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TOFC > SEC Filings for TOFC > Form 10-K on 31-Mar-2014All Recent SEC Filings

Show all filings for TOWER FINANCIAL CORP

Form 10-K for TOWER FINANCIAL CORP


31-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION.

Introduction

The following discussion presents management's discussion and analysis of the consolidated financial condition and results of operations of the Company as of December 31, 2013 and 2012 and for the years ended December 31, 2013, 2012 and 2011. This discussion should be read in conjunction with our audited consolidated financial statements and the related notes appearing elsewhere in this report.

Overview

Net income was $8.1 million in 2013 compared to net income of $5.7 million in 2012. The increase of $2.4 million, or 41.2%, was primarily the result of a $4.5 million change in our loan loss provision. In 2013, we recorded a loan loss provision credit (income) of $2.0 million, while in 2012 we recorded a loan loss provision expense of $2.5 million. This positive change in our loan loss provision helped offset a reduction in our net interest income of $1.5 million, due primarily to margin compression caused by lower interest rates.

Net interest income was $20.7 million for 2013, a decrease of 7.4% from 2012. Our average earning assets increased by $23.9 million in 2013. However, our yield on those assets dropped from 4.43% from 2012 to 3.94% in 2013. The low rate environment continues to impact the banking industry, as new loan and investment volume is being brought in at lower rates than the assets being paid off. The decrease in our earning asset yield was partially offset by a reduction in our cost of funds, which lowered interest expense by $971,000 in 2013.

Non-interest income increased by $1.7 million, or 20.5%, in 2013. This was primarily the result of an increase in gains on sales of investment securities of $1.2 million. The liquidation of some of our investment portfolio allowed us to realize some gains and improve our liquidity. Additionally, our Trust Company increased their revenues by $624,000, a 16.3% improvement from 2012.

Due to the improvement in our overall asset quality, as well as minimal growth in the loan portfolio, we were able to record a loan loss provision credit (income) of $2.0 million in 2013. This represents a $4.5 million change from the $2.5 million loan loss provision expense we recorded in 2012.

Non-interest expenses increased $611,860, or 2.9%, in 2013. The increase resulted primarily from the salaries and benefits, along with data processing and legal expenses. Salaries and benefits increased by $952,000 or 8.4%, of which $899,000, was related to our profit sharing incentive, which was higher than normal due to our improved financial results. Data processing increased by $216,000, or 15%, due to the increased volume in our deposit accounts, along with debit card processing expenses. Legal and professional expenses grew by $333,000, or 22.2%, which was primarily caused by $508,000 in legal and professional expenses related to our pending merger with Old National.

Income taxes for 2013 increased by $1.7 million, due to increased pre-tax income. Our effective tax rate increased to 29.1%, compared to 21.9% 2012. The increase was due primarily to increased profits from taxable assets, as the size of our tax exempt portfolio was relatively unchanged from 2012.

Total assets increased by $6.6 million, or 1%, at December 31, 2013. Cash and cash equivalents increased by $27.3 million, loans outstanding increased by $5.3 million, and bank-owned life insurance increased by $3.4 million. This growth was offset by a reduction in trading securities of $30.8 million, which allowed us to realize some gains and improve our liquidity.

Total deposits at December 31, 2013 were $598.4 million, an increase of 37.4 million. Interest-bearing checking accounts increased by $19.9 million, primarily due to an increase of $15.6 million in our health savings account product. Money market accounts increased by $9.8 million, and savings accounts increased by $3.9 million. This growth was offset by a reduction of $6.6 million in our in-market certificate of deposit accounts.

Total equity at December 31, 2013 decreased by $495,000, as a result of $8.1 million in net income offset by $2.6 million in cash dividends to our common stock shareholders, $862,000 of treasury stock repurchases, and a decrease of $5.4 million in the unrealized loss on our trading securities due to market fluctuations.


Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires that we make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions. Certain policies inherently have a greater reliance on the use of estimates, and as such have a greater possibility of producing results that could be materially different than originally reported. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Our critical accounting policies are limited to those described below. For a detailed discussion on the application of these and other accounting policies, see Note 1-Summary of Significant Accounting Policies to the audited consolidated financial statements included in this report.

Allowance for Loan Losses.

Our allowance for loan losses represents management's estimate of probable incurred losses inherent in the loan portfolio at the balance sheet date. Additions to the allowance may result from recording provision for loan losses and recoveries, while charge offs are deducted from the allowance. Allocation of the allowance is made for analytical purposes only, and the entire allowance is available to absorb any loan charged off.

We have an established process for determining the adequacy of the allowance for loan losses that relies on various procedures and pieces of information to arrive at a range of probable outcomes. No single statistic or measurement, in itself, determines the adequacy of the allowance. The allowance has two components: identified specific allocations and a percentage allocation based on loss history for different loan groups.

To determine the allocated component of the allowance, we combine estimated allowances required for specifically identified loans that are analyzed individually and loans that are analyzed on a group basis. First, management allocates specific portions of the allowance for loan losses based on identifiable problem loans. Problem loans are identified through a loan risk rating system and monitored through watch list reporting. The amount of impairment, or specific reserve, is calculated by using the present value of expected cash flows or the fair value of the underlying collateral less cost to sell as required by ASC310-10. Second, management's evaluation of the allowance for different loan groups is based on consideration of actual loss experience, the present and prospective financial condition of our borrowers, industry concentrations within the loan portfolio and general economic conditions. Lastly, the unallocated component of the allowance is maintained to supplement the allocated component and to recognize the imprecision of estimating and measuring loss when evaluating loss allocations for individual loans or pools of loans. The allocated and the unallocated components represent the total allowance for loan losses that under normal circumstances should adequately cover probable incurred losses inherent in the loan portfolio.

Actual loan losses are charged against the allowance when management believes that a loan or a portion thereof is uncollectible. A loan is impaired when full payment under the loan terms is not expected. Impairment is evaluated in the aggregate for smaller-balance loans of a similar nature such as residential mortgage and consumer loans, and on an individual loan basis for other loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When analysis of a borrower's operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, the loan is evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing interest rate or at the fair value of collateral if repayment is expected solely from the collateral.

There are many factors affecting judgment calls relating to allowances for loan losses. Some are quantitative while others require qualitative judgment. Although we believe our process for determining the allowance adequately considers all of the factors that could potentially result in credit losses, the process includes subjective elements and may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect earnings or financial position in future periods.


Results of Operations

Summary

Net income was $8.1 million, or $1.73 per diluted share for the year ended December 31, 2013. This represents the highest income in our history and an increase of $2.4 million from 2012. Our pre-tax earnings increased $4.1 million, or 55.4%. The primary driver of our record earnings was a loan loss provision credit (income) of $2.0 million in 2013, compared to a loan loss provision expense of $2.5 million in 2012, and gains on sales of securities of $1.3 million in 2013, compared to $149,000 in 2012. These increases were offset by a reduction in our net interest income of $1.5 million and an increase in noninterest expenses of $612,000.

Net Interest Income

Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. In 2013, our net interest income decreased by $1.5 million, or 7.4%, from 2012. This was primarily the result of a 31 basis point drop in our margin due to the competitive interest rate environment. Our net interest margin was 3.50% in 2013 compared to 3.81% in 2012 and 3.84% in 2011.

Our interest income for 2013 was $23.5 million, a decrease of $2.5 million from 2012. The yield on our earning assets was 3.94% compared to 4.43% in 2012 and 4.84% in 2011. Yields were lower in both our loan and investment categories. As older, higher yielding, loans and investments mature, they are being replaced by lower yielding loans and investments. Additionally, while our average earning assets increased by $23.9 million in 2013, the growth came entirely in our investment portfolio, which historically has lower yields than loans. Our average loans decreased by $18.9 million in 2013. Offsetting the reduction in interest income was a $971,000 decrease in interest expense as we strived to continue reducing our cost of funds. This reduction occurred by growing our low cost checking and savings accounts, and repositioning our brokered certificates of deposit with lower cost certificates. In 2013 our cost of funds was 0.55% compared to 0.80% in 2012 and 1.21% in 2011.

The level of net interest income is primarily a function of asset size, as the weighted-average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types of assets and liabilities, interest rate risk, liquidity, asset quality, and customer behavior also impact net interest income as well as the net yield.


The following table reflects the average balance, interest earned or paid, and yields or costs of our assets, liabilities and stockholders' equity during 2013, 2012, and 2011.

 Average Balance, Interest and Yield/Cost Analysis



                                       2013                                        2012                                        2011
                                     Interest                                    Interest                                    Interest
                       Average        Earned         Yield         Average        Earned         Yield         Average        Earned         Yield
($ in thousands)       Balance       or Paid        or Cost        Balance       or Paid        or Cost        Balance       or Paid        or Cost
Assets
Short-term
investments and
interest-earning
deposits              $   5,147     $       23           0.45 %   $   1,569     $       42           2.68 %   $   1,794     $       35           1.95 %
Federal funds sold          179              -           0.00 %       3,466              4           0.12 %       3,283              4           0.12 %
Securities -
taxable                  89,788          1,217           1.36 %      78,254          1,839           2.35 %      79,608          2,296           2.88 %
Securities - tax
exempt (1)               92,191          4,354           4.72 %      61,114          3,071           5.03 %      46,533          2,623           5.64 %
Loans held for sale       3,906              -           0.00 %       3,960              -           0.00 %       2,295              -           0.00 %
Loans                   442,702         19,362           4.37 %     461,609         22,064           4.78 %     481,933         24,828           5.15 %
Total
interest-earning
assets                  633,913         24,956           3.94 %     609,972         27,020           4.43 %     615,446         29,786           4.84 %

Allowance for loan
losses                   (7,700 )                                    (9,174 )                                   (11,868 )
Cash and due from
banks                    22,119                                      21,379                                      19,975
Other assets             39,782                                      40,144                                      39,751
Total assets          $ 688,114                                   $ 662,321                                   $ 663,304

Liabilities and
Stockholders'
Equity
Interest-bearing
checking              $ 181,596     $      132           0.07 %   $ 156,317     $      196           0.13 %   $ 112,283     $      156           0.14 %
Savings                  31,656             13           0.04 %      25,206             13           0.05 %      22,036             33           0.15 %
Money market            122,583            121           0.10 %     137,436            389           0.28 %     164,065            717           0.44 %
Certificates of
deposit                 141,521          2,104           1.49 %     122,273          2,560           2.09 %     176,176          4,185           2.38 %
Short-term
borrowings                    -              -           0.00 %          35              -           0.00 %          46              -           0.00 %
FHLB advances            13,451            109           0.81 %      14,636            161           1.10 %      15,987            231           1.44 %
Junior subordinated
debt                     17,527            320           1.83 %      17,527            451           2.57 %      17,527            817           4.66 %
Total
interest-bearing
liabilities             508,334          2,799           0.55 %     473,430          3,770           0.80 %     508,120          6,139           1.21 %
                              -                                           -                                           -
Noninterest-bearing
checking                111,272                                     116,724                                      93,532
Other liabilities         5,843                                       7,093                                       5,588
Stockholders'
equity                   62,665                                      65,074                                      56,064
Total liabilities
and stockholders'
equity                $ 688,114                                   $ 662,321                                   $ 663,304

Net interest income                 $   22,157                                  $   23,250                                  $   23,647
Rate spread                                              3.39 %                                      3.63 %                                      3.63 %
Net interest income
as a percent of
average earning
assets                                                   3.50 %                                      3.81 %                                      3.84 %

(1) Computed on a tax equivalent basis for tax equivalent securities using a 34% statutory tax rate.


The following table shows the changes in interest income, interest expense, and net interest income due to variances in rate and volume of average earning assets and interest-bearing liabilities. The change in interest not solely due to changes in rate or volume has been allocated in proportion to the absolute dollar amounts of the change in each.

Changes in Net Interest Income Due

To Rate and Volume

                                                             2013 over 2012
($ in thousands)                                  Rate           Volume           Total
Increase (decrease) in interest income:
Short-term investments and interest- earning
deposits                                       $       (23 )   $         -     $       (23 )
Federal funds sold                                       -               -               -
Securities - taxable                                  (746 )           124            (622 )
Securities - tax exempt                               (106 )         1,389           1,283
Loans                                               (1,619 )        (1,083 )        (2,702 )
Net change in interest income                       (2,494 )           430          (2,064 )
Increase (decrease) in interest expense:
Interest-bearing checking                              (83 )            17             (66 )
Savings                                                 (1 )             2               1
Money market                                          (213 )            (3 )          (216 )
Certificates of deposit                               (745 )           237            (508 )
Short-term borrowings                                    -               -               -
FHLB advances                                          (34 )           (18 )           (52 )
Trust preferred securities                            (131 )             -            (131 )
Net change in interest expense                      (1,207 )           235            (972 )
Net change in interest income and interest
expense                                        $    (1,287 )   $       195     $    (1,092 )




                                                             2012 over 2011
($ in thousands)                                  Rate           Volume           Total
Increase (decrease) in interest income:
Short-term investments and interest- earning
deposits                                       $        12     $        (5 )   $         7
Federal funds sold                                       -               -               -
Securities - taxable                                  (419 )           (38 )          (457 )
Securities - tax exempt                               (308 )           756             448
Loans                                               (1,745 )        (1,019 )        (2,764 )
Net change in interest income                       (2,460 )          (306 )        (2,766 )
Increase (decrease) in interest expense:
Interest-bearing checking                               13              27              40
Savings                                                (24 )             4             (20 )
Money market                                          (225 )          (103 )          (328 )
Certificates of deposit                               (454 )        (1,171 )        (1,625 )
Short-term borrowings                                    -               -               -
FHLB advances                                          (52 )           (18 )           (70 )
Trust preferred securities                            (366 )             -            (366 )
Net change in interest expense                      (1,108 )        (1,261 )        (2,369 )
Net change in interest income and interest
expense                                        $    (1,352 )   $       955     $      (397 )

Interest income is primarily generated from the loan portfolio. Average loans comprised 70%, 76%, and 78% of average earning assets during 2013, 2012, and 2011, respectively. During 2013, the loan portfolio had an average yield of 4.37%, and earned $19.4 million, or 82.5% of total interest income, a decrease of $2.7 million from 2012 and $5.5 million from 2011. Average loans were $442.7 million in 2013, a decrease of $18.9 million from 2012 and $39.2 million from 2011. This decrease in loans was offset by increases in long-term investments. Average investments were $182.0 million in 2013, compared to $139.4 million in 2012 and $126.1 in 2011. While the yield on the investment portfolio dropped to 3.06% in 2013, compared to 3.52% in 2012 and 3.90% in 2011, the increase in size of our portfolio provided for increased interest income of $226,000 compared to 2012 and $63,000 compared to 2011.


Interest expense is primarily generated from certificates of deposit, which equaled 27.8% of average interest-bearing liabilities during 2013, compared to 25.8% and 34.7% of average interest-bearing liabilities in 2012 and 2011, respectively. Total average borrowings were 6.1%, 6.8%, and 6.6% of average interest-bearing liabilities during 2013, 2012, and 2011, respectively.

Money market balances had an average rate of 0.10% and cost $122,583, or 4.32% of total interest expense, in 2013 compared to an average rate of 0.28% and cost $388,658, or 10.3% of total interest expense, in 2012. Certificates of deposit had an average rate of 1.49% and cost $2.1 million, or 75.2% of total interest expense in 2013, compared to an average rate of 2.09% and cost of $2.6 million, or 67.9% of total interest expense, in 2012. Interest expense on savings and interest-bearing checking totaled 4.72% of total interest expense at an average rate of 0.07% during 2013 and 5.2% of total interest expense at average rate of 0.13% during 2012. The Company paid $428,544 of interest expense on borrowings, or 15.3% of total interest expense, during 2013 and paid $612,489 of interest expense on borrowings, or 16.2% of total interest expense, during 2012.

In December 2010, $8.0 million of our Trust Preferred Debt Securities went to a floating rate of three-month LIBOR plus 1.34%. This provided for an average rate on this of 4.66% for the year ending December 31, 2011. In March 2012, the remaining $9.0 million of our Trust Preferred Debt Securities went to a floating rate of three-month LIBOR plus 1.69%, which lowered our costs from that funding type by $365,587, or 44.8%, from 2011 to 2012. This reduced the average rate on this funding from 4.66% for the year ending December 31, 2011 to 2.57% for the year ending December 31, 2012. Due to the continued low interest rate environment, our average rate on this debt in 2013 was 1.83%. This lowered our costs from this funding by $131,302 in 2013.

Provision for Loan Losses

In 2013 we recorded a loan loss provision credit (income) of $2.0 million, compared to loan loss provision expense of $2.5 million in 2012 and $4.2 million in 2011. The loan loss provision credit was the result of our improved asset quality over the past several years. This was accomplished through charging-down loans, selling loans, and working with customers to move these loans to other financial institutions. Additionally, we have had minimal deterioration in our existing loan portfolio. Our "watch list" loans decreased by $12.9 million during 2013, and are now only 5.69% of total loans. This decrease in poorly rated loans allowed us to reduce our loan loss reserve, which contributed to our provision credit for 2013.

We charged off $1.3 million in loan balances during 2013, compared to $3.9 million in 2012. Net recoveries (recoveries in excess of charge-offs) were $716,000 in 2013, compared to $307,000 in 2012.

We maintain the allowance for loan losses at a level management feels is adequate to absorb probable losses incurred in the loan portfolio. The evaluation is based upon our historical loan loss experience, along with the banking industry's historical loan loss experience, as well as known and inherent risks contained in the loan portfolio, composition and growth of the loan portfolio, current and projected economic conditions and other factors.

Noninterest Income

Total noninterest income was $10.3 million for the year ended December 31, 2013, compared to $8.5 million in 2012 and $8.2 million in 2011. The increase of $1.7 million from 2012 came primarily from increased trust and brokerage fees and gains on sales of securities. Trust and brokerage fees increased $624,000, or 16.3%, due to an increase in assets under management of $70.6 million from December 31, 2012. Trust assets under management were $538.3 million and brokerage assets under management were $204.5 million at December 31, 2013. At December 31, 2012, trust assets under management were $479.7 million and brokerage assets under management were $192.6 million. Gains on sales of securities were $1.3 million in 2013, compared to $149,000 in 2012 and $777,000 in 2011. The liquidation of a portion of our investment portfolio during the fourth quarter allowed us to realize some market gains. The proceeds were held in our cash and cash equivalents to boost our liquidity and allow us to selectively reduce borrowings and brokered certificates of deposit.

The increases in noninterest income were offset by a reduction in mortgage banking income of $403,000, or 37.5%. The reduction was primarily volume driven, as loan originations were $65.6 million in 2013 compared to $90.7 million in 2012. The decrease in origination volume was primarily due to the increase in long-term rates during the second half of the year, which slowed refinancing activity.


Noninterest Expense

Noninterest expense totaled $21.5 million in 2013, which was an increase of $611,860, or 2.9%, from 2012. The increase came primarily from three categories:
salaries and benefits, data processing, and legal and professional. Salaries and benefits increased by $1.2 million in 2013, of which $899,000, or 75%, related to our profit sharing plan. Our profit sharing expense was higher due to the 55.4% increase in our overall pre-tax net income for 2013. Additionally, salary expense increased by $191,000, or 2.5%, due primarily to annual increases awarded to our employees. Data processing expense increased by $216,000, or 15%, from 2012. The increase was the result of costs associated with our core processing system and debit cards due to the growth in deposit accounts. Legal and professional expenses increased by $333,000, or 22.2%, from 2012. The increase was due to $508,000 of costs incurred related to our pending merger with Old National Bank, which included $200,000 to our investment banking firm for a fairness opinion and $308,000 for legal fees. Notwithstanding our merger transaction, we experienced a reduction in legal and professional expenses . . .

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