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CBKW > SEC Filings for CBKW > Form 10-K on 30-Mar-2012All Recent SEC Filings

Show all filings for CHOICE BANCORP, INC.



Annual Report

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

The following discussion describes our consolidated results of operations for the year ended December 31, 2011, as compared to the Bank's results of operations for the year ended December 31, 2010 and also compares our consolidated financial condition as of December 31, 2011 to the Bank's financial condition at December 31, 2010. Since the consummation of the Reorganization, our sole asset is our investment in the Bank and our operations are conducted solely through the Bank. Accordingly, management believes the comparison of our financial information on a consolidated basis for dates and periods from and after the March 10, 2011 Reorganization with financial information for the Bank for dates and periods prior to the March 10, 2011 Reorganization are appropriate and meaningful.

Forward Looking Statements

Attention is called to the discussion under the caption "Forward-Looking Statements" appearing in Part I of this Report, immediately preceding Item 1. Business. The following discussion should be read in conjunction with the audited financial statements.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with GAAP and conform to general practices within the banking industry. Our significant accounting policies are described in the notes to the financial statements. Certain accounting policies require management to make significant estimates and assumptions, which have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions used are based on historical experience and other factors that management believes to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and results of operations for the reporting periods. We believe the following critical accounting policies require the most significant estimates and assumptions that are particularly susceptible to a significant change in the preparation of our financial statements.

Income Taxes

Deferred income taxes and liabilities are determined using the liability method.
Under this method deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the current enacted tax rates which will be in effect when these differences are expected to reverse. Provision (credit) for deferred taxes is the result of changes in the deferred tax assets and liabilities. A deferred tax valuation allowance is established if it is more likely than not that all or a portion of the deferred tax assets will not be realized.

We may also recognize a liability for unrecognized tax benefits from uncertain tax positions. Unrecognized tax benefits represent the differences between a tax position taken or expected to be taken in a tax return and the benefit recognized and measured in the financial statements. Interest and penalties related to unrecognized tax benefits are classified as income taxes.

Allowance for Loan and Lease Losses

Management considers the policies related to the Allowance critical to the financial statement presentation. The Allowance represents management's assessment of the risk associated with extending credit and its evaluation of the quality of the loan portfolio. Management's assessment of the adequacy of the Allowance is determined based on evaluation of individual loans as well as the general risk factors inherent to the extension of credit. At December 31, 2011 and 2010, our allowance was 2.60% and 2.17%, respectively, of our gross loan portfolio.

A provision for loan losses is charged to operations based on management's periodic evaluation of the factors previously mentioned, as well as other pertinent factors affecting the adequacy of the Allowance.

The following factors are considered in maintaining the Allowance:

? the asset quality of individual loans;

? changes in the national and local economy and business conditions/development, including underwriting standards, collections, charge off and recovery practices;

? changes in the nature and volume of the loan portfolio;

? changes in the experience, ability and depth of our lending staff and management;

? possible deterioration in collateral segments or other portfolio concentrations;

? changes in the quality of our loan review system and the degree of oversight by our board of directors;

? the effect of external factors such as competition and the legal and regulatory requirements on the level of estimated credit losses in our current loan portfolio; and

? off-balance sheet credit risks.

These factors are evaluated at least quarterly and changes in the asset quality of individual loans will be evaluated more frequently as needed. We establish minimum general reserves based on the asset quality of the loan. General reserve factors applied to each type of loan are based upon management's experience and common industry and regulatory guidelines. After a loan is underwritten and booked, loans are monitored or reviewed by the account officer, management, and external loan review personnel during the life of the loan.
Payment performance is monitored monthly for the entire loan portfolio. Account officers contact customers during the course of business and may be able to ascertain if weaknesses are developing with the borrower, external loan personnel perform an independent review annually, and federal and state banking regulators perform periodic reviews of the loan portfolio. If weaknesses develop in an individual loan relationship and are detected, the loan will be downgraded and higher reserves will be assigned based upon management's assessment of the weaknesses in the loan that may affect full collection of the debt. If a loan does not appear to be fully collectible as to principal and interest, the loan will be recorded as a non-accruing loan and further accrual of interest will be discontinued while previously accrued but uncollected interest is reversed against income. If a loan will not be collected in full, the Allowance is increased through a loan loss provision charged to earnings to reflect management's estimate of potential exposure of loss.

In 2011, the Bank charged off approximately $0.1 million related to two loans.
Management elected to provide regular loan loss provisions aggregating $1.2 million in 2011 to bolster our reserves to support loan growth in 2011. As of December 31, 2011, the Bank had four loans classified as non-accrual. Three of the loans, totaling $1.0 million, are secured by real estate. The remaining loan totaled $0.1 million and is secured primarily by inventory and equipment. Management has factored these loans into the Allowance reported as of December 31, 2011.

Management believes that resolution of these credits will be achieved without substantial additional impact to earnings. One of the loans listed as non-accrual totaling $0.8 million was classified as non-accruing based on the reporting requirements of our sale of real estate. In March 2011, we sold a property held as Other Real Estate Owned ("OREO") valued on our balance sheet at $850,000 for a total sales price of $1.2 million. We financed the sale under terms that defer recognition of the sale, including any gain, until sufficient loan payments are received under the installment method of accounting for sales of real estate. In addition, we are required to classify the loan as non-accruing until sufficient loan payments are received for conversion to full-accrual accounting. Management expects that the loan will convert to full-accrual status in the first quarter 2012, but there can be no assurance that it will be able to do so at that time, or ever.

Historical performance is not an indicator of future performance, particularly considering our very short operating history. Future results could differ materially. However, management believes, based upon known factors, management's judgment, and regulatory methodologies, that the current methodology used to determine the adequacy of our Allowance is reasonable.

The Allowance is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the Allowance and the size of the Allowance in comparison to a group of peer banks identified by the regulators. During their routine examinations of banks, regulatory agencies may require a bank to make additional provisions to its allowance for loan and lease losses when, in the opinion of the regulators, credit evaluations and methodology differ materially from those of management. While it is our policy to charge off in the

current period loans for which a loss is considered probable, there are additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans.


Our results of operations depend primarily on net interest income, which is the difference between interest earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. We also generate non-interest income, such as service charges, secondary market fees for mortgage loans, and other fees.
Non-interest expenses consist primarily of employee compensation and benefits, occupancy expenses, marketing expenses, data processing costs, and other operating expenses. We are subject to losses from our loan portfolio if borrowers fail to meet their obligations. Results of operations can also be significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory agencies.

The following discussion focuses on the major components of our operations.
This discussion should be read in conjunction with our financial statements and accompanying notes. Current performance may not be indicative of our future performance.

Strategic Plans and Initiatives

The Bank, in consultation with its banking regulators, is continuing its implementation of the following strategic plans and initiatives, among others:

1. The Bank will develop a written analysis and assessment of management and staffing needs to identify potential officer and staff positions needed to ensure that the Bank continues to operate in a safe and sound manner.

2. The Bank will formulate a written plan of action to lessen the Bank's risk position in each asset which is classified as "Substandard" by the Banking Regulators and which aggregated $200,000 or more. Such plan will include establishing dollar levels to which the Bank will strive to reduce each asset and the submission of monthly written progress reports to the Bank's board of directors for review.

3. Prior to submission of Reports of Condition and Income required by the FDIC, the board of directors of the Bank will review the adequacy of the Bank's allowance for loan and lease losses, provide an adequate allowance, and report such allowance.

4. The Bank will ensure ongoing compliance with the FFIEC Advisory on Interest Rate Risk Management issued on January 6, 2010.

5. The Bank will ensure ongoing compliance with the Interagency Statement Policy on Funding and Liquidity Risk Management, issued March 22, 2010.

6. The Bank will take steps to reduce certain concentrations of credit within its portfolio.

7. The Bank will insure that all watch list credits and "Troubled Debt Restructures" are properly reported to the board of directors.

8. The Bank will develop a written plan to address goals and strategies for improving and sustaining earnings. Such plan will address conservative growth initiatives and be consistent with the Bank's loan, investment, and funds management policies. It will include, among other things, areas of potential operational improvement, realistic and comprehensive budgets, a budget review process, a description of operating assumptions, and a periodic salary review for staff.

9. The Bank will strive to maintain a Tier 1 Leverage Capital ratio at a level equal to or exceeding 9% of the Bank's total assets and a Total Risk-Based Capital ratio level equal to or exceeding 12% of the Bank's total assets.


Comparisons of Operating Results for the periods ended December 31, 2011 and 2010

We reported net income of $3.2 million for the year ended December 31, 2011, an increase of $8.3 million compared to a net loss of $5.1 million in 2010. Both basic and diluted income per share were $1.50 for 2011 compared to loss per share of $2.35 for 2010. Return on average assets and return on average equity for 2011 were 1.93% and 24.27% respectively, compared to -3.53% and -28.82%, respectively, for 2010.

We experienced improved operating results during 2011 primarily due to improved asset quality that resulted in less provision for loan loss expense relative to 2010. A stable loan portfolio and reduction in problem assets resulted in a $1.4 million decrease in our provision for loan losses and a $1.4 million decrease in loss on valuation of other assets for 2011 relative to 2010. The annual provision for loan losses was $1.2 million in 2011 compared to $2.6 million for 2010. We incurred a $0.1 million charge to income for the devaluation of other assets in 2011 compared to a $1.5 million valuation loss during 2010.

Comparable net income for 2011 and 2010 was significantly impacted by the accounting for income taxes related to our deferred tax asset. Approximately $4.0 million of the increase in net income for 2011 relative to 2010 is attributed to the impact of income tax expense. Income tax expense of $2.8 million was recognized in 2010 for the establishment of a full valuation allowance on our deferred tax asset. An income tax credit of $1.2 million was recognized in 2011 for a partial reversal of the valuation allowance based on an impairment evaluation as of December 31, 2011.

Net interest income for 2011 was $7.0 million compared to $4.9 million during 2010. The $2.1 million or 43.1% increase in net interest income relative to 2010 is attributed to the combination of growth in earning assets and the increase in net interest spread during 2011. Our average net interest spread and average net interest margin improved by 59 basis points and 56 basis points, respectively, from the average ratios reported for 2010.

Noninterest revenues for 2011 declined $0.5 million or 50.0% from 2010 due primarily to a decrease in rental income, as well as a decline in mortgage financing fees.

Noninterest expense for 2011 decreased $1.3 million or 23.5% from 2010 due primarily to the above noted $1.4 million decrease in expense for devaluation of other assets.

Total assets were $175.1 million at December 31, 2011 compared to $163.7 million at December 31, 2010. Included in total asset growth was an increase of $18.4 million in net loans offset by a $7.1 million decrease in cash and cash equivalents compared to year-end 2010. Deposit growth totaled $7.4 million for 2011 and represented primarily an increase in term deposits.

As of December 31, 2011, nonperforming loans were $1.1 million representing 0.71% of total loans. Nonperforming loans at December 31, 2011 include a $0.9 million loan that is classified as non-accrual

based on the accounting for the financing of a purchase of bank-owned property.
The ratio of nonperforming loans to total loans is 0.18% when this loan is excluded. As of December 31, 2010, nonperforming loans were $0.3 million representing 0.19% of total loans.

As of December 31, 2011, OREO was $1.0 million representing 0.58% of total assets. OREO was $1.9 million representing 1.16% of total assets at December 31, 2010. OREO decreased $0.9 million during 2011.

The allowance for loan loss was $4.1 million, or 2.60% of total loans, at December 31, 2011 compared to an allowance of $3.0 million, or 2.17% of total loans, at December 31, 2010.

Our capital position remains strong with an 11.33% Tier I risk-based capital ratio for 2011. Our capital position, when combined with the Allowance, provides ample cushion in the event of potential loan charge-offs.

Basic ratios measuring performance for the years ended December 31, 2011 and 2010, respectively, are shown below:

                                                2011     2010

                    Return on average assets    1.93%    -3.53%

                    Return on average equity   24.27%   -28.82%

                    Earnings per share          $1.50    -$2.35

Net interest income

Net interest income is the difference between the income earned on assets and interest paid on deposits and borrowings used to support such assets. Net interest income is determined by the yields earned on our interest-earning assets and the rates paid on our interest-bearing liabilities, the relative amounts of interest-earning assets and interest-bearing liabilities, and the degree of mismatch and the maturity and repricing characteristics of our interest-earning assets and interest-bearing liabilities. Net interest income divided by average interest-earning assets represents our net interest margin.
Competition for loans and deposits has a direct effect on net interest margin.

The following table represents the average volume of interest-earning assets, interest-bearing liabilities, average yields and rates for the years ended December 31, 2011 and 2010:

                                                2011                                     2010                                      2009
(In thousands)                   Average      Income/      Annualized     Average      Income/      Annualized     Average      Income/        Annualized
                                 Balance      Expense      Yield/Cost     Balance      Expense      Yield/Cost     Balance      Expense        Yield/Cost
Interest-earning assets:
Investment securities (1)        $   9,950    $     327         3.29%     $   8,800    $     322         3.66%     $   6,398    $     299           4.68%
Federal funds sold                   2,428            3         0.14%         4,047            6         0.14%         1,292            2           0.15%
Loans (2)                          153,745        8,899         5.79%       121,231        6,943         5.73%       107,932        5,933           5.50%
Total earning assets             $ 166,123    $   9,229         5.56%     $ 134,078    $   7,271         5.42%     $ 115,622    $   6,234           5.39%

Noninterest-earning assets:
Cash and due from banks              1,332                                    1,206                                    1,330
Allowance for loan losses          (3,536)                                  (2,274)                                  (1,324)
Other Assets                         4,153                                   10,820                                    6,056

Total Assets                     $ 168,072                                $ 143,830                                $ 121,684

Interest-bearing demand          $  51,307    $     394         0.77%     $  44,848    $     693         1.55%     $  24,393      $     452         1.85%
Savings deposits                     3,730           12         0.31%         4,524           55         1.20%         3,344             56         1.67%
Certificates of deposit             88,882        1,849         2.08%        69,957        1,662         2.38%        67,575          2,176         3.22%
Borrowed funds                       1,264           17         1.37%           147            1         0.66%           501              3         0.67%

Total interest-bearing
liabilities                        145,183        2,272         1.57%       119,476        2,411         2.02%        95,813          2,687         2.80%

and stockholders' equity:
Non interest-bearing
deposits                             8,782                                    6,099                                    4,833
Other liabilities                      744                                      619                                      844
Stockholders equity                 13,363                                   17,636                                   20,194

Total Liabilities and
Stockholders' Equity             $ 168,072                                $ 143,830                                $ 121,684

Net interest income                           $   6,957                                $   4,860                                  $   3,547

Net interest spread                                             3.99%                                    3.41%                                      2.59%

Net interest margin                                             4.19%                                    3.63%                                      3.07%


No tax-exempt securities were held during the last three years that would affect the calculation of yield on investment securities.


Non-accrual loans are included in the average daily loan balance, but interest income associated with these loans is recognized under the cash basis method of accounting.


Interest rate spread is the weighted average yield on interest-earning assets minus the average rate on interest-bearing liabilities.


Net interest margin is net interest income divided by average interest-earning assets.

The following table presents a summary of the changes in interest income and expense attributed to both rate and volume for the periods indicated.

                                                    Year Ended December 31,
                                          2011                                   2010
                                  Increase (Decrease)                    Increase (Decrease)
                                    Due to Change In                       Due to Change In
(In thousands)             Average      Average       Total       Average      Average       Total
                           Balance        Rate        Change      Balance        Rate        Change
Interest income:
Investment securities             42         (37)            5          138        (115)           23
Federal Funds sold               (2)            0          (2)            4            0            4
Loans                          1,862           94        1,956          731          279        1,010

Total interest income          1,902           57        1,959          873          164        1,037

Interest expense:
Interest-bearing demand          100        (399)        (299)          379        (138)          241
Savings deposits                (10)         (33)         (43)           20         (21)          (1)
Certificates of deposit          450        (262)          188           77        (591)        (514)
Borrowed Funds                     7            9           16          (2)            0          (2)

Total interest expense           547        (685)        (138)          474        (750)        (276)

Net interest income            1,355          742        2,097          399          914        1,313

The increase in net interest income for 2011 relative to 2010 is due to the combination of growth in earning assets and the increase in net interest spread.
Average earning assets for 2011 were $32.0 million greater than the average earning assets held during 2010. The growth in volume of earning assets generated $1.9 million in additional interest income and, which when offset by $0.5 million in interest expense tied to the growth in deposit balances, resulted in a net increase attributable to volume of $1.4 million in net interest income for 2011 compared to 2010. The increase in net interest spread for 2011 relative to 2010 generated additional net interest income of $0.7 million for 2011. The net interest spread for 2011 was 3.99% compared to net interest spread of 3.40% for 2010.

The improvement in net interest spread for 2011 is attributed to a reduction in cost of funds combined with an increase in yield on earning assets. The reduction in cost of funds during 2011 enabled the Bank to generate additional net interest income of $0.7 million. The net impact of changing interest rates on net interest income contributed $0.7 million to the increase in net interest income for 2011, including a $0.1 million increase related to a rise in yields on earning assets.

Our average interest-earning assets of $166.1 million for 2011 yielded an average return of 5.56%, compared to average interest-earning assets of $134.1 million yielding a 5.42% average return for 2010. The growth from 2010 to 2011 in average interest-earning asset balances totaled $32.0 million including a $32.5 million increase in average loan balances offset by a $0.5 million net decline in average balances for overnight funds and investment securities. Loan growth was derived from the continued expansion of the commercial loan portfolio that was first initiated with the addition of another experienced commercial lender in 2010. The growth in commercial loans, which typically carry a higher interest rate than investment securities, is also credited with increasing the yield on average interest-earning assets.

Interest-bearing liabilities averaged $145.1 million for 2011 with an average interest rate of 1.57%. The average balance and average interest rate paid on interest-bearing liabilities were $119.5 million and 2.02%, respectively, for 2010. The growth from 2010 to 2011 in average interest-bearing liabilities totaled $25.6 million including $6.4 million in interest-bearing demand accounts. The influx of lower

cost demand deposits combined with the repricing of term deposits in a low rate environment enabled us to decrease our cost of funds by 45 basis points during 2011.

The Bank's net interest margin was 4.19% for 2011 compared to 3.63% for 2010.
The 56 basis point rise in net interest margin reflects the noted improvement in funding and earning asset management for 2011.

The increase in net interest income for 2010 relative to 2009 was attributed to growth in average earning assets of $18.5 million and an improvement in net interest spread of 82 basis points during 2010 over 2009. The growth in average earning assets from 2009 to 2010 included a $13.3 million increase in average loan balances and a $5.2 million increase in average investment assets.
The improvement in net interest spread for 2010 was largely attributed to a 78 basis point reduction in cost of funds from 2.80% in 2009 to 2.02% in 2010. The decrease in cost of funds included a decline in certificates of deposit rates of 84 basis points, a decline in interest-bearing demand rates of 30 basis points, and a decline of 47 basis points in savings deposits from the prior year.

Provision for loan losses

The provision for loan losses decreased by $1.4 million or 50.2% from $2.6 million during 2010 to $1.2 million during 2011. The decrease is attributed to improved asset quality that, based on management's evaluation of the adequacy of the allowance for loan losses, supported a lower provision for 2011 relative to 2010. During 2011, we charged off $0.1 million in loans compared to $1.8 . . .

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