also originate consumer loans, including automobile loans. We also purchase investment securities consisting primarily of securities issued by the United States Treasury, United States Government agencies, and Government-sponsored enterprises, and municipal securities issued by counties, cities, school districts and other political subdivisions in Nebraska and South Dakota. At December 31, 2013, we had total assets of $290.1 million, total deposits of $205.7 million and total stockholders' equity of $61.4 million.

Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets and the interest we pay on our interest-bearing liabilities. Our results of operations also are affected by our provisions for loan losses, non-interest income and non-interest expense. Non-interest income currently consists primarily of insurance commission income obtained from our insurance agency subsidiary, service charges on deposit accounts, ATM and debit card fees, loan service charges and loan servicing income, gain on sales of securities and loans, income from bank-owned life insurance and miscellaneous other income. Non-interest expense currently consists primarily of compensation and employee benefits, directors' fees and benefits, office occupancy, data processing, FDIC insurance premiums, advertising and supplies, core deposit intangible amortization, professional fees, and other operating expenses.

Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities. Specifically, our operations are significantly affected by the profitability of farming in our market area, the primary commodity of which is corn, and to a lesser extent, soybeans and livestock, including beef and pork production. The profitability of many of our agricultural borrowers is dependent, in part, on factors outside their control, including the price of commodities, adverse weather conditions that prevent the planting and/or harvesting of a crop or that limit crop yields, loss of livestock due to disease or other factors, declines in market prices for agricultural products (both domestically and internationally), crop production expenses (primarily fertilizer, fuel, seed and chemicals) and the impact of government regulations (including changes in price supports, subsidies and environmental regulations).

Although our emphasis on agricultural lending, both real estate and non-real estate based, presents specific risks to our results of operations, we believe that we mitigate these risks through our conservative underwriting standards and our understanding of the farming economy in our market area. Additionally, we believe that our overall loan portfolio, 58.3% of which consisted of variable-rate loans at December 31, 2013, reduces our vulnerability to changes in interest rates and improves our net interest rate spread. To reduce further our interest rate risk, in recent years and in the low interest rate environment, we have generally sold all of our conforming fixed-rate, one- to four-family residential real estate loans that we originate with terms of greater than 15 years.

Critical Accounting Policies

We consider accounting policies that require management to exercise significant judgment or discretion or make significant assumptions that have, or could have, a material impact on the carrying value of certain assets or on income, to be critical accounting policies.

The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for qualifying public companies. As an "emerging growth company" we may delay adoption of new or revised accounting pronouncements applicable to public companies until such pronouncements are made applicable to private companies. We intend to choose to take advantage of the benefits of this extended transition period. Accordingly, our financial statements may not be comparable to companies that comply with such new or revised accounting standards.

We consider the following to be our critical accounting policies:

Allowance for Loan Losses. Our allowance for loan losses is the estimated amount considered necessary to reflect probable incurred credit losses in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged against income. In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of the most critical for Madison County Financial, Inc. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management due to the high degree of judgment involved, the subjectivity of the assumptions utilized and the potential for changes in the economic environment that could result in changes to the amount of the recorded allowance for loan losses.

Since a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans and discounted cash flow valuations of properties are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisals and discounted cash flow valuations are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly impact the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals and discounted cash flow valuations are carefully reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.

Management performs a quarterly evaluation of the allowance for loan losses. Consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the value of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision based on changes in economic and real estate market conditions.

The analysis of the allowance for loan losses has two components: specific and general allocations. Specific allocations are made for loans that are determined to be impaired. Impairment loss is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. The general allocation is determined by segregating classified loans from the remaining loans, and then categorizing each group by type of loan. Loans within each type exhibit common characteristics including terms, collateral type, and other risk characteristics. We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general allocations.

Goodwill and Other Intangible Assets. In 2005, we acquired First Capital Investment Company, Inc. and its subsidiary financial institution, First National Bank of Albion, under the purchase method of accounting in effect at the time. Under the purchase method, we were required to allocate the cost of an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. The excess cost over the net assets acquired represents goodwill, which is not subject to periodic amortization. At December 31, 2013, we had recorded $481,000 of goodwill.

Customer relationship intangibles are required to be amortized over their estimated useful lives. The method of amortization reflects the pattern in which the economic benefits of these intangible assets are estimated to be consumed or otherwise used up. Our customer relationship intangibles are being amortized over 15 years using the double declining balance method. Since our acquired customer relationships are subject to routine customer attrition, the relationships are more likely to produce greater benefits in the near-term than in the long-term, which typically supports the use of an accelerated method of amortization for the related intangible assets. Management is required to evaluate the useful life of customer relationship intangibles to determine if events or circumstances warrant a change in the estimated life. Should management determine the estimated life of any intangible asset is shorter than originally estimated, we would adjust the amortization of that asset, which could increase future amortization expense. At December 31, 2013, we had recorded $654,000 of core deposit intangible.

Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Goodwill recorded by us in connection with our acquisition relates to the inherent value in the businesses acquired and this value is dependent upon our ability to provide quality, cost effective services in a competitive marketplace. In the event that the operations of Madison County Bank lack profitability, an impairment of goodwill may need to be recognized. Any impairment recognized would adversely impact earnings in the period in which it is recognized.

Goodwill is tested annually for impairment. If the implied fair value of goodwill is lower than its carrying value, a goodwill impairment is indicated and the goodwill is written down to its implied fair value. Subsequent increases in goodwill are not recognized in the financial statements. At our annual impairment assessment date of December 31, 2013, our analysis indicated that no impairment existed.

Future events, such as adverse changes in our business or changes in the economic market, could cause management to conclude that impairment indicators exist and require management to re-evaluate goodwill. Should such re-evaluation determine goodwill is impaired, the resulting impairment loss recognized could have a material, adverse impact on our financial condition and results of operations.

Comparison of Financial Condition at December 31, 2013 and December 31, 2012

Total assets increased $22.8 million, or 8.5%, to $290.1 million at December 31, 2013, from $267.3 million at December 31, 2012. The increase was primarily the result of increases in investment securities classified as available for sale, investment securities classified as held to maturity and net loans receivable, offset in part by a decrease in cash and cash equivalents, certificates of deposit and investment in Federal Home Loan Bank stock.

Net loans increased $17.1 million, or 8.3%, to $224.3 million at December 31, 2013, from $207.2 million at December 31, 2012. The increase in our loan portfolio during 2013 resulted from a $13.9 million increase in agricultural real estate loans, to $110.5 million from $96.6 million, a $2.3 million increase in our one- to four-family residential mortgages, to $38.3 million from $36.0 million and a $4.1 million increase in our agricultural and commercial non-real estate loans to $57.7 million from $53.6 million, offset by a $1.5 million decrease in our commercial and multi-family real estate loans to $19.7 million from $21.2 million. The increase in agricultural real estate loans reflects purchase activity by our current agricultural loan customers and the addition of new agricultural real estate customers. The increase in one- to four-family residential real estate loans reflects a higher demand for housing in our market area combined with the decline in competition for these loans from community banks reflecting increased compliance changes. The increase in agricultural and commercial non-real estate loans resulted from the steady demand for these types of loans in our market area in the current low interest rate environment combined with increasing commodities input prices (fertilizer, seed, fuel and chemicals). The decrease in commercial and multi-family real estate loans resulted from a $1.7 million paydown on our largest commercial real estate loan.

Investment securities classified as held to maturity increased $9.1 million, or 36.4%, to $34.1 million at December 31, 2013, from $25.0 million at December 31, 2012. Investment securities classified as available for sale increased $737,000, or 8.2%, to $9.7 million at December 31, 2013, from $9.0 million at December 31, 2012. These increases resulted from the investment of the stock offering proceeds, as evidenced by a decrease in cash and cash equivalents of $3.8 million, or 48.0%, to $4.1 million at December 31, 2013, from $7.9 million at December 31, 2012.

Accrued interest receivable on investment securities, certificates of deposit owned and loans remained relatively unchanged, with a decrease of $38,000, or 1.0%, from $3.8 million at December 31, 2012, to $3.8 million at December 31, 2013.

Other assets, consisting primarily of prepaid assets and deferred federal taxes, increased $705,000, or 29.0%, to $3.1 million at December 31, 2013, from $2.4 million at December 31, 2012, primarily attributable to an increase in deferred taxes.

Deposits increased $10.5 million, or 5.4%, to $205.7 million at December 31, 2013, from $195.2 million at December 31, 2012, as we experienced an increase in each category of our core deposits. Specifically, interest-bearing checking, noninterest-bearing checking, and money market savings accounts increased $5.2 million, or 4.8%, $2.8 million, or 16.1%, and $4.5 million, or 11.0%, respectively, at December 31, 2013, from December 31, 2012. We believe the increase in our core deposits resulted from our continued efforts to build relationships with our existing customers as well as our marketing efforts with new customers. Certificates and time deposits decreased $1.9 million, or 6.8%, at December 31, 2013, from December 31, 2012, reflecting customer preference for more liquid transaction accounts rather than longer term deposits.

We borrow periodically from the Federal Home Loan Bank of Topeka ("FHLB-Topeka") and the Federal Reserve Bank of Kansas City ("FRB-Kansas City"), and, as needed, to a lesser extent from the Bankers' Bank of the West. Our borrowings increased $13.7 million, or 217.5%, to $20.0 million at December 31, 2013, from $6.3 million at December 31, 2012, resulting from a $700,000 increase in advances and a $13.0 million increase in short-term advances. We continue to utilize borrowings as an alternative funding source, and our borrowings from the FHLB-Topeka generally consist of advances with laddered terms of up to 10 years and our borrowings from the FRB-Kansas City are short-term borrowings under our Line of Credit.

Total stockholders' equity decreased $672,000, or 1.1%, to $61.4 million at December 31, 2013, from $62.1 million at December 31, 2012. The decrease resulted primarily from the stock repurchase of 157,210 shares for a total of $2.7 million and an annual cash dividend of $0.28 per share, for an aggregate of $826,000, that was declared and paid during 2013, offset by net income of $3.0 million for the year ended December 31, 2013.

Comparison of Operating Results for the Years Ended December 31, 2013 and 2012

General. Net income decreased to $3.0 million for the year ended December 31, 2013, from $3.6 million for the year ended December 31, 2012. The decrease resulted primarily from decreases in interest income and noninterest income, and increases in provision for loan losses and noninterest expense, offset by decreases in interest expense and income tax expense.

Interest and Dividend Income. Interest and dividend income decreased $75,000, or 0.6%, to $11.7 million for 2013 from $11.7 million for 2012. The decrease reflected a 79 basis point decrease in the average yield on interest-earning assets to 4.35% in 2013 from 5.14% in 2012, offset by a $40.1 million increase in average interest-earning assets to $268.4 million for 2013 compared to $228.3 million for 2012.

Interest income on non-taxable investment securities increased $233,000, or 35.0%, to $898,000 for 2013 from $665,000 for 2012, reflecting an increase in the average balance of such securities to $27.6 million during 2013 from $17.6 million in 2012, offset in part by a decrease in the average yield on such securities to 3.26% in 2013 from 3.79% in 2012. Interest income and fees on loans decreased $293,000, or 2.7%, for 2013 resulting from a 62 basis point decrease in the average yield on loans to 5.01% during 2013 from 5.63% in 2012, reflecting lower market interest rates, offset by an increase in the average loans outstanding to $207.5 million during 2013, from $189.6 million during 2012.

Interest Expense. Interest expense decreased $133,000, or 7.2%, to $1.7 million in 2013 from $1.9 million in 2012. The decrease reflected a 15 basis point decrease in the average rate paid on interest-bearing deposits and borrowings to 0.87% in 2013 from 1.02% in 2012, offset by a $15.4 million increase in the average balance of interest-bearing deposits and borrowings to $197.5 million in 2013 from $182.1 million in 2012.

Interest expense on interest-bearing deposits decreased $125,000, or 7.7%, to $1.5 million for 2013 from $1.6 million for 2012 as the average rate paid on these deposits decreased to 0.79% during 2013 from 0.93% during 2012, offset in part by a $15.9 million increase in the average balance of these deposits to $190.6 million for 2013 from $174.7 million for 2012. Interest expense from borrowings decreased $8,000, or 3.5%, to $218,000 during 2013 from $226,000 during 2012, reflecting a decrease in the average balance of borrowings in 2013 to $6.9 million during 2013 from $7.5 million during 2012, offset by higher rates paid on such borrowings to 3.15% from 3.02% year to year.

Net Interest Income. Net interest income increased $58,000, or 0.6%, to $9.9 million for 2013 from $9.9 million for 2012. The increase in our net interest income resulted from a $24.7 million increase in our average net interest-earning assets to $70.9 million in 2013 from $46.2 million in 2012, which was offset in part by a 64 basis point decrease in our net interest rate spread to 3.48% for 2013 from 4.12% for 2012, and a corresponding 62 basis point decrease in our net interest margin to 3.71% for 2013 from 4.33% for 2012. The increase in our average net interest earning assets resulted primarily from the additional capital raised in the conversion stock offering and earnings which were reinvested in loans and investment securities. The ratio of our average interest-earning assets to average interest-bearing liabilities increased to 135.9% for 2013 from 125.3% for 2012. The decreases in our net interest rate spread and net interest margin reflected the 79 basis point decrease in the average yield on our interest-earning assets which was only partially offset by a 15 basis point decrease in the average cost of our interest-bearing liabilities.

Provision for Loan Losses. Based on our analysis of the factors described in "Critical Accounting Policies-Allowance for Loan Losses," we recorded a provision for loan losses of $1.3 million for 2013, an increase of $420,000, or 50.6%, from the provision of $830,000 for 2012. The increase in our provision resulted from the $17.1 million, or 8.3% increase in net loans, along with various factors which necessitate upward adjustments in the allowance for loan losses. A major reason for the upward adjustment throughout 2013 was management's determination that a possible asset bubble in agricultural real estate may be forming due to the continued increase in the farmland prices at a double-digit rate over the past several years and the corresponding decline noted in 2013 in gross operating income on most farming operations. There are no longer any ethanol subsidies paid by the Federal Government. Furthermore, in October, 2013 the Environmental Protection Agency issued a proposed rule reducing the federal government ethanol blending mandate, which proposal, if enacted would substantially decrease the volume of ethanol required to be blended in the nation's fuel supply and would have a negative effect on the demand for #2 Yellow Corn, our market area's most important agricultural commodity. This would, in turn, have a negative effect on the market price of corn, which would reduce our farm customers' farming income and their ability to pay loans owed to us which could in turn result in loss to Madison County Bank and increase the likelihood of Chapter 12 Bankruptcy treatment relating to loans owed to us. Moreover, the Agricultural Act of 2014 was signed into law on February 7, 2014 and the most significant change to farm programs in this Act is the elimination of a subsidy known as "direct payments." These payments, about $5 billion a year, were paid to farmers as a supplement to farm income to ensure safe, affordable and abundant food for the nation's people. The elimination of these direct payments is a major event in the evolution of Federal farm programs and increases the likelihood of reduced farm income for our customers, which would reduce their ability to pay loans to us, which could in turn result in loss to Madison County Bank and increase the likelihood of Chapter 12 Bankruptcy treatment relating to the loans owed to us. While the adoption of this Act was not completed by the end of our fiscal year, the elimination of "direct payments" was widely anticipated for several weeks in advance of its enactment and their elimination was taken into account by the company's management as part of the methodology for estimating allowances.

The provision for loan losses for the year ended December 31, 2013, reflected net charge-offs of $20,000, compared to net recoveries of $94,000 for the year ended December 31, 2012. The allowance for loan losses was $6.2 million, or 2.7% of total loans, at December 31, 2013, compared to $4.9 million, or 2.3% of total loans, at December 31, 2012. Total nonperforming loans were $402,000 at December 31, 2013 compared to $293,000 at December 31, 2012. As a percentage of nonperforming loans, the allowance for loan losses was 1535.1% at December 31, 2013, compared to 1692.1% at December 31, 2012.

Other Income. Other income decreased $120,000, or 6.1%, to $1.9 million for 2013 from $2.0 million for 2012. The decrease in other income was due primarily to a $230,000 decrease in gains on sales of mortgage loans to $548,000 for 2013 from $778,000 for 2012, reflecting a decline in the volume of loans sold, period to period, offset by a $33,000 increase in service charges on deposit accounts, a $55,000 increase in loan servicing income, and a $41,000 increase in insurance commission income derived from our insurance agency subsidiary. The increase in loan servicing income reflects the steady growth in the portfolio of serviced loans.

Other Expense. Other expense increased $507,000, or 8.5%, to $6.5 million for 2013, from $6.0 million for 2012. The increase was due primarily to a $48,000 increase in salaries and employees benefits, a $163,000 increase in director fees and benefits and a $195,000 increase in professional fees, offset in part by a $24,000 decrease in core deposit intangible amortization. Salaries and employee benefits and director fees and benefits increased due to an increase in ESOP-related expense, and other normal annual salary increases and payouts under our benefits plans. Professional fees increased as a result of additional expenses associated with being a public company.

Income Tax Expense. The provision for income taxes was $1.1 million for 2013 compared to $1.4 million for 2012, reflecting a decrease in pretax income. Our effective tax rate was 26.1% for 2013 compared to 28.4% for 2012. This difference resulted primarily from the levels of tax-exempt income derived from our municipal bond investment portfolio and from bank-owned life insurance.

Analysis of Net Interest Income

Net interest income represents the difference between the income we earn on interest-earning assets and the interest expense we pay on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them. The following tables set forth average balance sheets, average yields and costs, and certain other information at or for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the tables as loans carrying a zero yield. No tax equivalent yield adjustments have been made. The yields set forth below include the effect of loan fees, discounts and premiums that are amortized or accreted to interest income.

                                                                                      For the Years Ended December 31,
                                              2013                                                  2012                                                  2011
                            Average                                               Average                                               Average
                          Outstanding                                           Outstanding                                           Outstanding
                            Balance          Interest        Yield/ Rate          Balance          Interest        Yield/ Rate          Balance          Interest        Yield/ Rate

Interest-earning
assets:
Loans                   $       207,532     $    10,390              5.01 %   $       189,594     $    10,683              5.63 %   $       185,521     $    10,821              5.83 %
Securities - taxable             12,227             316              2.58              12,137             342              2.82              12,453             343              2.75
Securities -
non-taxable                      27,582             898              3.26              17,561             665              3.79              10,895             449              4.12
Other
interest-earning
assets                           19,144              34              0.18               6,970              14              0.20                  64               2              3.13
Federal Home Loan
Bank of Topeka stock              1,920              30              1.56               2,050              39              1.90               1,824              42              2.30
Total
interest-earning
assets                          268,405          11,668              4.35             228,312          11,743              5.14             210,757          11,657              5.53
Non-interest-earning
assets                           11,474                                                12,594                                                12,102
Total assets            $       279,879                                       $       240,906                                       $       222,859

Interest-bearing
liabilities:
. . .
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