UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------------
FORM 10-K
--------------------------
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________ TO __________.
Commission File Number: 000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
DELAWARE 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 W. PINE STREET, LODI, CALIFORNIA 95240
(Address of principal executiveoffices) (Zip Code)
Registrant's telephone number, including area code (209) 367-2300
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.01
PAR VALUE PER SHARE
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act) Yes [ ] No [X]
The aggregate market value of the Registrant's common stock held by
non-affiliates on June 30, 2006 (based on the last reported trade on June 29,
2006) was $437,367,315.
The number of shares of Common Stock outstanding as of February 28, 2007:
811,933
Documents Incorporated by Reference:
Portions of the definitive Proxy Statement for the 2007 Annual Meeting of
Shareholders to be filed with the Securities and Exchange Commission pursuant to
Regulation 14A are incorporated by reference in Part III, Items 10 through 14.
1
FARMERS & MERCHANTS BANCORP
FORM 10-K
TABLE OF CONTENTS
-----------------
PAGE
----
PART I
------
Introduction 3
Item 1. Business 3
Item 1A. Risk Factors 17
Item 1B. Unresolved Staff Comments 20
Item 2. Properties 21
Item 3. Legal Proceedings 21
Item 4. Submission of Matters to a Vote of Security Holders 21
PART II
-------
Item 5. Market for the Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities 21
Item 6. Selected Financial Data 24
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 26
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 45
Item 8. Financial Statements and Supplementary Data 48
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 77
Item 9A. Controls and Procedures 77
Item 9B. Other Information 77
PART III
--------
Item 10. Directors, Executive Officers and Corporate Governance 77
Item 11. Executive Compensation 78
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 78
Item 13. Certain Relationships and Related Transactions, and Director Independence 78
Item 14. Principal Accountant Fees and Services 78
PART IV
-------
Item 15. Exhibits and Financial Statement Schedules 79
Signatures 79
Index to Exhibits 80
2
INTRODUCTION - FORWARD LOOKING STATEMENTS
This Form 10-K contains various forward-looking statements, usually containing
the words "estimate," "project," "expect," "objective," "goal," or similar
expressions and includes assumptions concerning the Company's operations, future
results, and prospects. These forward-looking statements are based upon current
expectations and are subject to risk and uncertainties. In connection with the
"safe-harbor" provisions of the Private Securities Litigation Reform Act of
1995, the Company provides the following cautionary statement identifying
important factors which could cause the actual results of events to differ
materially from those set forth in or implied by the forward-looking statements
and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of further acts or threats of terrorism; and (viii) other factors
discussed in Item 1A. Risk Factors.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
PART I
ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF THE BUSINESS
August 1, 1916 marked the first day of business for Farmers & Merchants Bank of
Lodi. The Bank was incorporated under the laws of the State of California and
was licensed by the California Department of Financial Institutions as a
state-chartered bank. The Bank prospered and grew even through the Depression
years. Farmers & Merchants' first venture out of Lodi occurred in response to
the closure of the only bank serving the community of Galt, requiring area
residents to drive miles away for the simplest banking transaction. To meet this
need, the Galt office was opened in 1948. Shortly thereafter branches were
opened in Linden, North Modesto and South Sacramento. On April 12, 1957, the
Bank's name was changed to Farmers & Merchants Bank of Central California.
The Bank continued expansion in the Lodi market area and also acquired three
offices in Turlock and Hilmar in 1985. The service area was next expanded by
opening a loan production office in the community of Elk Grove. This office was
later converted to a full service branch. A third office was also opened in
Modesto. The year 2002 saw the opening of the Lincoln Center office, the
Company's first branch in the city of Stockton. In September, 2003 the Bank
opened its fourth office in Modesto. Located across from the Vintage Faire Mall,
this branch incorporates state of the art technology throughout and represents
the template for the Bank's future branch expansions and renovations.
During 2004 the Company initiated a major branch expansion, relocation and
renovation program. A second Galt office was opened in June 2005 and a new
full-service branch in downtown Sacramento in February 2006. In October 2006,
the Company opened its sixth Lodi office on the southwest side of town in the
Vintner's Square shopping center and in November 2006, the Company's flagship
commercial branch was opened on March Lane in Stockton. The downtown Turlock
branch will be relocated to a new facility during the second half of 2007. Many
branches received renovations during the previous three years, both to update
these facilities and to comply with the Americans with Disabilities Act. The
Company currently estimates that the capital expenditures associated with this
multi-year program, which began in 2004, will be in excess of $10 million, which
will result in increases in the Company's occupancy and equipment expenses.
3
On March 10, 1999, Farmers & Merchants Bancorp (together with its subsidiaries,
the "Company"), pursuant to a reorganization, acquired all of the voting stock
of Farmers & Merchants Bank of Central California (the "Bank"). Farmers &
Merchants Bancorp is a bank holding company incorporated in the State of
Delaware, and registered under the Bank Holding Company Act of 1956, as amended.
The Company's outstanding securities as of December 31, 2006 consisted of
811,933 shares of common stock, $0.01 par value and no shares of preferred stock
issued. The Bank is the Company's principal asset.
The Bank's two wholly owned subsidiaries are Farmers & Merchants Investment
Corporation and Farmers/Merchants Corp. Farmers & Merchants Investment
Corporation is currently dormant and Farmers/Merchants Corp. acts as trustee on
deeds of trust originated by the Bank.
F & M Bancorp, Inc. was created in March 2002 to protect the name "F & M Bank".
During 2002, the Company completed a fictitious name filing in California to
begin using the streamlined name, "F & M Bank" as part of a larger effort to
enhance the Company's image and build brand name recognition. Since 2002, the
Company has converted most of its daily operating and image advertising to the
"F & M Bank" name and the Company's logo, slogan and signage were redesigned to
incorporate the trade name, "F & M Bank".
During 2003 the Company formed a wholly owned Connecticut statutory business
trust, FMCB Statutory Trust I, for the sole purpose of issuing trust preferred
securities. See Note 17 located in "Item 8. Financial Statements and
Supplementary Data."
The Company's principal business is to serve as a holding company for the Bank
and for other banking or banking related subsidiaries which the Company may
establish or acquire. As a legal entity separate and distinct from its
subsidiary, the Company's principal source of funds is, and will continue to be,
dividends paid by and other funds advanced from the Bank. Legal limitations are
imposed on the amount of dividends that may be paid and loans that may be made
by the Bank to the Company. See "Item 1. Business - Dividends and Other Transfer
of Funds."
The Bank's deposit accounts are insured under the Federal Deposit Insurance Act
up to applicable limits.
As a bank holding company, the Company is subject to regulation and examination
by the Board of Governors of the Federal Reserve System ("FRB"). The Bank is a
California state-chartered non-fed member bank subject to the regulation and
examination of the California Department of Financial Institutions and the
Federal Deposit Insurance Corporation.
SERVICE AREA
The Company services the northern Central Valley of California with 21 banking
offices. The area includes Sacramento, San Joaquin, Stanislaus and Merced
Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden,
Modesto, Turlock and Hilmar.
Through its network of banking offices, the Company emphasizes personalized
service along with a full range of banking services to businesses and
individuals located in the service areas of its offices. Although the Company
focuses on marketing its services to small and medium sized businesses, a full
range of retail banking services are made available to the local consumer
market.
The Company offers a wide range of deposit instruments. These include checking,
savings, money market, time certificates of deposit, individual retirement
accounts and online banking services for both business and personal accounts.
The Company also serves as a federal tax depository for its business customers.
The Company provides a full complement of lending products, including
commercial, real estate construction, agribusiness, installment, credit card and
real estate loans. Commercial products include lines of credit and other working
capital financing and letters of credit. Financing products for individuals
include automobile financing, lines of credit, residential real estate, home
improvement and home equity lines of credit.
4
The Company also offers a wide range of specialized services designed for the
needs of its commercial accounts. These services include a credit card program
for merchants, collection services, lockbox, investment sweep, on-line account
access, and electronic funds transfers by way of domestic and international wire
and automated clearinghouse.
The Company makes investment products available to customers, including mutual
funds and annuities. These investment products are offered through a third
party, which employs investment advisors to meet with and provide investment
advice to the Company's customers.
EMPLOYEES
At December 31, 2006, the Company employed a total of 302 full time equivalent
employees. The Company believes that its employee relations are satisfactory.
COMPETITION
The banking and financial services industry in California generally, and in the
Company's market areas specifically, is highly competitive. The increasingly
competitive environment is a result primarily of changes in regulation, changes
in technology and product delivery systems, and the accelerating pace of
consolidation among financial service providers. The Company competes with other
major commercial banks, diversified financial institutions, credit unions,
savings and loan associations, money market and other mutual funds, mortgage
companies, and a variety of other non-banking financial services and advisory
companies. Federal legislation encourages competition between different types of
financial service providers and has fostered new entrants into the financial
services market, and it is anticipated that this trend will continue. Using the
financial holding company structure, insurance companies and securities firms
may compete more directly with banks and bank holding companies.
Many of our competitors are much larger in total assets and capitalization, have
greater access to capital markets and offer a broader range of financial
services than the Company. In order to compete with other financial service
providers, the Company relies upon personal contact by its officers, directors,
employees, and shareholders, along with various promotional activities and
specialized services. In those instances where the Company is unable to
accommodate a customer's needs, the Company may arrange for those services to be
provided through its correspondents.
GOVERNMENT POLICIES
The Company's profitability, like most financial institutions, is primarily
dependent on interest rate differentials. The difference between the interest
rates paid by the Company on interest-bearing liabilities, such as deposits and
other borrowings, and the interest rates received by the Company on its
interest-earning assets, such as loans extended to its customers and securities
held in its investment portfolio, comprise the major portion of the Company's
earnings. These rates are highly sensitive to many factors that are beyond the
control of the Company and the Bank, such as inflation, recession and
unemployment, and the impact which future changes in economic conditions might
have on the Company and the Bank cannot be predicted.
The business of the Company is also influenced by the monetary and fiscal
policies of the federal government and the policies of regulatory agencies,
particularly the Board of Governors of the Federal Reserve System (the "FRB").
The FRB implements national monetary policies (with objectives such as curbing
inflation and combating recession) through its open-market operations in U.S.
Government securities by adjusting the required level of reserves for depository
institutions subject to its reserve requirements, and by varying the target
federal funds and discount rates applicable to borrowings by depository
institutions. The actions of the FRB in these areas influence the growth of bank
loans, investments, and deposits and also affect interest rates earned on
interest-earning assets and paid on interest-bearing liabilities. The nature and
impact on the Company of any future changes in monetary and fiscal policies
cannot be predicted.
From time to time, legislative acts, as well as regulations, are enacted which
have the effect of increasing the cost of doing business, limiting or expanding
permissible activities, or affecting the competitive balance between banks and
5
other financial services providers. Proposals to change the laws and regulations
governing the operations and taxation of banks, bank holding companies, and
other financial institutions and financial services providers are frequently
made in the U.S. Congress, in the state legislatures, and before various
regulatory agencies. This legislation may change banking statutes and the
operating environment of the Company and its subsidiaries in substantial and
unpredictable ways. If enacted, such legislation could increase or decrease the
cost of doing business, limit or expand permissible activities or affect the
competitive balance among banks, savings associations, credit unions, and other
financial institutions. The Company cannot predict whether any of this potential
legislation will be enacted, and if enacted, the effect that it, or any
implementing regulations, would have on the financial condition or results of
operations of the Company or any of its subsidiaries. See "Item 1. Business -
Supervision and Regulation."
SUPERVISION AND REGULATION
General
Bank holding companies and banks are extensively regulated under both federal
and state law. The regulation is intended primarily for the protection of
depositors and the deposit insurance fund and not for the benefit of
shareholders of the Company. Set forth below is a summary description of the
material laws and regulations, which relate to the operations of the Company and
the Bank. This description does not purport to be complete and is qualified in
its entirety by reference to the applicable laws and regulations.
In recent years significant legislative proposals and reforms affecting the
financial services industry have been discussed and evaluated by Congress, the
state legislature and before the various bank regulatory agencies. These
proposals may increase or decrease the cost of doing business, limiting or
expanding permissible activities, or enhance the competitive position of other
financial service providers. The likelihood and timing of any such proposals or
bills and the impact they might have on the Company and its subsidiaries cannot
be predicted.
The Company
The Company is a registered bank holding company and is subject to regulation
under the Bank Holding Company Act of 1956 ("BHCA"), as amended. Accordingly,
the Company's operations are subject to extensive regulation and examination by
the FRB. The Company is required to file with the FRB quarterly and annual
reports and such additional information as the FRB may require pursuant to the
Bank Holding Company Act. The FRB conducts periodic examinations of the Company.
The FRB may require that the Company terminate an activity or terminate control
of or liquidate or divest certain subsidiaries of affiliates when the FRB
believes the activity or the control of the subsidiary or affiliate constitutes
a significant risk to the financial safety, soundness or stability of any of its
banking subsidiaries. The FRB also has the authority to regulate provisions of
certain bank holding company debt, including authority to impose interest
ceilings and reserve requirements on such debt. Under certain circumstances, the
Company must file written notice and obtain approval from the FRB prior to
purchasing or redeeming its equity securities.
Under the BHCA and regulations adopted by the FRB, a bank holding company and
its non-banking subsidiaries are prohibited from requiring certain tie-in
arrangements in connection with an extension of credit, lease or sale of
property or furnishing of services. For example, with certain exceptions, a bank
may not condition an extension of credit on a promise by its customer to obtain
other services provided by it, its holding company or other subsidiaries, or on
a promise by its customer not to obtain other services from a competitor. In
addition, federal law imposes certain restrictions on transactions between
Farmers & Merchants Bancorp and its subsidiaries. Further, the Company is
required by the FRB to maintain certain levels of capital. See "Item 1. Business
- Supervision and Regulation - Capital Standards."
Directors, officers and principal shareholders of the Company, and the companies
with which they are associated, have had and will continue to have banking
transactions with the Bank in the ordinary course of business. All such
extensions of credit are made on substantially the same terms (including
interest rates and collateral) as, and following credit-underwriting procedures
that are not less stringent than, those prevailing at the time for comparable
transactions by the Bank with other persons not covered by 12 USC 215.1 et seq.
and who are not employed by the Bank, and does not involve more than the normal
risk of repayment or present other unfavorable features. Extensions
6
of credit to insiders have been and may be made pursuant to a benefit or
compensation program that is widely available to employees of the Bank and that
does not give preference to any insider of the Bank over other employees.
The Company is prohibited by the BHCA, except in certain statutorily prescribed
instances, from acquiring direct or indirect ownership or control of more than
5% of the outstanding voting shares of any company that is not a bank or bank
holding company and from engaging directly or indirectly in activities other
than those of banking, managing or controlling banks or furnishing services to
its subsidiaries. However, the Company, subject to the prior approval of the
FRB, may engage in any, or acquire shares of companies engaged in, activities
that are deemed by the FRB to be so closely related to banking or managing or
controlling banks as to be a proper incident thereto.
Under FRB regulations, a bank holding company is required to serve as a source
of financial and managerial strength to its subsidiary banks and may not conduct
its operations in an unsafe or unsound manner. In addition, it is the FRB's
policy that in serving as a source of strength to its subsidiary banks, a bank
holding company should stand ready to use available resources to provide
adequate capital funds to its subsidiary banks during periods of financial
stress or adversity and should maintain the financial flexibility and
capital-raising capacity to obtain additional resources for assisting its
subsidiary banks. This support may be required at times when a bank holding
company may not be able to provide such support. A bank holding company's
failure to meet its obligations to serve as a source of strength to its
subsidiary banks will generally be considered by the FRB to be an unsafe and
unsound banking practice or a violation of the FRB's regulations or both.
The Gramm-Leach-Bliley Act of 1999 ("GLBA") eliminated many of the restrictions
placed on the activities of bank holding companies that become financial holding
companies. Among other things, GLBA repealed certain Glass-Steagall Act
restrictions on affiliations between banks and securities firms, and amended the
BHCA to permit bank holding companies that are financial holding companies to
engage in activities, and acquire companies engaged in activities, that are:
financial in nature (including insurance underwriting, insurance company
portfolio investment, financial advisory, securities underwriting, dealing and
market-making, and merchant banking activities); incidental to financial
activities; or complementary to financial activities if the FRB determines that
they pose no substantial risk to the safety or soundness of depository
institutions or the financial system in general. The Company has not become a
financial holding company. GLBA also permits national banks to engage in
activities considered financial in nature through a financial subsidiary,
subject to certain conditions and limitations.
The Company's securities are registered with the Securities and Exchange
Commission under the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). As such, the Company is subject to the information, proxy solicitation,
insider trading and other requirements and restrictions of the Exchange Act.
The Bank
The Bank, as a California chartered non-member bank, is subject to primary
supervision, periodic examination and regulation by the California Department of
Financial Institutions ("DFI") and the Federal Deposit Insurance Corporation
("FDIC"). If, as a result of an examination of the Bank, the FDIC should
determine that the financial condition, capital resources, asset quality,
earnings prospects, management, liquidity, or other aspects of the Bank's
operations are unsatisfactory or that the Bank or its management is violating or
has violated any law or regulation, various remedies are available to the FDIC.
Such remedies include the power to enjoin "unsafe or unsound" practices, to
require affirmative action to correct any conditions resulting from any
violation or practice, to issue an administrative order that can be judicially
enforced, to direct an increase in capital, to restrict the growth of the Bank,
to assess civil monetary penalties, to remove officers and directors and
ultimately to terminate the Bank's deposit insurance, which for a California
chartered bank would result in a revocation of the Bank's charter. The DFI has
many of the same remedial powers.
Various requirements and restrictions under the laws of the State of California
and the United States affect the operations of the Bank. State and federal
statutes and regulations relate to many aspects of the Bank's operations,
including reserves against deposits, ownership of deposit accounts, interest
rates payable on deposits, loans, investments, mergers and acquisitions,
borrowings, dividends, locations of branch offices, and capital requirements.
Further, the Bank is required to maintain certain levels of capital. See "Item
1. Business - Supervision and Regulation - Capital Standards."
7
The USA Patriot Act
Title III of the United and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism Act of 2001 (the USA Patriot Act")
includes numerous provisions for fighting international money laundering and
blocking terrorism access to the U.S. financial system. The USA Patriot Act
requires certain additional due diligence and record keeping practices,
including, but not limited to, new customers, correspondent and private banking
accounts.
Part of the USA Patriot Act requires covered financial institutions to: (i)
establish an anti-money laundering program; (ii) establish appropriate
anti-money laundering policies, procedures and controls; (iii) appoint a Bank
Secrecy Act officer responsible for day-to-day compliance; and (iv) conduct
independent audits. The Patriot Act also expands penalties for violation of the
anti-money laundering laws, including expanding the circumstances under which
funds in a bank account may be forfeited. The Patriot Act also requires covered
financial institutions to respond under certain circumstances to requests for
information from federal banking agencies within 120 hours. Various measures are
currently pending before Congress to extend portions of the Patriot Act.
Privacy Restrictions
The GLBA, in addition to the previous described changes in permissible
non-banking activities permitted to banks, bank holding companies and financial
holding companies, also requires financial institutions in the U.S. to provide
certain privacy disclosures to customers and consumers, to comply with certain
restrictions on the sharing and usage of personally identifiable information,
and to implement and maintain commercially reasonable customer information
safeguarding standards.
The Company believes that it complies with all provisions of the GLBA and all
implementing regulations and the Bank has developed appropriate policies and
procedures to meet its responsibilities in connection with the privacy
provisions of GLBA.
Dividends and Other Transfer of Funds
Dividends from the Bank constitute the principal source of income to the
Company. The Company is a legal entity separate and distinct from the Bank. The
Bank is subject to various statutory and regulatory restrictions on its ability
to pay dividends to the Company. Under such restrictions, the amount available
for payment of dividends to the Company by the Bank totaled $19.4 million at
December 31, 2006.
The FDIC and the DFI also have authority to prohibit the Bank from engaging in
activities that, in their opinion, constitute unsafe or unsound practices in
conducting its business. It is possible, depending upon the financial condition
of the bank in question and other factors, that the FDIC and the DFI could
assert that the payment of dividends or other payments might, under some
circumstances, be an unsafe or unsound practice. Further, the FRB and the FDIC
have established guidelines with respect to the maintenance of appropriate
levels of capital by banks or bank holding companies under their jurisdiction.
Compliance with the standards set forth in such guidelines and the restrictions
that are or may be imposed under the prompt corrective action provisions of
federal law could limit the amount of dividends which the Bank or the Company
may pay. An insured depository institution is prohibited from paying management
fees to any controlling persons or, with certain limited exceptions, making
capital distributions if after such transaction the institution would be
undercapitalized. The DFI may impose similar limitations on the Bank. See
"Prompt Corrective Regulatory Action and Other Enforcement Mechanisms" and
"Capital Standards" for a discussion of these additional restrictions on capital
distributions.
Transactions with Affiliates
The Bank is subject to certain restrictions imposed by federal law on any
extensions of credit to, or the issuance of a guarantee or letter of credit on
behalf of, the Company or other affiliates, the purchase of, or investments in,
stock or other securities thereof, the taking of such securities as collateral
for loans, and the purchase of assets of the Company or other affiliates. Such
restrictions prevent the Company and other affiliates from borrowing from the
Bank unless the loans are secured by marketable obligations of designated
amounts. Further, such secured loans and investments by the Bank to or in the
Company or to or in any other affiliates are limited, individually, to 10% of
the Bank's capital and surplus (as defined by federal regulations), and such
secured loans and investments are limited, in the aggregate, to 20% of the
Bank's capital and surplus (as defined by federal regulations).
8
In addition, the Company and its operating subsidiaries generally may not
purchase a low-quality asset from an affiliate, and other specified transactions
between the Company or its operating subsidiaries and an affiliate must be on
terms and conditions that are consistent with safe and sound banking practices.
Also, the Company and its operating subsidiaries may engage in transactions with
affiliates only on terms and under conditions that are substantially the same,
or at least as favorable to the Company or its subsidiaries, as those prevailing
at the time for comparable transactions with (or that in good faith would be
offered to) non-affiliated companies.
California law also imposes certain restrictions with respect to transactions
with affiliates. Additionally, limitations involving the transactions with
affiliates may be imposed on the Bank under the prompt corrective action
provisions of federal law. See "Item 1. Business - Supervision and Regulation -
Prompt Corrective Action and Other Enforcement Mechanisms."
Capital Standards
The FRB and the FDIC have established risk-based capital guidelines with respect
to the maintenance of appropriate levels of capital by United States banking
organizations. These guidelines are intended to provide a measure of capital
that reflects the risk associated with a banking organization's operations for
both transactions reported on the balance sheet as assets and transactions, such
as letters of credit and recourse arrangements, which are recorded as off
balance sheet items. Under these guidelines, nominal dollar amounts of assets
and credit equivalent amounts of off balance sheet items are multiplied by one
of several risk adjustment percentages, which range from 0% for assets with low
credit risk, such as certain U.S. Treasury securities, to 100% for assets with
relatively high credit risk, such as commercial loans.
The federal banking agencies require a minimum ratio of qualifying total capital
to risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to
risk-weighted assets of 4%. In addition to the risk-based guidelines, federal
banking regulators require banking organizations to maintain a minimum amount of
Tier 1 capital to total assets, referred to as the leverage ratio. For a banking
organization rated in the highest of the five categories used by regulators to
rate banking organizations, the minimum leverage ratio of Tier 1 capital to
total assets must be 4%. In addition to these uniform risk-based capital
guidelines and leverage ratios that apply across the industry, the regulators
have the discretion to set individual minimum capital requirements for specific
institutions at rates significantly above minimum guidelines and ratios. For
further information on the Company and the Bank's risk-based capital ratios, see
Note 10 located in "Item 8. Financial Statements and Supplementary Data."
Prompt Corrective Action and Other Enforcement Mechanisms
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"),
among other things, identifies five capital categories for insured depository
institutions (well capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized and critically undercapitalized) and requires the
respective Federal regulatory agencies to implement systems for "prompt
corrective action" for insured depository institutions that do not meet minimum
capital requirements within such categories. FDICIA imposes progressively more
restrictive constraints on operations, management and capital distributions,
depending on the category in which an institution is classified. Failure to meet
the capital guidelines could also subject a banking institution to capital
raising requirements. An "undercapitalized" Company must develop a capital
restoration plan. At December 31, 2006 the Bank exceeded all of the required
ratios for classification as "well capitalized." It should be noted, however,
that the Bank's capital category is determined solely for the purpose of
applying the federal banking agencies' prompt corrective action regulations and
the capital category may not constitute an accurate representation of the Bank's
overall financial condition or prospects.
An institution that, based upon its capital levels, is classified as well
capitalized, adequately capitalized, or undercapitalized may be treated as
though it were in the next lower capital category if the appropriate federal
banking agency, after notice and opportunity for hearing, determines that an
unsafe or unsound condition or practice warrants such treatment. At each
successive lower capital category, an insured depository institution is subject
to more restrictions.
9
Banking agencies have also adopted regulations which mandate that regulators
take into consideration (i) concentrations of credit risk; (ii) interest rate
risk (when the interest rate sensitivity of an institution's assets does not
match the sensitivity of its liabilities or its off-balance-sheet position); and
(iii) risks from non-traditional activities, as well as an institution's ability
to manage those risks, when determining the adequacy of an institution's
capital. That evaluation will be made as a part of the institution's regular
safety and soundness examination. In addition, the banking agencies have amended
their regulatory capital guidelines to incorporate a measure for market risk. In
accordance with the amended guidelines, the Company and any company with
significant trading activity must incorporate a measure for market risk in its
regulatory capital calculations.
In addition to measures taken under the prompt corrective action provisions,
commercial banking organizations may be subject to potential enforcement actions
by the federal banking agencies for unsafe or unsound practices in conducting
their businesses or for violations of any law, rule, regulation or any condition
imposed in writing by the agency or any written agreement with the agency.
Enforcement actions may include the imposition of a conservator or receiver, the
issuance of a cease-and-desist order that can be judicially enforced, the
termination of insurance of deposits (in the case of a depository institution),
the imposition of civil money penalties, the issuance of directives to increase
capital, the issuance of formal and informal agreements, the issuance of removal
and prohibition orders against institution-affiliated parties and the
enforcement of such actions through injunctions or restraining orders based upon
a judicial determination that the agency would be harmed if such equitable
relief was not granted. Additionally, a holding company's inability to serve as
a source of strength to its subsidiary banking organizations could serve as an
additional basis for a regulatory action against the holding company.
Safety and Soundness Standards
The federal banking agencies have adopted guidelines designed to assist in
identifying and addressing potential safety and soundness concerns before
capital becomes impaired. The guidelines set forth operational and managerial
standards relating to: (i) internal controls, information systems and internal
audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) asset
growth; (v) earnings; and (vi) compensation, fees and benefits. In addition, the
federal banking agencies have also adopted safety and soundness guidelines with
respect to asset quality and earnings standards. These guidelines provide six
standards for establishing and maintaining a system to identify problem assets
and prevent those assets from deteriorating. Under these standards, any insured
depository institution should: (i) conduct periodic asset quality reviews to
identify problem assets; (ii) estimate the inherent losses in problem assets and
establish reserves that are sufficient to absorb estimated losses; (iii) compare
problem asset totals to capital; (iv) take appropriate corrective action to
resolve problem assets; (v) consider the size and potential risks of material
asset concentrations; and (vi) provide periodic asset quality reports with
adequate information for management and the Board of Directors to assess the
level of asset risk. These guidelines also set forth standards for evaluating
and monitoring earnings and for ensuring that earnings are sufficient for the
maintenance of adequate capital and reserves.
Premiums for Deposit Insurance
The Company's deposit accounts are insured by the Bank Insurance Fund ("BIF"),
as administered by the FDIC, up to the maximum permitted by law. Insurance of
deposits may be terminated by the FDIC upon a finding that the institution has
engaged in unsafe or unsound practices, is in an unsafe or unsound condition to
continue operation, or has violated any applicable law, regulation, rule, order,
or condition imposed by the FDIC or the Company's primary regulator.
For the year ending December 31, 2006, the FDIC charges an annual assessment for
the insurance of deposits ranging from 0 to 27 basis points per $100 of insured
deposits, based on the results of examinations, findings by the Company's
primary federal regulator and other information deemed relevant by the FDIC to
the Company's financial condition and the risk posed to the BIF. The risk
classification is based on an institution's capital group and supervisory
subgroup assignment. An institution's risk category is based upon whether the
institution is well capitalized, adequately capitalized, or less than adequately
capitalized. Each insured depository institution is also assigned to one of the
following "supervisory subgroups." Subgroup A, B or C. Subgroup A institutions
are financially sound institutions with few minor weaknesses; Subgroup B
institutions are institutions that demonstrate weaknesses which, if not
corrected, could result in significant deterioration; and Subgroup C
institutions are institutions for which there is a substantial probability that
the FDIC will suffer a loss in connection with the institution unless effective
action is taken to correct the areas of weakness. Insured institutions are not
allowed to
10
disclose their risk assessment classification and no assurance can be given as
to what the future level of premiums will be.
Effective January 1, 2007 the FDIC has adopted a new rule for the insurance
assessment on deposits. Under the new rule the charge for annual insurance
deposit assessments will range from a minimum of 5 basis points to a maximum of
43 basis points per $100 of insured deposits. The new rule consolidates the
number of assessment risk categories from nine to four and names them Risk
Categories I, II, III and IV. The four new categories will continue to be
defined based upon supervisory and capital evaluations, which are both
established measures of risk. Risk Category I contains all well-capitalized
institutions generally with CAMELS composite ratings of 1 or 2 and will be
assessed annual insurance rates of 5 to 7 basis points per $100 in deposits.
Risk Category II contains both well capitalized and adequately capitalized
institutions with CAMELS composite ratings of 1, 2 or 3 and will be assessed an
annual insurance rate of 10 basis points per $100 in deposits. Risk Category III
contains all undercapitalized institutions generally with CAMELS composite
ratings of 4 or 5 and will be assessed an annual insurance rate of 28 basis
points. Risk Category IV contains all undercapitalized institutions for which
there is substantial probability the FDIC will suffer a loss in connection with
the institution unless effective action is taken to correct the areas of
weakness. Those institutions in Risk Category IV will be assessed an annual
insurance rate of 43 basis points per $100 in deposits. Insured institutions are
not all allowed to disclose their risk assessment classification and no
assurance can be given as to what the future level of premiums will be.
The President signed the budget reconciliation package (S. 1932) that contains
the comprehensive Federal Deposit Insurance Reform Act of 2005 which provides
for the following:
- Merging the Bank Insurance Fund (BIF) and the Savings Association Insurance
Fund (SAIF) into a new fund, the Deposit Insurance Fund (DIF). This change
was made effective March 31, 2006.
- Increasing the coverage limit for retirement accounts to $250,000 and
indexing the coverage limit for retirement accounts to inflation as with
the general deposit insurance coverage limit. This change was made
effective April 1, 2006.
- Establishing a range of 1.15 percent to 1.50 percent within which the FDIC
Board of Directors may set the Designated Reserve Ratio (DRR).
- Allowing the FDIC to manage the pace at which the reserve ratio varies
within this range.
- If the reserve ratio falls below 1.15 percent-or is expected to within
6 months-the FDIC must adopt a restoration plan that provides that the
DIF will return to 1.15 percent generally within 5 years.
- If the reserve ratio exceeds 1.35 percent, the FDIC must generally
dividend to DIF members half of the amount above the amount necessary
to maintain the DIF at 1.35 percent, unless the FDIC Board,
considering statutory factors, suspends the dividends.
- If the reserve ratio exceeds 1.5 percent, the FDIC must generally
dividend to DIF members all amounts above the amount necessary to
maintain the DIF at 1.5 percent.
- Eliminating the restrictions on premium rates based on the DRR and granting
the FDIC Board the discretion to price deposit insurance according to risk
for all insured institutions regardless of the level of the reserve ratio.
- Granting a one-time initial assessment credit (of approximately $4.7
billion) to recognize institutions' past contributions to the fund.
Based upon the Company's preliminary assessment of the effect of this
regulation, management believes it will not currently have a material financial
impact.
11
Community Reinvestment Act ("CRA") and Fair Lending
The Bank is subject to certain fair lending requirements involving lending,
investing and other CRA activities. CRA requires each insured depository
institution to identify the communities served by the institution's offices and
to identify the types of credit and investments the institution is prepared to
extend within such communities including low and moderate income neighborhoods.
It also requires the institution's regulators to assess the institution's
performance in meeting the credit needs of its community and to take such
assessment into consideration in reviewing application for mergers,
acquisitions, relocation of existing branches, opening of new branches and other
transactions. A bank may be subject to substantial penalties and corrective
measures for a violation of certain fair lending laws.
A bank's compliance with the Community Reinvestment Act is based on a
performance based evaluation system which bases CRA ratings on an institution's
lending service and investment performance. An unsatisfactory rating may be the
basis for denying a merger application. The Bank's latest CRA examination was
completed by the Federal Reserve Bank of San Francisco and the lending test
portion included a review of small business, small farm, and home mortgage loans
originated between October 1, 2001 and September 30, 2003. Community development
lending as well as investment and service activities were reviewed for all of
2002 and 2003. The Bank received a High Satisfactory rating in the lending area
and an Outstanding rating in the areas of investment and service. The Bank
received an overall rating of Outstanding in complying with its CRA obligations.
The Bank is expecting to have another CRA exam during the 1st quarter of 2007.
The Sarbanes-Oxley Act of 2002 ("the Act")
This legislation addresses accounting oversight and corporate governance
matters, including:
- The creation of a five-member oversight board that sets standards for
accountants and has investigative and disciplinary powers.
- The prohibition of accounting firms from providing various types of
consulting services to public clients and requires accounting firms to
rotate partners among public client assignments every five years.
- Increased penalties for financial crimes.
- Expanded disclosure of corporate operations and internal controls and
certification of financial statements.
- Enhanced controls on, and reporting of, insider trading.
- Prohibition on lending to officers and directors of public companies,
although the bank may continue to make these loans within the constraints
of existing banking regulations.
As a public reporting company, the Company is subject to the requirements of
this legislation and related rules and regulations issued by the Securities and
Exchange Commission (the "Commission").
AVAILABLE INFORMATION
Company reports filed with the Securities and Exchange Commission including the
annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K, proxy statements and ownership reports filed by Directors, executive
officers and principal shareholders can be accessed through the Company's web
site at http://www.fmbonline.com. The link to the Securities and Exchange
Commission is on the About F & M Bank page.
STATISTICAL DISCLOSURES
The tables on the following pages set forth certain statistical information for
Farmers & Merchants Bancorp on a consolidated basis. This information should be
read in conjunction with Item 7. "Management's Discussion and
12
Analysis" and with the Company's Consolidated Financial Statements and the Notes
thereto included in Item 8. "Financial Statements and Supplementary Data."
FARMERS & MERCHANTS BANCORP
INVESTMENT PORTFOLIO
The following table summarizes the balances
and distributions of the
investment securities held on the dates indicated. Available Held to Available Held to Available Held to
for Sale Maturity for Sale Maturity for Sale Maturity
-------------------------------------------------------------------
DECEMBER 31: (IN THOUSANDS) 2006 2005 2004
------------------------------------------------------------------------------------------------------------------------
U. S. Agency $ - $ 30,539 $ 29,926 $ 30,644 $ 75,065 $ 19,943
Municipal 11,274 69,910 15,576 66,260 18,009 56,240
Mortgage-Backed Securities 109,385 8,677 106,433 10,881 85,831 13,471
Other 11,968 2,114 6,094 2,126 6,583 298
------------------------------------------------------------------------------------------------------------------------
TOTAL BOOK VALUE $ 132,627 $ 111,240 $ 158,029 $ 109,911 $ 185,488 $ 89,952
========================================================================================================================
FAIR VALUE $ 132,627 $ 110,132 $ 158,029 $ 108,060 $ 185,488 $ 90,212
========================================================================================================================
ANALYSIS OF INVESTMENT SECURITIES AVAILABLE-FOR-SALE
The following table is a summary of the relative maturities and yields of the
Company's investment securities Available-for-Sale as of December 31, 2006.
Non-taxable municipal securities have been calculated on a fully taxable
equivalent basis.
Fair Average
DECEMBER 31, 2006 (IN THOUSANDS) Value Yield
-----------------------------------------------------------------------
MUNICIPAL - NON-TAXABLE
One year or less $ 2,590 5.51%
After one year through five years 6,436 6.72%
After ten years 2,248 9.12%
-----------------------------------------------------------------------
TOTAL NON-TAXABLE MUNICIPAL SECURITIES 11,274 6.92%
-----------------------------------------------------------------------
MORTGAGE-BACKED SECURITIES
After ten years 109,385 5.11%
-----------------------------------------------------------------------
OTHER
One year or less 11,968 4.57%
-----------------------------------------------------------------------
TOTAL INVESTMENT SECURITIES AVAILABLE FOR SALE $132,627 5.21%
=======================================================================
Note: The average yield for floating rate securities is calculated using the
current stated yield.
ANALYSIS OF INVESTMENT SECURITIES HELD-TO-MATURITY
The following table is a summary of the relative maturities and yields of the
Company's investment securities Held-to-Maturity as of December 31, 2006.
Non-taxable municipal securities have been calculated on a fully taxable
equivalent basis.
Book Average
DECEMBER 31, 2006 (IN THOUSANDS) Value Yield
---------------------------------------------------------------------
U.S. AGENCY
After one year through five years $ 19,935 4.01%
After five years through ten years 10,604 4.35%
---------------------------------------------------------------------
TOTAL U.S. AGENCY SECURITIES 30,539 4.13%
---------------------------------------------------------------------
MUNICIPAL - NON-TAXABLE
One year or less 3,769 4.89%
After one year through five years 8,533 4.80%
After five years through ten years 10,214 5.28%
After ten years 47,394 6.20%
---------------------------------------------------------------------
TOTAL NON-TAXABLE MUNICIPAL SECURITIES 69,910 5.82%
---------------------------------------------------------------------
MORTGAGE-BACKED SECURITIES
After five years through ten years 8,677 3.88%
---------------------------------------------------------------------
OTHER
After five years through ten years 133 8.49%
After ten years 1,981 2.55%
---------------------------------------------------------------------
TOTAL OTHER SECURITIES 2,114 2.92%
---------------------------------------------------------------------
TOTAL INVESTMENT SECURITIES HELD-TO-MATURITY $111,240 5.15%
=====================================================================
13
FARMERS & MERCHANTS BANCORP
LOAN DATA
(in thousands)
The following table shows the Bank's loan composition by type of loan.
December 31,
2006 2005 2004 2003 2002
------------------------------------------------------------------------------------------------------
Real Estate $ 516,606 $ 432,378 $ 431,746 $ 386,735 $ 322,074
Real Estate Construction 95,378 110,235 62,446 77,115 66,467
Home Equity 67,132 69,013 63,782 55,827 45,150
Agricultural 183,589 170,657 151,002 134,862 109,130
Commercial 165,412 174,530 142,133 136,955 135,877
Consumer 13,949 12,653 11,933 11,979 13,948
Credit Card 5,543 5,353 5,021 4,549 4,252
Other 1,730 952 1,019 976 1,795
------------------------------------------------------------------------------------------------------
TOTAL LOANS 1,049,339 975,771 869,082 808,998 698,693
Less:
Unearned Income 2,427 2,514 2,174 2,092 2,018
Allowance for Loan Losses 18,099 17,860 17,727 17,220 16,684
------------------------------------------------------------------------------------------------------
LOANS, NET $ 1,028,813 $ 955,397 $ 849,181 $ 789,686 $ 679,991
======================================================================================================
There were no concentrations of loans exceeding 10% of total loans which were
not otherwise disclosed as a category of loans in the above table.
NON-PERFORMING LOANS
(in thousands)
December 31,
2006 2005 2004 2003 2002
--------------------------------------------------------------------------------------------------
NONACCRUAL LOANS
Real Estate $ 3 $ 464 $ 214 $1,670 $2,180
Commercial 36 142 - 516 452
Consumer - - - 181 2
Other - - - - 263
--------------------------------------------------------------------------------------------------
TOTAL NONACCRUAL LOANS 39 606 214 2,367 2,897
--------------------------------------------------------------------------------------------------
ACCRUING LOANS PAST DUE 90 DAYS OR MORE
Real Estate - 66 - 139 1
Commercial - - - 41 -
Credit Card 15 22 11 37 9
Other 0 0 0 0 0
--------------------------------------------------------------------------------------------------
TOTAL ACCRUING LOANS PAST DUE 90 DAYS OR MORE 15 88 11 217 10
--------------------------------------------------------------------------------------------------
TOTAL NON-PERFORMING LOANS $ 54 $ 694 $ 225 $2,584 $2,907
==================================================================================================
Non-Performing Loans as a Percent of Total Loans 0.01% 0.07% 0.03% 0.32% 0.42%
==================================================================================================
Allowance for Loan Losses as a Percent of Total Loans 1.72% 1.83% 2.04% 2.13% 2.39%
==================================================================================================
The Bank's policy is to place loans (excluding Credit Card loans) on nonaccrual
status when the principal or interest is past due for ninety days or more unless
it is both well secured and in the process of collection. Any interest accrued,
but unpaid, is reversed against current income. Thereafter interest is
recognized as income only as it is collected in cash. The gross interest income
that would have been recorded if the loans had been current for the year ending
December 31, 2006 was $15,000. For a discussion of impaired loan policy see Note
3. located in "Item 8. Financial Statements and Supplementary Data."
14
FARMERS & MERCHANTS BANCORP
PROVISION AND ALLOWANCE FOR LOAN LOSSES
(dollars in thousands)
A five-year review of activity in the allowance for loan losses and an allocation by loan
type of the allowance is shown in the tables below.
2006 2005 2004 2003 2002
---------------------------------------------------------------------------------------------
Allowance for Loan Losses Beginning of Year $17,860 $17,727 $17,220 $16,684 $12,709
Provision Charged to Expense 275 425 1,275 625 4,926
CHARGE OFFS:
Real Estate - - - 1 -
Agricultural 333 199 5 0 149
Commercial 121 442 700 282 966
Consumer 41 26 7 175 78
Credit Card 284 200 243 239 93
Other 60 - - - -
---------------------------------------------------------------------------------------------
TOTAL CHARGE OFFS 839 867 955 697 1,286
---------------------------------------------------------------------------------------------
RECOVERIES:
Real Estate - - - 143 -
Agricultural 75 376 26 17 141
Commercial 624 134 209 394 149
Consumer 37 19 32 25 34
Credit Card 26 46 31 29 11
Other 41 - - - -
---------------------------------------------------------------------------------------------
TOTAL RECOVERIES 803 575 298 608 335
---------------------------------------------------------------------------------------------
NET (CHARGE-OFFS) RECOVERIES (36) (292) (657) (89) (951)
---------------------------------------------------------------------------------------------
LESS RECLASSIFICATION ADJUSTMENT* - - (111) - -
---------------------------------------------------------------------------------------------
TOTAL ALLOWANCE FOR LOAN LOSSES $18,099 $17,860 $17,727 $17,220 $16,684
=============================================================================================
*As of December 31, 2004, the Company reclassified $111,000 of the Allowance for
Loan Losses that pertained to commitments under commercial and standby letters
of credit to the "Other Liabilities" section of the Consolidated Balance Sheet.
RATIOS:
Allowance for Loan Losses to:
Loans at Year End 1.72% 1.83% 2.04% 2.13% 2.39%
Average Loans 1.81% 1.98% 2.15% 2.33% 2.62%
Consolidated Net Charge-Offs to:
Loans at Year End 0.00% 0.03% 0.08% 0.01% 0.14%
Average Loans 0.00% 0.03% 0.08% 0.01% 0.15%
For a description of the Company's policy regarding the Allowance for Loan
Losses, see Note 1 located in "Item 8. Financial Statements and Supplementary
Data."
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
(dollars in thousands) AMOUNT OF ALLOWANCE ALLOCATION AT DECEMBER 31,
-------------------------------------------------------------------------
2006 2005 2004 2003 2002
---------------------------------------------------------------------------------------------------
Real Estate $ 5,548 $ 5,344 $ 5,136 $ 6,216 $ 4,718
Real Estate Construction 880 1,088 427 1,080 912
Home Equity 436 416 170 471 450
Agricultural 3,564 1,786 4,342 4,681 3,702
Commercial 6,007 8,317 5,849 3,957 5,681
Consumer 92 89 133 104 427
Other 1,199 543 1,312 569 715
Unallocated 373 277 358 142 79
---------------------------------------------------------------------------------------------------
Total $ 18,099 $ 17,860 $ 17,727 $ 17,220 $ 16,684
===================================================================================================
PERCENT OF LOANS IN EACH CATEGORY
TO TOTAL LOANS AT DECEMBER 31,
-------------------------------------------------------------------------
2006 2005 2004 2003 2002
-------------------------------------------------------------------------
Real Estate 49.2% 44.3% 49.7% 47.8% 46.1%
Real Estate Construction 9.1% 11.3% 7.2% 9.5% 9.5%
Home Equity 6.4% 7.1% 7.3% 6.9% 6.5%
Agricultural 17.5% 17.5% 17.4% 16.7% 15.6%
Commercial 15.8% 17.9% 16.4% 16.9% 19.4%
Consumer 1.3% 1.3% 1.4% 1.5% 2.0%
Credit Card 0.5% 0.5% 0.6% 0.6% 0.6%
Other 0.2% 0.1% 0.1% 0.1% 0.3%
---------------------------------------------------------------------------------------------------
Total 100.0% 100.0% 100.0% 100.0% 100.0%
===================================================================================================
15
FARMERS & MERCHANTS BANCORP
MATURITIES AND RATE SENSITIVITY OF LOANS
(in thousands)
The following table shows the maturity distribution and interest
rate sensitivity of certain loans of the Company on December 31, 2006
Over One
Year to Over
One Year Five Five
or Less Years Years Total Percent
----------------------------------------------------------------------------------
Real Estate $ 13,413 $ 86,439 $416,754 $ 516,606 50.25%
Real Estate Construction 72,223 6,755 16,400 95,378 9.28%
Home Equity - 362 66,770 67,132 6.53%
Agricultural 101,551 71,227 10,811 183,589 17.85%
Commercial 89,755 64,649 11,008 165,412 16.09%
----------------------------------------------------------------------------------
Total $ 276,942 $ 229,432 $521,743 $1,028,117 100.00%
==================================================================================
Rate Sensitivity:
Predetermined Rate $ 40,965 $ 92,459 $180,579 $ 314,003 30.54%
Floating Rate 235,978 136,972 341,164 714,114 69.46%
----------------------------------------------------------------------------------
Total $ 276,943 $ 229,431 $521,743 $1,028,117 100.00%
==================================================================================
Percent 26.94% 22.32% 50.75% 100.00%
========================================================================
COMMITMENTS AND LINES OF CREDIT
The Company issues formal commitments or lines of credit to financially
responsible commercial and agricultural enterprises. Such commitments can be
either secured or unsecured and are typically in the form of revolving lines of
credit for seasonal working capital needs. Occasionally, such commitments are in
the form of letters of credit to facilitate the customer's particular business
transactions. For further discussion about commitments and contingencies, see
Note 14 located in "Item 8. Financial Statements and Supplementary Data."
FARMERS & MERCHANTS BANCORP
ANALYSIS OF CERTIFICATES OF DEPOSIT
(In thousands)
The following table sets forth, by time remaining to maturity, the Company's
time deposits in amounts of $100,000 or more for the periods indicated.
December 31,
2006
----------------------------------------------------------
TIME DEPOSITS OF $100,000 OR MORE
Three Months or Less $ 213,708
Over Three Months Through Six Months 72,991
Over Six Months Through Twelve Months 43,948
Over Twelve Months 9,640
----------------------------------------------------------
TOTAL TIME DEPOSITS OF $100,000 OR MORE $ 340,287
==========================================================
Refer to the Year-To-Date Average Balances and Rate Schedules located in "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations" for information on separate deposit categories.
16
ITEM 1A. RISK FACTORS
An investment in our common stock is subject to risks inherent in our business.
The material risks and uncertainties that management believes may affect our
business are described below. Before making an investment decision, you should
carefully consider the risks and uncertainties described below together with all
of the other information included or incorporated by reference in this report.
The risks and uncertainties described below are not the only ones facing our
business. Additional risks and uncertainties that management is not aware of or
focused on or that management currently deems immaterial may also impair our
business operations. This report is qualified in its entirety by these risk
factors.
If any of the following risks actually occur, our financial condition and
results of operations could be materially and adversely affected. If this were
to happen, the value of our common stock could decline significantly, and you
could lose all or part of your investment.
RISKS ASSOCIATED WITH OUR BUSINESS
We Are Dependent On Real Estate And A Downturn In The Real Estate Market Could
Hurt Our Business - A significant portion of our loan portfolio is dependent on
real estate. At December 31, 2006, real estate served as the principal source of
collateral with respect to approximately 66% of our loan outstandings. A decline
in current economic conditions or rising interest rates could have an adverse
effect on the demand for new loans, the ability of borrowers to repay
outstanding loans, the value of real estate and other collateral securing loans
and the value of real estate owned by us, as well as our financial condition and
results of operations in general and the market value of our common stock.
Acts of nature, including earthquakes, floods and fires, which may cause
uninsured damage and other loss of value to real estate that secures these
loans, may also negatively impact our financial condition.
Our Real Estate Lending Also Exposes Us To The Risk Of Environmental Liabilities
- In the course of our business, we may foreclose and take title to real estate,
and could be subject to environmental liabilities with respect to these
properties. We may be held liable to a governmental entity or to third persons
for property damage, personal injury, investigation and clean-up costs incurred
by these parties in connection with environmental contamination, or may be
required to investigate or clean up hazardous or toxic substances, or chemical
releases at a property. The costs associated with investigation or remediation
activities could be substantial. In addition, as the owner or former owner of a
contaminated site, we may be subject to common law claims by third parties based
on damages and costs resulting from environmental contamination emanating from
the property. If we ever become subject to significant environmental
liabilities, our business, financial condition, liquidity and results of
operations could be materially and adversely affected.
Our Business Is Subject To Interest Rate Risk And Changes In Interest Rates May
Adversely Affect Our Performance And Financial Condition - Our earnings are
impacted by changing interest rates. Changes in interest rates impact the demand
for new loans, the credit profile of our borrowers, the rates received on loans
and securities and rates paid on deposits and borrowings. The difference between
the rates received on loans and securities and the rates paid on deposits and
borrowings is known as interest rate spread. Given our current volume and mix of
interest-bearing liabilities and interest-earning assets, we would expect our
interest rate spread to increase if interest rates rise and, conversely, to
decline if interest rates fall. Increasing levels of competition in the banking
and financial services business may decrease our interest rate spread by forcing
us to offer lower lending interest rates and pay higher deposit interest rates.
Although we believe our current level of interest rate sensitivity is
reasonable, significant fluctuations in interest rates and increasing
competition may have an adverse effect on our business, financial condition and
results of operations.
A sustained decrease in market interest rates could adversely affect our
earnings. When interest rates decline, borrowers tend to refinance higher-rate,
fixed-rate loans at lower rates, prepaying their existing loans. Under those
circumstances, we would not be able to reinvest those prepayments in assets
earning interest rates as high as the rates on the prepaid loans. In addition,
our commercial real estate and commercial loans, which carry interest rates
that, in general, adjust in accordance with changes in the prime rate, will
adjust to lower rates. We are also significantly affected by the level of loan
demand available in our market. The inability to make sufficient loans directly
affects
17
the interest income we earn. Lower loan demand will generally result in lower
interest income realized as we place funds in lower yielding investments.
Failure To Successfully Execute Our Strategy Could Adversely Affect Our
Performance - Our financial performance and profitability depends on our ability
to execute our corporate growth strategy. Continued growth, however, may present
operating and other problems that could adversely affect our business, financial
condition and results of operations. Accordingly, there can be no assurance that
we will be able to execute our growth strategy or maintain the level of
profitability that we have recently experienced. Factors that may adversely
affect our ability to attain our long-term financial performance goals include
those stated elsewhere in this section, as well as:
- Inability to control non-interest expense, including, but not limited to,
rising employee and healthcare costs.
- Inability to increase non-interest income.
- Continuing ability to expand through de novo branching or otherwise.
Economic Conditions In Our Service Areas Could Adversely Affect Our Operations
And/Or Cause Us To Sustain Losses - Our retail and commercial banking operations
are concentrated primarily in Sacramento, San Joaquin, Stanislaus and Merced
Counties. As a result of this geographic concentration, our results of
operations depend largely upon economic conditions in this area. A significant
source of risk arises from the possibility that losses will be sustained if a
significant number of our borrowers, guarantors and related parties fail to
perform in accordance with the terms of their loans. This risk increases when
the economy is weak. We have adopted underwriting and credit monitoring
procedures and credit policies, including the establishment and review of the
allowance for loan losses, that management believes are appropriate to minimize
this risk by assessing the likelihood of nonperformance, tracking loan
performance and diversifying our credit portfolio. These policies and
procedures, however, may not prevent unexpected losses that could materially
adversely affect our results of operations in general and the market value of
our stock.
This Company's service areas can be significantly impacted by the seasonal and
cyclical trends of the agricultural industry. As a result, the Company's
financial results are influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and the planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in late fall and winter as crops are harvested and
sold). Additionally, although the Company's loan portfolio is believed to be
well diversified, at various times during the year approximately 35% of the
Company's loan balances can be outstanding to agricultural borrowers.
Commitments are well diversified across various commodities, including dairy,
grapes, walnuts, almonds, cherries, apples, pears, walnuts, and various row
crops. Additionally, many individual borrowers are themselves diversified across
commodity types, reducing their exposure, and therefore the Company's, to
cyclical downturns in any one commodity.
We Face Strong Competition From Financial Service Companies And Other Companies
That Offer Banking Services That Could Hurt Our Business - The financial
services business in our market areas is highly competitive. It is becoming
increasingly competitive due to changes in regulation, technological advances,
and the accelerating pace of consolidation among financial services providers.
We face competition both in attracting deposits and in making loans. We compete
for loans principally through the interest rates and loan fees we charge and the
efficiency and quality of services we provide. Increasing levels of competition
in the banking and financial services business may reduce our market share,
decrease loan demand, cause the prices we charge for our services to fall, or
decrease our net interest margin by forcing us to offer lower lending interest
rates and pay higher deposit interest rates. Therefore, our results may differ
in future periods depending upon the nature or level of competition.
Technology and other changes are allowing parties to complete financial
transactions that historically have involved banks through alternative methods.
For example, consumers can now maintain funds that would have historically been
held as bank deposits in brokerage accounts or mutual funds. Consumers can also
complete transactions such as paying bills and/or transferring funds directly
without the assistance of banks. The process of eliminating banks as
intermediaries, known as "disintermediation," could result in the loss of fee
income, as well as the loss of customer deposits and the related income
generated from those deposits. The loss of these revenue streams and the lower
cost
18
deposits as a source of funds could have a material adverse effect on our
financial condition and results of operations.
We May Not Be Able To Attract And Retain Skilled People - Our success depends,
in large part, on our ability to attract and retain key people. Competition for
the best people in most of our activities can be intense and we may not be able
to hire people or to retain them. The unexpected loss of services of one or more
of our key personnel could have a material adverse impact on our business
because of their skills, knowledge of our market, years of industry experience
and the difficulty of promptly finding qualified replacement personnel.
Our Internal Operations Are Subject To A Number Of Risks - We are subject to
certain operations risks, including, but not limited to, information system
failures and errors, customer or employee fraud and catastrophic failures
resulting from terrorist acts or natural disasters. We maintain a system of
internal controls to mitigate against such occurrences and maintain insurance
coverage for such risks that are insurable, but should such an event occur that
is not prevented or detected by our internal controls, uninsured or in excess of
applicable insurance limits, it could have a significant adverse impact on our
business, financial condition or results of operations.
We rely heavily on communications and information systems to conduct our
business. Any failure, interruption or breach in security of these systems could
result in failures or disruptions in our customer relationship management,
general ledger, deposit, loan and other systems. While we have policies and
procedures designed to prevent or limit the effect of the failure, interruption
or security breach of our information systems, there can be no assurance that
any such failures, interruptions or security breaches will not occur or, if they
do occur, that they will be adequately addressed. The occurrence of any
failures, interruptions or security breaches of our information systems could
damage our reputation, result in a loss of customer business, subject us to
additional regulatory scrutiny, or expose us to civil litigation and possible
financial liability, any of which could have a material adverse effect on our
financial condition and results of operations.
The financial services industry is continually undergoing rapid technological
change with frequent introductions of new technology-driven products and
services. The effective use of technology increases efficiency and enables
financial institutions to better serve customers and to reduce costs. Our future
success depends, in part, upon our ability to address the needs of our customers
by using technology to provide products and services that will satisfy customer
demands, as well as to create additional efficiencies in our operations. Many of
our competitors have substantially greater resources to invest in technological
improvements. We may not be able to effectively implement new technology-driven
products and services or be successful in marketing these products and services
to our customers. Failure to successfully keep pace with technological change
affecting the financial services industry could have a material adverse impact
on our business and, in turn, our financial condition and results of operations.
Severe weather, natural disasters, acts of war or terrorism and other adverse
external events could have a significant impact on our ability to conduct
business. Such events could affect the stability of our deposit base, impair the
ability of borrowers to repay outstanding loans, impair the value of collateral
securing loans, cause significant property damage, result in loss of revenue
and/or cause us to incur additional expenses. Operations in several of our
markets could be disrupted by both the evacuation of large portions of the
population as well as damage and or lack of access to our banking and operation
facilities. While we have not experienced such an occurrence to date, other
severe weather or natural disasters, acts of war or terrorism or other adverse
external events may occur in the future. Although management has established
disaster recovery policies and procedures, the occurrence of any such event
could have a material adverse effect on our business, which, in turn, could have
a material adverse effect on our financial condition and results of operations.
We Depend On Cash Dividends From Our Subsidiary Bank To Meet Our Cash
Obligations - As a holding company, dividends from our subsidiary bank provide a
substantial portion of our cash flow used to service the interest payments on
our Trust Preferred Securities and our other obligations, including cash
dividends. See "Item 5. Market for the Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities." Various
statutory provisions restrict the amount of dividends our subsidiary bank can
pay to us without regulatory approval.
19
RISKS ASSOCIATED WITH OUR INDUSTRY
We Are Subject To Government Regulation That Could Limit Or Restrict Our
Activities, Which In Turn Could Adversely Impact Our Operations - The financial
services industry is regulated extensively. Federal and State regulation is
designed primarily to protect the deposit insurance funds and consumers, and not
to benefit our shareholders. These regulations can sometimes impose significant
limitations on our operations.
New laws and regulations or changes in existing laws and regulations or repeal
of existing laws and regulations may adversely impact our business.
Further, federal monetary policy, particularly as implemented through the
Federal Reserve System, significantly affects economic conditions for us.
New Legislative And Regulatory Proposals May Affect Our Operations And Growth -
Proposals to change the laws and regulations governing the operations and
taxation of, and federal insurance premiums paid by, banks and other financial
institutions and companies that control such institutions are frequently raised
in the U.S. Congress, the California legislature and before bank regulatory
authorities. The likelihood of any major changes in the future and the impact
such changes might have on us or our subsidiaries are impossible to determine.
Similarly, proposals to change the accounting treatment applicable to banks and
other depository institutions are frequently raised by the SEC, the federal
banking agencies, the IRS and other appropriate authorities. The likelihood and
impact of any additional future changes in law or regulation and the impact such
changes might have on us or our subsidiaries are impossible to determine at this
time.
RISKS ASSOCIATED WITH OUR STOCK
Our Stock Trades Less Frequently Than Others - The Company's common stock is not
widely held or listed on any exchange. However, trades may be reported on the
OTC Bulletin Board under the symbol "FMCB.OB". Management is aware that there
are private transactions in the Company's common stock. However, the limited
trading market for the Company's common stock may make it difficult for
stockholders to dispose of their shares.
Our Stock Price Is Affected By A Variety Of Factors - Stock price volatility may
make it more difficult for you to resell your common stock when you want and at
prices you find attractive. Our stock price can fluctuate significantly in
response to a variety of factors discussed in this section, including, among
other things:
- Actual or anticipated variations in quarterly results of operations.
- Operating and stock price performance of other companies that investors
deem comparable to our Company.
- News reports relating to trends, concerns and other issues in the financial
services industry.
- Perceptions in the marketplace regarding our Company and/or its
competitors.
Our Common Stock Is Not An Insured Deposit - Our common stock is not a bank
deposit and, therefore, is not insured against loss by the FDIC, any other
deposit insurance fund or by any other public or private entity. Investment in
our common stock is inherently risky for the reasons described in this "Risk
Factors" section and elsewhere in this report and is subject to the same market
forces that affect the price of common stock in any company. As a result, if you
acquire our common stock, you may lose some or all of your investment.
ITEM 1B. UNRESOLVED STAFF COMMENTS
The Company has no unresolved comments received from staff at the SEC.
20
ITEM 2. PROPERTIES
Farmers & Merchants Bancorp along with its subsidiaries are headquartered in
Lodi, California. Executive offices are located at 111 W. Pine Street. Banking
services are provided in twenty-one locations in the Company's service area. Of
the twenty-one locations, thirteen are owned and eight are leased. The
expiration of these leases occurs between the years 2007 and 2016. See Note 14
located in "Item 8. Financial Statements and Supplementary Data."
ITEM 3. LEGAL PROCEEDINGS
Certain lawsuits and claims arising in the ordinary course of business have been
filed or are pending against the Company or its subsidiaries. Based upon
information available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.
There are no material proceedings adverse to the Company to which any Director,
officer or affiliate of the Company is a party.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders during the
fourth quarter of 2006.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
The common stock of Farmers & Merchants Bancorp is not widely held or listed on
any exchange. However, trades may be reported on the OTC Bulletin Board under
the symbol "FMCB.OB". Additionally, management is aware that there are private
transactions in the Company's common stock.
The following table summarizes the actual high and low sale prices for the
Company's common stock since the first quarter of 2005. These figures are based
on activity posted on the OTC Bulletin Board and on private transactions between
individual shareholders that are reported to the Company.
Cash Dividends
Calendar Quarter High Low Declared (Per Share)
---------------- ----- ---- ---------------------
2006 Fourth quarter $ 557 $505 $ 4.80
Third quarter 565 505 -
Second quarter 550 475 3.75
First quarter 510 485 -
2005 Fourth quarter $ 500 $465 $ 4.50
Third quarter 515 465 -
Second quarter 515 438 3.18
First quarter 525 415 -
As of January 31, 2007, there were approximately 1,483 shareholders of record of
the Company's common stock.
Beginning in 1975 and continuing through 2005, the Company issued a 5% stock
dividend annually. However, this dividend was discontinued in 2006 based upon
management's and the Board's assessment that: (1) the Company had a sufficient
number of shares outstanding to provide for orderly and timely market trades;
(2) the costs associated with the issuance of stock dividends could be better
spent in other areas of the Company's operations; and (3)
21
whereas the required accounting for a stock dividend has no impact on the
Company's overall capital position it does require that Retained Earnings be
reclassified to Additional Paid-In Capital, which over time limits the growth of
the Retained Earnings account from which cash dividends are paid.
There are limitations under Delaware corporate law as to the amounts of
dividends that may be paid by the Company. Additionally, if we decided to defer
interest on our subordinated debentures, we would be prohibited from paying cash
dividends on the Company's common stock. The Company is dependent on dividends
paid by the Bank to fund its dividend payments to its stockholders. There are
regulatory limitations on cash dividends that may be paid by the Bank under
state and federal laws. See "Item 1. Business - Supervision and Regulation."
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continued
to have more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as "well capitalized." On April 4,
2006, the Board unanimously approved expanding the Repurchase Program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired.
The following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the fourth quarter of 2006.
Approximate Dollar
Number of Shares Value of Shares that
Average Purchased as Part of a May Yet Be Purchased
Number of Price per Publicly Announced Under the Plan or
Period Shares Share Plan or Program Program
-----------------------------------------------------------------------------------
October 2006 800 $ 510 800 $ 10,817,820
November 2006 - - - 10,817,820
December 2006 - - - 10,817,820
-----------------------------------------------------------------------------------
Total 800 $ 510 800 $ 10,817,820
All of the above shares were repurchased in private transactions.
22
PERFORMANCE GRAPHS
The following graphs compare the yearly percentage change in the Company's
cumulative total stockholder return on common stock with: (i) the cumulative
total return of the American Stock Exchange market index; and (ii) a published
index compiled by Hemscott Group (formerly Core Data) of banks and bank holding
companies throughout the United States. The following comparisons cover the
period January 1, 2002 to December 31, 2006. The graphs assume an initial
investment of $100 on January 1, 2002 and reinvestment of dividends. The stock
price performance set forth in the following graphs is not necessarily
indicative of future price performance.
These graphs shall not be deemed filed or incorporated by reference into any
filing under the Securities Act of 1933 or under the Securities Exchange Act of
1934, except to the extent that we specifically incorporate these graphs by
reference.
[GRAPHIC OMITTED]
[GRAPHIC OMITTED]
23
ITEM 6. SELECTED FINANCIAL DATA
FARMERS & MERCHANTS BANCORP
FIVE YEAR FINANCIAL SUMMARY OF OPERATIONS
(in thousands except per share data)
SUMMARY OF INCOME: 2006 2005 2004 2003 2002
-----------------------------------------------------------------------------------------------------------------
Total Interest Income $ 88,396 $ 72,458 $ 59,300 $ 54,884 $ 54,238
Total Interest Expense 24,621 14,032 9,818 11,073 13,596
-----------------------------------------------------------------------------------------------------------------
Net Interest Income 63,775 58,426 49,482 43,811 40,642
Provision for Loan Losses 275 425 1,275 625 4,926
-----------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 63,500 58,001 48,207 43,186 35,716
Total Non-Interest Income 12,063 11,274 14,267 12,918 13,866
Total Non-Interest Expense 43,121 40,617 36,175 33,286 29,109
-----------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 32,442 28,658 26,299 22,818 20,473
Provision for Income Taxes 11,813 10,230 9,625 8,043 7,054
-----------------------------------------------------------------------------------------------------------------
Net Income Before Cumulative Effect
of Change in Accounting Principle 20,629 18,428 16,674 14,775 13,419
Cumulative Effect of a Change in
Accounting Principle (net of tax) - - (224) - -
-----------------------------------------------------------------------------------------------------------------
Net Income $ 20,629 $ 18,428 $ 16,450 $ 14,775 $ 13,419
=================================================================================================================
BALANCE SHEET DATA:
-----------------------------------------------------------------------------------------------------------------
Total Assets $1,411,233 $1,352,989 $1,226,295 $1,148,565 $1,021,907
Loans 1,046,912 973,257 866,908 806,906 696,675
Allowance for Loan Losses 18,099 17,860 17,727 17,220 16,684
Investment Securities 243,867 267,940 275,440 261,922 233,933
Deposits 1,198,528 1,103,340 1,002,110 904,349 850,225
Federal Home Loan Bank Advances 47,532 98,847 80,889 111,928 40,965
Shareholders' Equity 132,340 123,648 116,547 109,605 103,565
-----------------------------------------------------------------------------------------------------------------
SELECTED RATIOS:
Return on Average Assets 1.51% 1.46% 1.40% 1.36% 1.41%
Return on Average Equity 16.16% 15.26% 14.50% 13.68% 13.16%
Dividend Payout Ratio(1) 33.77% 34.55% 34.79% 32.05% 32.82%
Average Loans to Average Deposits 90.24% 87.28% 86.41% 85.29% 79.71%
Average Equity to Average Assets 9.38% 9.58% 9.68% 9.97% 10.71%
Period-end Shareholders' Equity to Total Assets 9.38% 9.14% 9.50% 9.54% 10.13%
PER SHARE DATA:
Net Income (2) (3) $ 25.25 $ 22.24 $ 19.68 $ 17.55 $ 15.78
Cash Dividends Per Share (1)(3) $ 8.55 $ 7.68 $ 6.85 $ 5.63 $ 5.18
(1) Not including cash paid in lieu of fractional shares related to stock
dividend.
(2) Based on the weighted average number of shares outstanding of 817,044,
828,537, 835,746, 841,857 and 850,490 for the years ended December 31,
2006, 2005, 2004, 2003, and 2002, respectively.
(3) Per share data has been adjusted, where applicable, for stock dividends
issued in any of the above years.
24
FARMERS & MERCHANTS BANCORP
QUARTERLY FINANCIAL DATA
(in thousands except per share data)
First Second Third Fourth
2006 Quarter Quarter Quarter Quarter Total
-----------------------------------------------------------------------------
Total Interest Income $ 20,703 $ 21,669 $ 22,950 $ 23,074 $88,396
Total Interest Expense 4,754 5,773 6,856 7,238 24,621
-----------------------------------------------------------------------------
Net Interest Income 15,949 15,896 16,094 15,836 63,775
Provision for Loan Losses 275 - - - 275
-----------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 15,674 15,896 16,094 15,836 63,500
Total Non-Interest Income 2,604 3,499 3,114 2,846 12,063
Total Non-Interest Expense 10,534 11,376 10,777 10,434 43,121
-----------------------------------------------------------------------------
Income Before Income Taxes 7,744 8,019 8,431 8,248 32,442
Provision for Income Taxes 2,807 2,925 3,098 2,983 11,813
-----------------------------------------------------------------------------
Net Income $ 4,937 $ 5,094 $ 5,333 $ 5,265 $20,629
=============================================================================
Earnings Per Share (1) $ 6.00 $ 6.22 $ 6.54 $ 6.49 $ 25.25
=============================================================================
First Second Third Fourth
2005 Quarter Quarter Quarter Quarter Total
-----------------------------------------------------------------------------
Total Interest Income $ 16,093 $ 17,817 $ 18,705 $ 19,843 $72,458
Total Interest Expense 2,729 3,319 3,847 4,137 14,032
-----------------------------------------------------------------------------
Net Interest Income 13,364 14,498 14,858 15,706 58,426
Provision for Loan Losses - - - 425 425
-----------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 13,364 14,498 14,858 15,281 58,001
Total Non-Interest Income 2,902 3,023 2,984 2,365 11,274
Total Non-Interest Expense 9,299 10,357 10,452 10,509 40,617
-----------------------------------------------------------------------------
Income Before Income Taxes 6,967 7,164 7,390 7,137 28,658
Provision for Income Taxes 2,536 2,575 2,643 2,476 10,230
-----------------------------------------------------------------------------
Net Income $ 4,431 $ 4,589 $ 4,747 $ 4,661 $18,428
=============================================================================
Earnings Per Share (1) $ 5.33 $ 5.52 $ 5.74 $ 5.65 $ 22.24
=============================================================================
(1) Per share data has been adjusted, where applicable, for stock dividends
issued in any of the above years.
Farmers & Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Based on
information from shareholders and from Company stock transfer records, the
prices paid in 2006, 2005 and 2004 ranged from $565.00 to $300.00 per share.
Additional information about the Company's common stock is available in Part II,
Item 5.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This annual report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the Private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of further acts or threats of terrorism; and (viii) other factors
discussed in the Company's filings with the Securities and Exchange Commission.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
INTRODUCTION
Farmers & Merchants Bancorp, or the Company, is a bank holding company formed
March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California,
or the Bank, is a California state-chartered bank formed in 1916. The Bank
serves the northern Central Valley of California with 21 banking offices. The
service area includes Sacramento, San Joaquin, Stanislaus and Merced Counties
with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto,
Turlock and Hilmar.
Substantially all of the Company's business activities are conducted within its
market area.
As a bank holding company, the Company is subject to regulation and examination
by the Board of Governors of the Federal Reserve System ("FRB"). As a
California, state-chartered, non-fed member bank, the Bank is subject to
regulation and examination by the California Department of Financial
Institutions and the Federal Deposit Insurance Corporation.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report.
OVERVIEW
The Company's primary service area encompasses the northern Central Valley of
California, a region that can be significantly impacted by the seasonal needs of
the agricultural industry. Accordingly, discussion of the Company's Financial
Condition and Results of Operations is influenced by the seasonal banking needs
of its agricultural customers (e.g., during the spring and summer customers draw
down their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in late fall and winter as crops are harvested and
sold).
26
The Five Year Period: 2002 through 2006
The following table presents key performance data for the Company over the past five years.
(in thousands, except per share data)
Financial Performance Indicator 2006 2005 2004 2003 2002
------------------------------------------------------------------------------------------------------
Net Income $ 20,629 $ 18,428 $ 16,450 $ 14,775 $ 13,419
------------------------------------------------------------------------------------------------------
Total Assets $1,411,233 $1,352,989 $1,226,295 $1,148,565 $1,021,907
------------------------------------------------------------------------------------------------------
Total Loans $1,046,912 $ 973,257 $ 866,908 $ 806,906 $ 696,675
------------------------------------------------------------------------------------------------------
Total Deposits $1,198,528 $1,103,340 $1,002,110 $ 904,349 $ 850,225
------------------------------------------------------------------------------------------------------
Total Shareholders' Equity $ 132,340 $ 123,648 $ 116,547 $ 109,605 $ 103,565
------------------------------------------------------------------------------------------------------
Total Risk-Based Capital Ratio 12.17% 12.32% 13.34% 13.24% 12.25%
------------------------------------------------------------------------------------------------------
Non-Performing Loans as a % of Total
Loans 0.01% 0.07% 0.03% 0.32% 0.42%
------------------------------------------------------------------------------------------------------
Net Charge-Offs to Average Loans 0.00% 0.03% 0.08% 0.01% 0.15%
------------------------------------------------------------------------------------------------------
Loan Loss Allowance as a % of Total
Loans 1.72% 1.83% 2.04% 2.13% 2.39%
------------------------------------------------------------------------------------------------------
Return on Average Assets 1.51% 1.46% 1.40% 1.36% 1.41%
------------------------------------------------------------------------------------------------------
Return on Average Equity 16.16% 15.26% 14.50% 13.68% 13.16%
------------------------------------------------------------------------------------------------------
Earnings Per Share (1) $ 25.25 $ 22.24 $ 19.68 $ 17.55 $ 15.78
------------------------------------------------------------------------------------------------------
Cash Dividends Per Share (1) (2) $ 8.55 $ 7.68 $ 6.85 $ 5.63 $ 5.18
------------------------------------------------------------------------------------------------------
Cash Dividends Declared (2) $ 6,966 $ 6,366 $ 5,723 $ 4,736 $ 4,404
------------------------------------------------------------------------------------------------------
# Shares Repurchased During Year 11,718 8,066 7,981 5,732 20,749
------------------------------------------------------------------------------------------------------
Average Share Price of Repurchased
Shares $ 507 $ 496 $ 389 $ 256 $ 241
------------------------------------------------------------------------------------------------------
High Stock Price - Fourth Quarter $ 557 $ 500 $ 455 $ 375 $ 300
------------------------------------------------------------------------------------------------------
Low Stock Price - Fourth Quarter $ 505 $ 465 $ 400 $ 300 $ 250
------------------------------------------------------------------------------------------------------
___________________________
(1) Prior years have been restated for stock dividends issued in 2002 through
2005. No stock dividend was issued in 2006.
(2) Not including cash paid in lieu of fractional shares related to stock
dividends. These payments totaled $779,000 between 2002 and 2005.
During the five year period 2002 through 2006, the Company's operating
performance improved every year.
- Annual net income increased 54% to $20.6 million from $13.4 million.
- Earnings Per Share increased 60% to $25.25 from $15.78.
- Return on Average Equity increased 300 basis points to 16.16% from 13.16%.
- Total assets increased 38% to $1.4 billion.
- Total loans increased 50% to $1.0 billion.
Importantly, during this period of asset and earnings growth:
- The Bank's risk based capital ratio has remained above the 10% level that
federal and state banking regulators require for banks to be considered
"well capitalized." See "Financial Condition - Capital."
27
- The Company's asset quality has remained strong, as reflected by net
charge-offs never exceeding 0.15% of average loans in any year and
non-performing loans totaling 0.01% of total loans at December 31, 2006.
See "Financial Condition - Non-Performing Assets."
- The Company's allowance for loan losses has been maintained above 1.7% of
total loans, reflecting a conservative approach to providing for loan
losses. See "Results of Operations - Provision and Allowance for Loan
Losses."
As a result of this strong earnings performance, capital position and asset
quality, shareholders have benefited well in excess of overall stock market
returns over the past five years.
- Return on Average Equity has increased every year from 13.16% in 2002 to
16.16% in 2006.
- Cash Dividends per Share, restated for stock dividends issued, have
increased 89% since 2001, and totaled $33.87 per share over the five year
period.
- The market price of the Company's stock has increased $265 per share from a
close of $250 in the fourth quarter of 2001 to a close of $515 in the
fourth quarter of 2006. Additionally, as a result of the 5% stock dividend
declared in 2002 through 2005; the average shareholder owned approximately
121 shares at December 31, 2006 for every 100 shares they owned at December
31, 2001.
- The total return on the Company's stock over the past five years compares
very favorably to overall stock market returns as represented by the AMEX
Market Index and the Hemscott Group Index of Banks and Bank Holding
Companies. See "Performance Graphs."
- The total market capitalization of the Company has increased $238.3
million, or 133%, over the five year period.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continued
to have more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as "well capitalized." On April 4,
2006, the Board unanimously approved expanding the Repurchase Program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.Repurchases under the program will continue to be made on the open market
or through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired.
Since the second stock repurchase program was expanded in 2006, the Company has
repurchased over 8,200 shares for total consideration of $4.2 million.
The Current Year: 2006
At the completion of our 90th year, management and the Board are pleased to
report the highest net income in the Company's history. For the year ended
December 31, 2006, Farmers & Merchants Bancorp reported net income of $20.6
million, earnings per share of $25.25, return on average assets of 1.51% and
return on average equity of 16.16%.
The Company's continuing strong earnings performance in 2006 was due to a
carefully implemented strategy to balance growth and margin protection, which
resulted in: (1) 7.6% growth in average earning assets; (2) improvement in the
mix of earning assets as reflected by an increase in loans as a percentage of
average earning assets from 77% in 2005 to 79% in 2006; (3) improvement in the
net interest margin from 5.12% in 2005 to 5.18% in 2006 due to the continuing
residual impact of increases in market interest rates that occurred in mid-2004
through mid-2006; and (4) improvement in the efficiency ratio from 58.3% in 2005
to 56.9% in 2006.
28
The following is a summary of the financial accomplishments achieved during 2006
as compared to 2005.
- Net income increased 11.9% to $20.6 million from $18.4 million.
- Earnings per share increased 13.5% to $25.25 from $22.24.
- Net interest income increased 9.2% to $63.8 million from $58.4 million.
- Total assets increased 4.3% to $1.41 billion from $1.35 billion.
- Gross loans increased 7.6% to $1.0 billion from $973.3 million.
- Total deposits increased 8.6% to $1.2 billion from $1.1 billion.
- Total shareholders' equity increased 7.3% to $132.3 million from $123.6
million, after dividends of $7.0 million, stock buybacks of $5.9 million
and a decrease in Accumulated Other Comprehensive Loss of $975,000.
- Total market capitalization increased $14.6 million.
Looking Forward: 2007 and Beyond
In management's opinion, the following key issues will influence the financial
results of the Company in 2007 and future years:
- The Company is asset sensitive. See "Item 7A. Quantitative and Qualitative
Disclosures About Market Risk - Interest Rate Risk." As a result, between
2005 and 2006, the Company's net interest margin improved approximately 6
basis points as a result of the continuing residual impact of increases in
market interest rates that occurred in mid-2004 through mid-2006. However,
since increases in the Company's deposit rates typically lag increases in
loan rates, once short-term market rates stabilized in June 2006 the
Company's net interest margin has dropped by approximately 33 bps from a
high of 5.37% in the first quarter of 2006 to 5.04% in the fourth quarter
of 2006. Some economists are predicting that short-term market rates may
drop in late 2007 which will place further pressure on the net interest
margin as decreases in deposit rates will lag decreases in loan rates.
Additionally, the Company's net interest margin is coming under pressure
from (1) competitor pricing strategies for both loans and deposits that the
Company may need to respond to in order to retain key customers and (2)
changes in deposit mix as customers move funds from low or non-interest
bearing transaction and savings accounts to higher yielding time deposits.
- The Company's results can be influenced by changes in the credit quality of
its borrowers. Non-performing loans totaled $54,000 or 0.01% of total loans
at December 31, 2006 and $694,000 or 0.07% of total loans at December 31,
2005. Management believes that these levels are adequately covered by the
Company's current loan loss reserves and that the general economic
conditions in the Company's service area appear positive at the current
time. However, future financial results could be impacted should
deterioration in economic conditions or other factors that affect credit
quality cause the level of the Company's non-performing loans to increase.
In addition to the preceding issues, over the past several years management has
reviewed the Company's existing branch delivery system, along with the
availability and desirability of additional branch locations, and initiated a
major branch expansion, relocation and renovation program. New branches were
opened during 2006 in Sacramento, Lodi and Stockton and the downtown Turlock
branch will be relocated to a new facility in 2007. In management's opinion,
these moves are integral to the long-term strategic positioning of the Company.
The Company currently estimates that the total capital expenditures associated
with this multi-year branch program, which began in 2004, will be in excess of
$10 million which will result in an increase in the Company's future occupancy
expense as compared to 2006. In addition, the increased staffing and other
operating expense associated
29
with these new branches will place pressure on the Company's earnings over the
next 24-36 months, the timeframe in which these branches are estimated to reach
break-even.
RESULTS OF OPERATIONS
The following discussion and analysis is intended to provide a better
understanding of Farmers & Merchants Bancorp and its subsidiaries' performance
during each of the years in the three-year period ended December 31, 2006 and
the material changes in financial condition, operating income and expense of the
Company and its subsidiaries as shown in the accompanying financial statements.
Net Interest Income/Net Interest Margin
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the years ending 2006, 2005 and 2004. Average
balance amounts for assets and liabilities are the computed average of daily
balances.
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" adjustment and is noted wherever applicable.
The Volume and Rate Analysis of Net Interest Income summarizes the changes in
interest income and interest expense based on changes in average asset and
liability balances (volume) and changes in average rates (rate). For each
category of interest-earning assets and interest-bearing liabilities,
information is provided with respect to changes attributable to: (1) changes in
volume (change in volume multiplied by initial rate); (2) changes in rate
(change in rate multiplied by initial volume); and (3) changes in rate/volume
(allocated in proportion to the respective volume and rate components).
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix. See "Item 7A. Quantitative
and Qualitative Disclosures About Market Risk - Interest Rate Risk."
2006 Compared to 2005
Net interest income increased 9.2% to $63.8 million during 2006. During 2005,
net interest income was $58.4 million, representing an increase of 18.1% from
2004. On a fully taxable equivalent basis, net interest income increased 8.9%
and totaled $65.4 million during 2006, compared to $60.1 million for 2005. The
increase in net interest income was due to a combination of (1) growth in
average earning assets in 2006 and (2) improvement in the net interest margin.
Net interest income on a taxable equivalent basis, expressed as a percentage of
average total earning assets, is referred to as the net interest margin. For
2006, the Company's net interest margin was 5.18% compared to 5.12% in 2005. As
discussed previously, this improvement is due to the continuing residual impact
of increases in market interest rates that occurred in mid-2004 through
mid-2006. See "Overview - Looking Forward: 2007 and Beyond" for a discussion of
factors impacting the Company's future net interest margin.
Loans, generally the Company's highest earning assets, increased $73.7 million
as of December 31, 2006 compared to December 31, 2005. See "Financial Condition
- Loans" for further discussion on this increase. On an average balance basis,
loans increased by $94.8 million for the year ended December 31, 2006. As a
result of this loan growth, the mix of the Company's earning assets improved as
loans increased from 77.0% of average earning assets during 2005 to 79% in 2006.
Due to increases in market rates from mid- 2004 through mid-2006, the
year-to-date yield on the loan portfolio increased 86 basis points to 7.70% for
the year ended December 31, 2006 compared to 6.84% for the year ended December
31, 2005. This increase in yield plus the growth in loan balances resulted in
interest revenue from loans increasing 24.3% to $76.9 million for 2006.
30
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Year Ended December 31,
2006
ASSETS Balance Interest Rate
----------------------------------------------------------------------------------------------------------
Federal Funds Sold and Securities Purchased Under Agreements to Resell $ 1,030 $ 49 4.76%
Investment Securities Available-for-Sale
U.S. Agencies 27,295 1,112 4.07%
Municipals - Non-Taxable 15,121 957 6.33%
Mortgage Backed Securities 103,763 4,981 4.80%
Other 6,870 385 5.60%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 153,049 7,435 4.86%
----------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 30,593 1,270 4.15%
Municipals - Non-Taxable 67,490 3,947 5.85%
Mortgage Backed Securities 9,785 375 3.83%
Other 2,120 62 2.92%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 109,988 5,654 5.14%
----------------------------------------------------------------------------------------------------------
Loans
Real Estate 567,479 40,915 7.21%
Home Equity 67,251 5,356 7.96%
Agricultural 164,897 13,843 8.39%
Commercial 178,528 14,976 8.39%
Consumer 13,587 1,205 8.87%
Credit Card 5,445 536 9.84%
Municipal 1,215 41 3.37%
----------------------------------------------------------------------------------------------------------
Total Loans 998,402 76,872 7.70%
----------------------------------------------------------------------------------------------------------
Total Earning Assets 1,262,469 $ 90,010 7.13%
=====================
Unrealized Gain (Loss) on Securities Available-for-Sale (3,629)
Allowance for Loan Losses (18,280)
Cash and Due From Banks 37,906
All Other Assets 83,238
-----------------------------------------------------------------------------------
TOTAL ASSETS $1,361,704
===================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 128,199 $ 89 0.07%
Savings 277,185 2,310 0.83%
Time Deposits 424,745 16,231 3.82%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 830,129 18,630 2.24%
Other Borrowed Funds 99,484 5,164 5.19%
Subordinated Debt 10,310 827 8.02%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 939,923 $ 24,621 2.62%
=====================
Interest Rate Spread 4.51%
Demand Deposits 276,289
All Other Liabilities 17,824
-----------------------------------------------------------------------------------
TOTAL LIABILITIES 1,234,036
Shareholders' Equity 127,668
-----------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,361,704
===================================================================================
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.67%
Net Interest Income and Margin on Total Earning Assets 65,389 5.18%
Tax Equivalent Adjustment (1,614)
----------------------------------------------------------------------------------------------------------
Net Interest Income $ 63,775 5.05%
==========================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis. Loan interest income includes fee income and unearned discount
of $2.7 million for the year ended December 31, 2006. Nonaccrual loans and lease
financing receivables have been included in the average balances. Yields on
securities available-for-sale are based on historical cost.
31
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Year Ended December 31,
2005
ASSETS Balance Interest Rate
----------------------------------------------------------------------------------------------------------
Federal Funds Sold and Securities Purchased Under Agreements to Resell $ 5,593 $ 188 3.36%
Investment Securities Available-for-Sale
U.S. Agencies 58,226 2,187 3.76%
Municipals - Taxable 81 5 6.17%
Municipals - Non-Taxable 15,987 976 6.10%
Mortgage Backed Securities 79,290 3,112 3.92%
Other 4,582 255 5.57%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 158,166 6,535 4.13%
----------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 28,255 1,167 4.13%
Municipals - Non-Taxable 64,968 3,880 5.97%
Mortgage Backed Securities 12,223 465 3.80%
Other 432 26 6.02%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 105,878 5,538 5.23%
----------------------------------------------------------------------------------------------------------
Loans
Real Estate 507,315 34,133 6.73%
Home Equity 65,397 4,172 6.38%
Agricultural 142,008 9,880 6.96%
Commercial 170,081 12,012 7.06%
Consumer 12,694 1,106 8.71%
Credit Card 5,046 491 9.73%
Municipal 1,029 44 4.28%
----------------------------------------------------------------------------------------------------------
Total Loans 903,570 61,838 6.84%
----------------------------------------------------------------------------------------------------------
Total Earning Assets 1,173,207 $ 74,099 6.32%
=====================
Unrealized Gain/(Loss) on Securities Available-for-Sale (1,856)
Allowance for Loan Losses (17,910)
Cash and Due From Banks 35,453
All Other Assets 72,235
-----------------------------------------------------------------------------------
TOTAL ASSETS $1,261,129
===================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 117,460 $ 79 0.07%
Savings 298,181 1,319 0.44%
Time Deposits 351,552 8,430 2.40%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 767,193 9,828 1.28%
Other Borrowed Funds 78,719 3,561 4.52%
Subordinated Debt 10,310 643 6.24%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 856,222 $ 14,032 1.64%
=====================
Interest Rate Spread 4.68%
Demand Deposits 268,038
All Other Liabilities 16,092
-----------------------------------------------------------------------------------
TOTAL LIABILITIES 1,140,352
Shareholders' Equity 120,777
-----------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,261,129
===================================================================================
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.44%
Net Interest Income and Margin on Total Earning Assets 60,067 5.12%
Tax Equivalent Adjustment (1,641)
----------------------------------------------------------------------------------------------------------
Net Interest Income $ 58,426 4.98%
==========================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis. Loan interest income includes fee income and unearned discount
of $3.5 million for the year ended December 31, 2005. Nonaccrual loans and lease
financing receivables have been included in the average balances. Yields on
securities available-for-sale are based on historical cost.
32
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Year Ended December 31,
2004
ASSETS Balance Interest Rate
----------------------------------------------------------------------------------------------------------
Federal Funds Sold and Securities Purchased Under Agreements to Resell $ 14,267 $ 194 1.36%
Investment Securities Available-for-Sale
U.S. Agencies 67,419 2,449 3.63%
Municipals - Taxable 1,005 63 6.27%
Municipals - Non-Taxable 19,044 1,162 6.10%
Mortgage Backed Securities 97,947 3,703 3.78%
Other 7,098 381 5.37%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 192,513 7,758 4.03%
----------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 13,409 564 4.21%
Municipals - Non-Taxable 37,303 2,383 6.39%
Mortgage Backed Securities 9,604 384 4.00%
Other 333 15 4.50%
----------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 60,649 3,346 5.52%
----------------------------------------------------------------------------------------------------------
Loans
Real Estate 477,220 29,771 6.24%
Home Equity 58,187 2,852 4.90%
Agricultural 131,971 7,091 5.37%
Commercial 140,145 8,062 5.75%
Consumer 11,307 1,037 9.17%
Credit Card 4,599 442 9.61%
Municipal 1,070 47 4.39%
----------------------------------------------------------------------------------------------------------
Total Loans 824,499 49,302 5.98%
----------------------------------------------------------------------------------------------------------
Total Earning Assets 1,091,928 $ 60,600 5.55%
=====================
Unrealized Gain/(Loss) on Securities Available-for-Sale 779
Allowance for Loan Losses (17,850)
Cash and Due From Banks 33,389
All Other Assets 63,005
-----------------------------------------------------------------------------------
TOTAL ASSETS $1,171,251
===================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 96,152 $ 62 0.06%
Savings 285,796 1,090 0.38%
Time Deposits 333,377 5,509 1.65%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 715,325 6,661 0.93%
Other Borrowed Funds 81,598 2,703 3.31%
Subordinated Debt 10,310 454 4.40%
----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 807,233 $ 9,818 1.22%
=====================
Interest Rate Spread 4.33%
Demand Deposits 238,817
All Other Liabilities 11,780
-----------------------------------------------------------------------------------
TOTAL LIABILITIES 1,057,830
Shareholders' Equity 113,421
-----------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,171,251
===================================================================================
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.32%
Net Interest Income and Margin on Total Earning Assets 50,782 4.65%
Tax Equivalent Adjustment (1,300)
----------------------------------------------------------------------------------------------------------
Net Interest Income $ 49,482 4.53%
==========================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis. Loan interest income includes fee income and unearned discount
of $3.2 million for the year ended December 31, 2004. Nonaccrual loans and lease
financing receivables have been included in the average balances. Yields on
securities available-for-sale are based on historical cost.
33
FARMERS & MERCHANTS BANCORP
VOLUME AND RATE ANALYSIS OF NET INTEREST REVENUE
(Rates on a Taxable Equivalent Basis) 2006 versus 2005
(in thousands) Amount of Increase
(Decrease) Due to Change in:
----------------------------------------
INTEREST EARNING ASSETS Volume Rate Net Chg.
--------------------------------------------------------------------------------------------
Federal Funds Sold $ (195) $ 56 $ (139)
Investment Securities Available for Sale
U.S. Agencies (1,247) 172 (1,075)
Municipals - Taxable (2) (3) (5)
Municipals - Non-Taxable (54) 35 (19)
Mortgage Backed Securities 1,085 784 1,869
Other 128 2 130
--------------------------------------------------------------------------------------------
Total Investment Securities Available for Sale (90) 990 900
--------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Agencies 97 6 103
Municipals - Non-Taxable 149 (82) 67
Mortgage Backed Securities (94) 4 (90)
Other 56 (20) 36
--------------------------------------------------------------------------------------------
Total Investment Securities Held to Maturity 208 (92) 116
--------------------------------------------------------------------------------------------
Loans:
Real Estate 4,229 2,553 6,782
Home Equity 121 1,063 1,184
Agricultural 1,736 2,227 3,963
Commercial 620 2,344 2,964
Installment 79 20 99
Credit Card 39 6 45
Other 7 (10) (3)
--------------------------------------------------------------------------------------------
Total Loans 6,831 8,203 15,034
--------------------------------------------------------------------------------------------
Total Earning Assets 6,754 9,157 15,911
--------------------------------------------------------------------------------------------
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Transaction 7 3 10
Savings (99) 1,090 991
Time Deposits 2,026 5,775 7,801
--------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 1,934 6,868 8,802
Other Borrowed Funds 1,028 575 1,603
Subordinated Debt 0 184 184
--------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 2,962 7,627 10,589
--------------------------------------------------------------------------------------------
TOTAL CHANGE $ 3,792 $ 1,530 $ 5,322
============================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship
of changes in volume and changes in rate to the total "net change." The above
figures have been rounded to the nearest whole number.
34
FARMERS & MERCHANTS BANCORP
VOLUME AND RATE ANALYSIS OF NET INTEREST REVENUE
(Rates on a Taxable Equivalent Basis) 2005 versus 2004
(in thousands) Amount of Increase
(Decrease) Due to Change in:
----------------------------------------
INTEREST EARNING ASSETS Volume Rate Net Chg.
--------------------------------------------------------------------------------------------
Federal Funds Sold $ (169) $ 163 $ (6)
Investment Securities Available for Sale
U.S. Agencies (343) 81 (262)
Municipals - Taxable (57) (1) (58)
Municipals - Non-Taxable (186) 0 (186)
Mortgage Backed Securities (727) 136 (591)
Other (140) 14 (126)
--------------------------------------------------------------------------------------------
Total Investment Securities Available for Sale (1,453) 230 (1,223)
--------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Agencies 613 (10) 603
Municipals - Non-Taxable 1,661 (163) 1,498
Mortgage Backed Securities 101 (20) 81
Other 5 6 11
--------------------------------------------------------------------------------------------
Total Investment Securities Held to Maturity 2,380 (187) 2,193
--------------------------------------------------------------------------------------------
Loans:
Real Estate 1,943 2,419 4,362
Home Equity 384 936 1,320
Agricultural 572 2,217 2,789
Commercial 1,912 2,038 3,950
Installment 123 (54) 69
Credit Card 43 6 49
Other (2) (1) (3)
--------------------------------------------------------------------------------------------
Total Loans 4,975 7,561 12,536
--------------------------------------------------------------------------------------------
Total Earning Assets 5,733 7,767 13,500
--------------------------------------------------------------------------------------------
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Transaction 14 3 17
Savings 49 180 229
Time Deposits 318 2,603 2,921
--------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 381 2,786 3,167
Other Borrowed Funds (98) 956 858
Subordinated Debt 1 189 190
--------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 284 3,931 4,215
--------------------------------------------------------------------------------------------
TOTAL CHANGE $ 5,449 $ 3,836 $ 9,285
============================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship
of changes in volume and changes in rate to the total "net change." The above
figures have been rounded to the nearest whole number.
35
The investment portfolio is the other main component of the Company's earning
assets. The Company invests primarily in mortgage-backed securities, U.S.
Government Agencies, and high-grade municipals. Since the risk factor for these
types of investments is significantly lower than that of loans, the yield earned
on investments is generally less than that of loans.
Average investment securities decreased $1.0 million in 2006 compared to the
average balance during 2005. Interest income on securities increased $1.0
million to $13.1 million for the year ended December 31, 2006 compared to $12.1
million for the year ended December 31, 2005. The average yield, on a taxable
equivalent basis, in the investment portfolio was 5.0% in 2006 compared to 4.6%
in 2005. See "Financial Condition - Investment Securities" for a discussion of
the Company's repositioning of its securities portfolio during 2006 which
resulted in this increase in yield. Net interest income on the Schedule of
Year-to-Date Average Balances and Interest Rates shown on a taxable equivalent
basis, which is higher than net interest income as reflected on the Consolidated
Statement of Income because of adjustments that relate to income on securities
that are exempt from federal income taxes.
Average interest-bearing sources of funds increased $83.7 million or 9.8% during
2006. Of that increase, average borrowed funds (primarily FHLB Advances)
increased $20.8 million, interest-bearing deposits increased $62.9 million, and
subordinated debt remained unchanged.
During 2006, the Company was able to grow average interest bearing deposits by
$62.9 million. The increase was primarily in time deposits, which grew $73.2
million, as lower cost savings and interest bearing DDA decreased by $10.3
million. See "Financial Condition - Deposits" for a discussion of trends in the
Company's deposit base. Total interest expense on deposit accounts for 2006 was
$18.6 million as compared to $9.8 million in 2005. As deposits increased,
interest expense on deposits increased 89.6% or $8.8 million in 2006. The
average rate paid on interest-bearing deposits was 2.2% in 2006 and 1.3% in
2005. This increase in rates is a result of the lagging impact of increases in
market interest rates that occurred in mid-2004 through mid-2006. The Company
anticipates that its deposit rates will continue to increase in 2007, even
though market rates have been stable since June 2006. See "Overview - Looking
Forward: 2007 and Beyond" for a discussion of factors impacting the Company's
future deposit rates and their impact on net interest margin.
2005 Compared to 2004
Net interest income increased 18.1% to $58.4 million during 2005. During 2004,
net interest income was $49.5 million, representing an increase of 12.9% from
2003. On a fully taxable equivalent basis, net interest income increased 18.3%
and totaled $60.1 million during 2005, compared to $50.8 million for 2004.
Although average earning assets grew 7.4% during 2005, a significant reason for
the increase in net interest income during 2005 was increased market interest
rates by the FRB.
For 2005, the Company's net interest margin was 5.12% compared to 4.65% in 2004.
This improvement is primarily a result of the FRB's 200 basis point increase in
market rates since December 31, 2004.
Loans, generally the Company's highest earning assets, increased $106.3 million
as of December 31, 2005 compared to December 31, 2004. On an average balance
basis, loans increased by $79.1 million for the year ended December 31, 2005. As
a result of this loan growth, the mix of the Company's earning assets improved
as loans increased from 75.5% of average earning assets during 2004 to 77.0% in
2005. Due to increases in the prime rate during the latter half of 2004 through
2005, the year-to-date yield on the loan portfolio increased 86 basis points to
6.84% for the year ended December 31, 2005 compared to 5.98% for the year ended
December 31, 2004. This increase in yield plus the growth in loan balances
resulted in interest revenue from loans increasing 25.4% to $61.8 million for
2005.
Average investment securities increased slightly from the prior year. Average
balances increased $10.9 million in 2005 compared to the average balance during
2004. Interest income on securities increased $969,000 to $12.1 million for the
year ended December 31, 2005 compared to $11.1 million for the year ended
December 31, 2004. The average yield, on a taxable equivalent basis, in the
investment portfolio was 4.6% in 2005 compared to 4.4% in 2004. Net interest
income on the Schedule of Year-to-Date Average Balances and Interest Rates shown
on a taxable
36
equivalent basis, which is higher than net interest income as reflected on the
Consolidated Statement of Income because of adjustments that relate to income on
securities that are exempt from federal income taxes.
Average interest-bearing sources of funds increased $49.0 million or 6.1% during
2005. Of that increase, average borrowed funds (primarily FHLB Advances)
decreased $2.9 million, interest-bearing deposits increased $51.9 million, and
subordinated debt remained unchanged.
During 2005, the Company was able to grow average interest bearing deposits by
$51.9 million. The increase was primarily in lower cost savings and interest
bearing DDA deposits, which grew $33.7 million, as higher cost time deposits
grew by $18.2 million. Total interest expense on deposit accounts for 2005 was
$9.8 million as compared to $6.7 million in 2004. As deposits increased,
interest expense on deposits increased 47.6% or $3.2 million in 2005. The
average rate paid on interest-bearing deposits was 1.3% in 2005 and 0.9% in
2004. This increase in rates is a result of the FRB's increase in market rates
during 2005.
Provision and Allowance for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the loan portfolio. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approval standards, dollar limits on loans to one borrower and
by restricting loans made primarily to its principal market area where
management believes it is better able to assess the applicable risk.
Additionally, management has established guidelines to ensure the
diversification of the Company's credit portfolio such that even within key
portfolio sectors such as real estate or agriculture, the portfolio is
diversified across factors such as location, building type, crop type, etc.
Management reports regularly to the Board of Directors regarding trends and
conditions in the loan portfolio and regularly conducts credit reviews of
individual loans. Loans that are performing but have shown some signs of
weakness are subjected to more stringent reporting and oversight.
The provision for loan losses totaled $275,000 in 2006, compared to $425,000 in
2005 and $1.3 million in 2004. Changes in the provision between years were the
result of management's evaluation of the adequacy of the allowance for loan
losses relative to factors such as the credit quality of the loan portfolio,
loan growth, current loan losses and the prevailing economic climate and its
effect on borrowers' ability to repay loans in accordance with the terms of the
notes. See "Critical Accounting Policies and Estimates - Allowance for Loan
Losses" and "Item 7A. Quantitative and Qualitative Disclosures About Market
Risk-Credit Risk."
As of December 31, 2006, the allowance for loan losses was $18.1 million, which
represented 1.7% of the total loan balance. At December 31, 2005, the allowance
for loan losses was $17.9 million or 1.8% of the total loan balance. After
reviewing all factors above, management concluded that the allowance for loan
losses as of December 31, 2006 was adequate.
37
The table below summarizes the activity in the allowance for losses for the
years 2006, 2005 and 2004.
Allowance for Losses
(IN THOUSAND)S 2006 2005 2004
--------------------------------------------------------------------------------------------
Allowance for Loan Losses, Beginning of Year $17,860 $17,727 $17,220
Allowance for Losses - Unfunded Commitments 141 111 -
--------------------------------------------------------------------------------------------
Total Allowance for Losses, Beginning of Year 18,001 17,838 17,220
Provision for Loan Losses Charged to Expense 275 425 1,275
Provision for Losses - Unfunded Commitments Charged to Expense - 30 -
Loans Charged Off (839) (867) (955)
Recoveries of Loans Previously Charged Off 803 575 298
--------------------------------------------------------------------------------------------
Total Allowance for Losses, End of Year $18,240 $18,001 $17,838
============================================================================================
Allocation of Allowance for Losses
--------------------------------------------------------------------------------------------
Allowance for Loan Losses $18,099 $17,860 $17,727
Allowance for Losses - Unfunded Commitments* 141 141 111
--------------------------------------------------------------------------------------------
Total Allowance for Losses, End of Year $18,240 $18,001 $17,838
============================================================================================
*As of December 31, 2004, the Company reclassified $111,000 of the Allowance for
Loan Losses that pertained to commitments under commercial and standby letters
of credit to the "Other Liabilities" section of the Consolidated Balance Sheet.
Non-Interest Income
Non-interest income includes: (1) service charges and fees from deposit
accounts; (2) net gains and losses from the sale of investment securities; (3)
credit card merchant fees; (4) ATM fees; (5) gains and losses from the sale of
assets; (6) increases in the cash surrender value of bank owned life insurance;
and (7) fees from other miscellaneous business services.
2006 Compared to 2005
Non-interest income totaled $12.1 million, an increase of $789,000 or 7.0% from
non-interest income of $11.3 million for 2005.
Most of the increase in 2006 occurred in service charges on deposit accounts.
Service charges totaled $6.0 million, an increase of $1.7 million or 38.5% from
service charges on deposit accounts of $4.4 million in 2005. This increase was
due to fees related to the Company's Overdraft Privilege Service which was
offered to eligible customers with deposit accounts in good standing beginning
May 1, 2006.
The increase in service charges was offset by an increase in loss on sale of
investment securities, which was a loss of $2.2 million in 2006 as compared to a
loss of $953,000 for 2005. During 2006 the Company made the decision to sell
some of its investment portfolio at a loss in order to better align the
portfolio with its evolving asset/liability management objectives. See
"Financial Condition-Investment Securities."
ATM fees totaled $1.2 million, an increase of $211,000 or 21.3% over fees in
2005. The increase in these fees is due to the convenience and increased number
of ATM's at strategic locations which benefit both customers and non-customers.
2005 Compared to 2004
Non-interest income totaled $11.3 million, a decrease of $3.0 million or 20.9%
from non-interest income of $14.3 million for 2004.
Most of the decrease in 2005 occurred in gain (loss) on sale of investment
securities, which was a loss of $953,000 in 2005 as compared to a gain of $1.9
million for 2004. During 2005 the Company made the decision to sell some of its
investment portfolio at a loss in order to better align the portfolio with its
evolving asset/liability management
38
objectives. See "Financial Condition-Investment Securities." Additionally, $1.1
million of the gain in 2004 was a result of a non-recurring gain from the sale
of common stock of another Company.
Service charges on deposit accounts totaled $4.4 million, a decrease of $427,000
or 8.9% from service charges on deposit accounts of $4.8 million in 2004 due to:
(1) the conversion of certain deposit customers to a newly offered high
performance checking product that does not have a monthly service charge; (2)
increasing interest rates which reduced service charges for those commercial
customers on business account analysis; and (3) a decrease in fees generated
from money service business relationships as a result of the Company's strategic
decision to exit this product line.
Credit card merchant fees totaled $2.0 million, an increase of $286,000 or 16.3%
over fee income of $1.8 million in 2004. The increase during 2005 was due to an
increase in merchant volume during the year.
ATM fees totaled $991,000, an increase of $257,000 or 35.0% over fees in 2004.
The increase in these fees is due to the convenience and increased number of
ATM's at strategic locations which benefit both customers and non-customers.
Non-Interest Expense
Non-interest expense for the Company includes expenses for salaries and employee
benefits, occupancy, equipment, supplies, legal fees, professional services,
data processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.
2006 Compared to 2005
Overall, non-interest expense totaled $43.1 million, an increase of $2.5 million
or 6.2% for the year ended December 31, 2006.
Salaries and employee benefits increased $1.0 million due to: (1) officer salary
merit increases which occurred in November 2005; (2) increased contributions to
the Company's incentive compensation and supplemental retirement plans; and (3)
increased staff related to the three new branches opened during 2006. At the end
of 2006, the Company had 302 full time equivalent employees compared to 294 at
the end of 2005.
Occupancy and equipment expenses represent the cost of operating and maintaining
branch and administrative facilities, including the purchase and maintenance of
furniture, fixtures, and office equipment and data processing equipment.
Occupancy expense in 2006 totaled $2.5 million, an increase of $382,000 or 18.4%
over 2005. This increase was due to: (1) three new branches opened in 2006; (2)
increased utilities due to increased gas and electricity prices; (3) increased
rents on leased properties; and (4) increased property taxes.
Equipment expense in 2006 totaled $3.2 million, an increase of $709,000 or 28.3%
over 2005. This increase was due to: (1) annual computer hardware/software
maintenance and upgrades; and (2) increased furniture and equipment depreciation
related to remodeling and adding branch locations.
Marketing expense was $1.2 million in 2006, a decrease of $355,000 or 23.3% from
$1.5 million in 2005. In 2005 there were significant marketing expenses for a
new high performance checking product started in November 2004, including the
associated direct mail and other ancillary expenses incurred to promote this
product. These same expenses were not required in 2006.
Other operating expense totaled $6.9 million, a 9.7% increase from the prior
year. This increase in other operating expense during 2006 was due to: (1)
$228,000 early payoff penalties of FHLB borrowings; (2) operating losses related
to non-sufficient funds and electronic funds transactions; and (3) increased
stationary and printing expense related to the Company's 90th anniversary logo.
2005 Compared to 2004
Overall, non-interest expense totaled $40.6 million, an increase of $4.4 million
or 12.3% for the year ended December 31, 2005, primarily as a result of a $2.7
million increase in salaries and employee benefits. This increase was due to:
(1) officer salary merit increases which occurred in November 2005; (2)
increased contributions to the
39
Company's incentive compensation and supplemental retirement plans; and (3)
increased expense recognition associated with the termination of the Company's
defined benefit pension plan which took place in 2005. At the end of 2005, the
Company had 294 full time equivalent employees compared to 288 at the end of
2004.
Occupancy and equipment expenses represent the cost of operating and maintaining
branch and administrative facilities, including the purchase and maintenance of
furniture, fixtures, and office equipment and data processing equipment.
Occupancy expense in 2005 totaled $2.1 million, an increase of $343,000 or 19.8%
over 2004. This increase was due to: (1) increased branch maintenance and
equipment expense; and (2) increased furniture and equipment depreciation
related to remodeling and adding branch locations. Equipment expense in 2005
totaled $2.5 million, an increase of $190,000 or 8.2% over 2004.
Marketing expense was $1.5 million in 2005, an increase of $520,000 or 51.9%
from $1.0 million in 2004. This increase in 2005 was due to marketing expenses
for a new high performance checking product started in November 2004, including
the associated direct mail and other ancillary expenses incurred to promote this
product.
Other operating expense totaled $6.3 million, a 7.9% increase from the prior
year. This increase in other operating expense during 2005 was due primarily to
increases in insurance premiums and charitable contributions.
Income Taxes
The provision for income taxes increased $1.6 million during 2006. The effective
tax rate in 2006 was 36.4% compared to 35.7% in 2005 and 36.5% in 2004. The
increase in the effective tax rate during 2006 was due primarily to decreased
municipal security income that is tax exempt for federal tax purposes. The
effective rates were lower than the statutory rate of 42% due primarily to
benefits regarding the cash surrender value of life insurance, California
enterprise zone interest income exclusion, and tax exempt interest income on
municipal securities and loans.
Current tax law causes the Company's current taxes payable to approximate or
exceed the current provision for taxes on the income statement. Three provisions
have had a significant effect on the Company's current income tax liability: the
restrictions on the deductibility of loan losses, deductibility of pension and
other long-term employee benefits only when paid and the statutory deferral of
deductibility of California franchise taxes on the Company's federal return.
FINANCIAL CONDITION
Investment Securities
The investment portfolio provides the Company with an income alternative to
loans. The Company's investment portfolio at the end of 2006 was $244.4 million,
a decrease of $23.5 million or 8.8% from 2005.
During 2006 the Company sold $63.3 million in available-for-sale investment
securities at a loss of $2.2 million. These securities generally had a remaining
life under three years and yields below current market rates. Funds not invested
in loans or used to pay down short-term borrowings were reinvested in higher
yielding, somewhat longer term (5-7 years) securities which management believes
should strengthen the Company's net interest margin and reduce the Company's
asset sensitivity, thereby better protecting against future declines in market
interest rates.
The Company's total investment portfolio represented 17.3% of the Company's
total assets during 2006 and 19.8% of the Company's total assets during 2005.
Not included in the investment portfolio are overnight investments in Federal
Funds Sold. In 2006, average Federal Funds Sold on a year to date basis was $1.0
million compared to $5.6 million in 2005.
The Company classifies its investments as held-to-maturity, trading or
available-for-sale. Securities are classified as held-to-maturity and are
carried at amortized cost when the Company has the intent and ability to hold
the securities to maturity. Trading securities are securities acquired for
short-term appreciation and are carried at fair value, with unrealized gains and
losses recorded in non-interest income. As of December 31, 2006 and 2005 there
were no securities in the trading portfolio. Securities classified as
available-for-sale include securities which may be sold to effectively manage
interest rate risk exposure, prepayment risk, satisfy liquidity demands and
other factors. These
40
securities are reported at fair value with aggregate, unrealized gains or losses
excluded from income and included as a separate component of shareholders'
equity, net of related income taxes.
Note 2 located in "Item 8. Financial Statements and Supplementary Data" displays
the classifications of the Company's investment portfolio, the market value of
the Company's investment portfolio and the maturity distribution.
Loans
The Company's loan portfolio at December 31, 2006 increased $73.6 million from
December 31, 2005. The increase was due to strong loan demand in the Company's
market area, along with a focused calling program on selected loan prospects.
Most of the current year's growth occurred in Agricultural Loans and Real Estate
Loans (primarily those secured by production agricultural properties), market
segments where the Company believes that current market rates are more
reasonable than in the areas of Commercial, Consumer, Home Equity and Other Real
Estate loans. Additionally, on an average balance basis, loans have increased
$94.8 million or 10.5%. In 2005, average balances increased 9.6% or $79.1
million from the prior year. The table following sets forth the distribution of
the loan portfolio by type as of the dates indicated.
Loan Portfolio
(in thousands) December 31, 2006 December 31, 2005
--------------------------------------------------------------------
Real Estate $ 516,606 $ 432,378
Real Estate Construction 95,378 110,235
Home Equity 67,132 69,013
Agricultural 183,589 170,657
Commercial 165,412 174,530
Consumer 21,222 18,958
--------------------------------------------------------------------
Gross Loans 1,049,339 975,771
Less:
Unearned Income 2,427 2,514
Allowance for Loan Losses 18,099 17,860
--------------------------------------------------------------------
Net Loans $ 1,028,813 $ 955,397
====================================================================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of December 31, 2006, the
Company had entered into loan commitments amounting to $442.5 million compared
to $447.7 million at December 31, 2005. In addition, letters of credit issued by
the Company to guarantee the performance of a customer to a third party at
December 31, 2006 and December 31, 2005, were $10.9 million and $11.5 million,
respectively.
Non-Performing Assets
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of
December 31, 2006 were $54,000 compared to $694,000 at December 31, 2005. The
Company reported no other real estate owned at either December 31, 2006 or
December 31, 2005.
The Company's policy is to place loans on non-accrual status when, for any
reason, principal or interest is past due for ninety days or more unless it is
both well secured and in the process of collection. Any interest accrued, but
unpaid, is reversed against current income. Thereafter, interest is recognized
as income only as it is collected in cash. Accrued interest reversed from income
on loans placed on a non-accrual status totaled $15,000 at December 31, 2006
compared to $50,000 at December 31, 2005. Non-performing loans as a percentage
of total loans for the year ended 2006 was 0.01%. For the year ended 2005 the
percentage was 0.07%.
41
Non-Performing Assets
(in thousands) December 31, 2006 December 31, 2005
--------------------------------------------------------------------------
Non-Performing Loans $ 54 $ 694
Other Real Estate Owned - -
--------------------------------------------------------------------------
Total $ 54 $ 694
==========================================================================
Non-Performing Assets
as a % of Total Loans 0.01% 0.07%
Allowance for Loan Losses as a %
of Non-Performing Loans 33,516.7% 2,573.5%
Except for non-performing loans shown in the table above, the Company's
management is not aware of any loans as of December 31, 2006 for which known
credit problems of the borrower would cause serious doubts as to the ability of
such borrowers to comply with their present loan repayment terms, or any known
events that would result in the loan being designated as non-performing at some
future date. The Company's management cannot, however, predict the extent to
which the following or other factors may affect a borrower's ability to pay: (1)
deterioration in general economic conditions, real estate values or agricultural
commodity prices; (2) increases in general rates of interest; or (3) changes in
the financial condition or business of a borrower.
Although management believes that non-performing loans are generally
well-secured and that potential losses are provided for in the Company's
allowance for loan losses, there can be no assurance that future deterioration
in economic conditions or collateral values will not result in future credit
losses.
Deposits
One of the key sources of funds to support earning assets is the generation of
deposits from the Company's customer base. The ability to grow the customer base
and subsequently deposits is a significant element in the performance of the
Company.
Consistent with general banking industry trends, the Company saw a slowing of
overall deposit growth during 2006 along with a significant shift in the mix of
deposits to higher yielding Time Deposits as customers sought to take advantage
of increasing market interest rates. Additionally, the Company's strategy of
balancing growth and margin protection called for not pursuing "high cost" local
deposits by offering the deposit specials that many of its competitors were
using. The Company is continually reviewing this strategy with regard to
liquidity trends and market rates.
At December 31, 2006, total deposits were $1.2 billion, an increase of 8.6% or
$95.2 million from December 31, 2005. Of the $95.2 million in overall deposit
growth, core deposits (exclusive of State of California Time Deposits) increased
$25.0 million or 2.3% during 2006. As previously discussed, the mix of core
deposits changed significantly as Time Deposits increased $73.0 million and all
other core deposit types (Demand, Interest Bearing Transaction and Savings)
decreased $48.0 million. Should this trend continue in 2007, it will place
additional pressure on the Company's net interest margin. See "Results of
Operations - Net Interest Income/Net Interest Margin."
Time Deposits with the State of California increased $70.0 million since
December 31, 2005. These CD's are used to manage the Company's liquidity
position, as they represent a cost effective alternative to (1) high cost local
deposit specials and (2) short-term borrowings. See "Federal Home Loan Bank
Advances."
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank (FHLB) are another key source of funds
to support earning assets. These advances are also used to manage the Bank's
interest rate risk exposure, and as opportunities exist to borrow and invest the
proceeds at a positive spread through the investment portfolio. FHLB advances as
of December 31, 2006 were $47.5 million compared to $98.8 million as of December
31, 2005. This decrease of $51.3 million in
42
borrowings occurred as a result of the Company's management of its liquidity
needs using State of California Time Deposits which generally have rates from 20
to 30 basis points lower than FHLB advances. The average rate on FHLB advances
during 2006 was 5.2% compared to 4.5% in 2005.
Subordinated Debentures
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. See Note 17 located in "Item 8. Financial Statements and
Supplementary Data." Although this amount is reflected as subordinated debt on
the Company's balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital. See "Capital." These
securities accrue interest at a variable rate based upon 3-month LIBOR plus
2.85%. Interest rates reset quarterly (the next reset is March 16, 2007) and the
rate was 8.21% as of December 31, 2006. The average rate paid for these
securities in 2006 was 8.02% compared to 6.24% in 2005. Additionally, if the
Company decided to defer interest on the subordinated debentures, the Company
would be prohibited from paying cash dividends on the Company's common stock.
Capital
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders' Equity totaled $132.3 million at
December 31, 2006 and $123.6 million at the end of 2005.
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company's and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company's and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios of Total
and Tier 1 capital to risk-weighted assets (as defined in the regulations), and
of Tier 1 capital to average assets (as defined in the regulations). Management
believes, as of December 31, 2006, that the Company and the Bank meet all
capital adequacy requirements to which they are subject. For further information
on the Company and the Bank's risk-based capital ratios, see Note 10 located in
"Item 8. Financial Statements and Supplementary Data."
As previously discussed (see "Subordinated Debentures"), in order to supplement
its regulatory capital base, during December 2003 the Company issued $10 million
of trust preferred securities. See Note 17 located in "Item 8. Financial
Statements and Supplementary Data." On March 1, 2005 the Federal Reserve Board
issued its final rule effective April 11, 2005, concerning the regulatory
capital treatment of trust preferred securities ("TPS") by bank holding
companies ("BHCs"). Under the final rule BHCs may include TPS in Tier 1 capital
in an amount equal to 25% of the sum of core capital net of goodwill. The
quantitative limitation concerning goodwill will not be effective until March
31, 2009. Any portion of trust preferred securities not qualifying as Tier 1
capital would qualify as Tier 2 capital subject to certain limitations. The
Company has received notification from the Federal Reserve Bank of San Francisco
that all of the Company's trust preferred securities currently qualify as Tier 1
capital.
In accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continued
to have more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as "well capitalized." On April 4,
2006, the Board unanimously approved expanding the Repurchase Program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.
43
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired.
See Part II, "Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities."
During 2006, the Company repurchased 11,718 shares at an average share price of
$507 per share. In 2005, the Company repurchased 8,066 shares at an average
share price of $498. Since the second share repurchase program was expanded in
2006, the Company has repurchased over 8,200 shares for total consideration of
$4.2 million.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This "Management's Discussion and Analysis of Financial Condition and Results of
Operations," is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company's financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. Management believes that the most
significant subjective judgments that it makes include the following:
- Allowance for Loan Losses. As a financial institution which assumes lending
and credit risks as a principle element in its business, the Company
anticipates that credit losses will be experienced in the normal course of
business. Accordingly, the allowance for loan losses is maintained at a
level considered adequate by management to provide for losses that are
inherent in the portfolio. The allowance is increased by provisions charged
to operating expense and reduced by net charge-offs. Management employs a
systematic methodology for determining the allowance for loan losses. On a
quarterly basis, management reviews the credit quality of the loan
portfolio and considers problem loans, delinquencies, internal credit
reviews, current economic conditions, loan loss experience and other
factors in determining the adequacy of the allowance balance.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may
vary from current estimates. The estimates are reviewed periodically and,
as adjustments become necessary, are reported in earnings in the periods in
which they become known. For additional information, see Note 3 located in
"Item 8. Financial Statements and Supplementary Data."
- Fair Value. The Company discloses the fair value of financial instruments
and the methods and significant assumptions used to estimate those fair
values. The estimated fair value amounts have been determined by the
Company using available market information and appropriate valuation
methodologies. The use of assumptions and various valuation techniques, as
well as the absence of secondary markets for certain financial instruments,
will likely reduce the comparability of fair value disclosures between
financial institutions. In some cases, book value is a reasonable estimate
of fair value due to the relatively short period of time between
origination of the instrument and its expected realization. For additional
information, see Note 12 located in "Item 8. Financial Statements and
Supplementary Data."
- Income Taxes. The Company uses the liability method of accounting for
income taxes. This method results in the recognition of deferred tax assets
and liabilities that are reflected at currently enacted income tax rates
applicable to the period in which the deferred tax assets or liabilities
are expected to be realized or settled. As changes in tax laws or rates are
enacted, deferred tax assets and liabilities are adjusted through the
provision for income taxes. The deferred provision for income taxes is the
result of the net change in the deferred tax asset and deferred tax
liability balances during the year. This amount combined with the current
taxes payable or refundable results in the income tax expense for the
current year. For additional information, see Note 7 located in "Item 8.
Financial Statements and Supplementary Data."
OFF-BALANCE SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS AND
COMMITMENTS
Off-balance sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a
44
material variable interest held by us in an unconsolidated entity that provides
financing, liquidity, market risk or credit risk support to the Company, or
engages in leasing, hedging or research and development services with the
Company.
Our most significant off-balance sheet arrangements are limited to: (1) the full
and unconditional payment guarantee of accrued distributions relating to $10
million of Trust Preferred Securities issued by FMCB Statutory Trust (see Note
17 located in "Item 8. Financial Statements and Supplementary Data"); (2)
derivative instruments indexed to the Prime Rate (see Note 13 located in "Item
8. Financial Statements and Supplementary Data"); (3) obligations under
guarantee contracts such as financial and performance standby letters of credit
for our credit customers (see Note 14 located in "Item 8. Financial Statements
and Supplementary Data"); (4) unfunded commitments to lend (see Note 14 located
in "Item 8. Financial Statements and Supplementary Data"); and (5) lease
contracts (see Note 14 located in "Item 8. Financial Statements and
Supplementary Data"). It is our belief that none of these arrangements expose us
to any greater risk of loss than is already reflected on our balance sheet. We
do not have any off-balance sheet arrangements in which we have any retained or
contingent interest (as we do not transfer or sell our assets to entities in
which we have a continuing involvement), any exposure to derivative instruments
that are indexed to stock indices nor any variable interests in any
unconsolidated entity to which we may be a party.
The following table presents, as of December 31, 2006, our significant and
determinable contractual obligations by payment date. The payment amounts
represent those amounts contractually due to the recipient and do not include
any unamortized premiums or discount, hedge basis adjustments or other similar
carrying value adjustments. For further information on the nature of each
obligation type, see applicable note disclosure located in "Item 8. Financial
Statements and Supplementary Data."
Payments Due By Period
(in thousands)
Less Than 1 More Than 5
Contractual Obligations Total Year 1-3 Years 3-5 Years Years
-----------------------------------------------------------------------------------------------
Operating Lease Obligations $ 2,620 $ 475 $ 706 $ 579 $ 860
FHLB Advances 47,532 46,730 - - 802
Long-Term Subordinated Debentures 10,310 - - - 10,310
Deferred Compensation (1) 10,846 158 133 219 10,336
-----------------------------------------------------------------------------------------------
Total $71,308 $ 47,363 $ 839 $ 798 $ 22,308
===============================================================================================
(1) These amounts represent payments to participants under the Company's
non-qualified deferred compensation and supplemental retirement plans. See Note
11 located in "Item 8. Financial Statements and Supplementary Data."
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company. Specifically, credit risk, interest rate risk, liquidity risk,
compliance risk, strategic risk, reputation risk and price risk can all affect
the market risk of the Company. These specific risk factors are not mutually
exclusive. It is recognized that any product or service offered by the Company
may expose the Company to one or more of these risk factors.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.
45
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Company's policy statements. In
addition, certain securities carry insurance to enhance credit quality of the
bond. Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Company.
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan - Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectible in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system, specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies". In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
- then-existing general economic and business conditions affecting the key
lending areas of the Company;
- credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
- collateral values;
- loan volumes and concentrations;
- seasoning of the loan portfolio;
- specific industry conditions within portfolio segments;
- recent loss experience within portfolio segments;
- duration of the current business cycle;
- bank regulatory examination results; and
46
- findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions are evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio.
Management believes that the allowance for loan losses at December 31, 2006 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan charge-offs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company does not attempt to predict
interest rates and positions the balance sheet in a manner which seeks to
minimize, to the extent possible, the effects of changing interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: (1) analysis of asset and liability mismatches (GAP
analysis); (2) the utilization of a simulation model; and (3) limits on
maturities of investment, loan and deposit products which reduces the market
volatility of those instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative Gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 200 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
December 31, 2006, the Company's estimated net interest income sensitivity to
changes in interest rates, as a percent
47
of net interest income was an increase in net interest income of 0.92% if rates
increase by 200 basis points and a decrease in net interest income of 2.43% if
rates decline 200 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape; prepayments on loans and securities; pricing strategies on loans and
deposits; replacement of asset and liability cash flows; and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change. See Note 12 located in "Item 8. Financial Statements and Supplementary
Data."
Liquidity Risk
Liquidity risk is the risk to earnings or capital resulting from the Company's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Company's ability to liquidate assets or acquire
funds quickly and with minimum loss of value. The Company endeavors to maintain
a cash flow adequate to fund operations, handle fluctuations in deposit levels,
respond to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. During 2006, Federal Funds Sold averaged
$1.0 million. The Company maintains Federal Funds credit lines of $75 million
with major banks subject to the customary terms and conditions for such
arrangements and $150 million in repurchase lines with major brokers. In
addition, the Company has additional borrowing capacity of $179.8 million from
the Federal Home Loan Bank.
At December 31, 2006, the Company had available sources of liquidity, which
included cash and cash equivalents and unpledged investment securities of
approximately $75.7 million, which represents 5.4% of total assets.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULES
PAGE
----
Report of Management on Internal Control Over Financial Reporting 49
Reports of Independent Registered Public Accounting Firms 50
Consolidated Financial Statements
Consolidated Statement of Income - Years ended December 31, 2006, 2005 and 2004 53
Consolidated Balance Sheet - December 31, 2006 and 2005 54
Consolidated Statement of Changes in Shareholders' Equity - Years ended December 31,
2006, 2005 and 2004 55
Consolidated Statement of Comprehensive Income. 56
Consolidated Statement of Cash Flows - Years Ended December 31, 2006, 2005 and 2004 57
Notes to Consolidated Financial Statements 58
48
FARMERS & MERCHANTS BANCORP
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal
control over financial reporting at Farmers & Merchants Bancorp ("the Company").
Internal control over financial reporting includes controls over the preparation
of financial statements in accordance with the instructions to the Consolidated
Financial Statements for Bank Holding Companies (Form FR Y-9C) to comply with
the reporting requirements of Section 112 of the Federal Deposit Insurance
Corporation Improvement Act ("FDICIA").
Management has assessed the effectiveness of the Company's internal control over
financial reporting as of December 31, 2006 based on criteria described in
"Internal Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on that assessment, management
concluded that the Company maintained effective internal control over financial
reporting as of December 31, 2006.
Perry-Smith LLP, the independent registered public accounting firm that audited
the financial statements included in this Annual Report has audited management's
assessment of the effectiveness of the Company's internal control over financial
reporting as of December 31, 2006, as stated in their report which follows this
report.
/s/ Kent A. Steinwert /s/ Stephen W. Haley
Kent A. Steinwert Stephen W. Haley
President & Chief Executive Officer Executive Vice President &
Chief Financial Officer
49
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Shareholders and Board of Directors
Farmers & Merchants Bancorp
Lodi, California
We have audited the accompanying consolidated balance sheet of Farmers &
Merchants Bancorp and subsidiaries (the "Company") as of December 31, 2006 and
2005 and the related consolidated statements of income, changes in shareholders'
equity, comprehensive income and cash flows for the years then ended. We also
have audited management's assessment, included in the accompanying Report of
Management on Internal Control Over Financial Reporting, that Farmers &
Merchants Bancorp and subsidiaries maintained effective internal control over
financial reporting as of December 31, 2006, based on criteria established in
Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the "COSO criteria"). The Company's
management is responsible for these consolidated financial statements, for
maintaining effective internal control over financial reporting, and for its
assessment of the effectiveness of internal control over financial reporting.
Our responsibility is to express an opinion on these consolidated financial
statements, an opinion on management's assessment, and an opinion on the
effectiveness of the Company's internal control over financial reporting based
on our audits. The consolidated financial statements for the Company for the
year ended December 31, 2004 were audited by other auditors whose report, dated
March 14, 2005, expressed an unqualified opinion on those financial statements.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the consolidated financial statements are free of material misstatement and
whether effective internal control over financial reporting was maintained in
all material respects. Our audit of financial statements included examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
Our audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, evaluating
management's assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a
reasonable basis for our opinions.
50
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
(Continued)
A company's internal control over financial reporting is a process designed
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. Management's assessment and our
audit of internal control over financial reporting included controls over the
Company's preparation of financial statements in accordance with the
instructions to the Consolidated Financial Statements for Bank Holding Companies
(Form FR Y9C) to comply with the requirements of Section 112 of the Federal
Deposit Insurance Corporation Improvement Act (FDICIA). A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Farmers &
Merchants Bancorp and subsidiaries as of December 31, 2006 and 2005 and the
related consolidated statements of income, changes in shareholders' equity,
comprehensive income and cash flows for the years then ended in conformity with
accounting principles generally accepted in the United States of America. Also
in our opinion, management's assessment that Farmers & Merchants Bancorp and
subsidiaries maintained effective internal control over financial reporting as
of December 31, 2006, is fairly stated, in all material respects, based on the
COSO criteria. Furthermore, in our opinion, Farmers & Merchants Bancorp and
subsidiaries maintained, in all material respects, effective internal control
over financial reporting as of December 31, 2006, based on the COSO criteria.
/s/ Perry-Smith LLP
Sacramento, California
March 6, 2007
51
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
and Stockholders of Farmers & Merchants Bancorp:
In our opinion, the accompanying consolidated statements of income, of changes
in shareholders' equity, of comprehensive income and of cash flows present
fairly, in all material respects, the result of the operations and the cash
flows of Farmers & Merchants Bancorp and its subsidiaries for the year ended
December 31, 2004, in conformity with accounting principles generally accepted
in the United States of America. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit. We conducted our audit
of these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers
San Francisco, California
March 14, 2005
52
CONSOLIDATED STATEMENT OF INCOME
---------------------------------------------------------------------------------------------------
(in thousands except per share data)
Year Ended December 31,
2006 2005 2004
---------------------------------------------------------------------------------------------------
INTEREST INCOME
Interest and Fees on Loans $76,872 $61,838 $49,302
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 49 188 194
Interest on Investment Securities:
Taxable 8,184 7,217 7,558
Tax-Exempt 3,291 3,215 2,246
---------------------------------------------------------------------------------------------------
Total Interest Income 88,396 72,458 59,300
---------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 18,630 9,828 6,661
Borrowed Funds 5,164 3,561 2,703
Subordinated Debentures 827 643 454
---------------------------------------------------------------------------------------------------
Total Interest Expense 24,621 14,032 9,818
---------------------------------------------------------------------------------------------------
NET INTEREST INCOME 63,775 58,426 49,482
Provision for Loan Losses 275 425 1,275
---------------------------------------------------------------------------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 63,500 58,001 48,207
---------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposit Accounts 6,046 4,364 4,791
Net (Loss) Gain on Sale of Investment Securities (2,168) (953) 1,886
Credit Card Merchant Fees 2,124 2,039 1,753
Gain on Sale of Property and Equipment 6 1 171
Increase in Cash Surrender Value of Life Insurance 1,645 1,563 1,582
ATM Fees 1,202 991 734
Other 3,208 3,269 3,350
---------------------------------------------------------------------------------------------------
Total Non-Interest Income 12,063 11,274 14,267
---------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries and Employee Benefits 27,820 26,773 24,103
Occupancy 2,455 2,073 1,730
Equipment 3,218 2,509 2,319
Credit Card Merchant Expense 1,569 1,458 1,200
Marketing 1,167 1,522 1,002
Other 6,892 6,282 5,821
---------------------------------------------------------------------------------------------------
Total Non-Interest Expense 43,121 40,617 36,175
---------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 32,442 28,658 26,299
Provision for Income Taxes 11,813 10,230 9,625
---------------------------------------------------------------------------------------------------
Net Income Before Cumulative Effect of Change in Accounting Principle 20,629 18,428 16,674
Cumulative Effect of Change in Accounting Principle, Net of Tax* - - (224)
---------------------------------------------------------------------------------------------------
NET INCOME $20,629 $18,428 $16,450
===================================================================================================
Earnings Per Share Before Cumulative Effect of Change in
Accounting Principle $ 25.25 $ 22.24 $ 19.95
Cumulative Effect of Change in Accounting Principle, Net of Tax $ - $ - $ (0.27)
---------------------------------------------------------------------------------------------------
EARNINGS PER SHARE $ 25.25 $ 22.24 $ 19.68
===================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
* See Note 11 for full disclosure.
53
CONSOLIDATED BALANCE SHEET
------------------------------------------------------------------------------------------------------------
(in thousands except share data)
December 31,
ASSETS 2006 2005
------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due from Banks $ 47,006 $ 50,669
Investment Securities:
Available-for-Sale 132,627 158,029
Held-to-Maturity 111,240 109,911
------------------------------------------------------------------------------------------------------------
Total Investment Securities 243,867 267,940
------------------------------------------------------------------------------------------------------------
Loans: 1,046,912 973,257
Less: Allowance for Loan Losses 18,099 17,860
------------------------------------------------------------------------------------------------------------
Loans, Net 1,028,813 955,397
------------------------------------------------------------------------------------------------------------
Premises and Equipment, Net 20,496 17,522
Bank Owned Life Insurance 38,444 36,799
Interest Receivable and Other Assets 32,607 24,662
------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $1,411,233 $1,352,989
============================================================================================================
LIABILITIES
Deposits:
Demand $ 295,142 $ 325,745
Interest-Bearing Transaction 132,875 138,321
Savings 271,019 283,226
Time 499,492 356,048
------------------------------------------------------------------------------------------------------------
Total Deposits 1,198,528 1,103,340
============================================================================================================
Federal Funds Purchased - 650
Federal Home Loan Bank Advances 47,532 98,847
Subordinated Debentures 10,310 10,310
Interest Payable and Other Liabilities 22,523 16,194
------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 1,278,893 1,229,341
------------------------------------------------------------------------------------------------------------
COMMITMENTS & CONTINGENCIES (SEE NOTE 14)
SHAREHOLDERS' EQUITY
Preferred Stock: No Par Value. 1,000,000 Authorized, None Issued or Outstanding - -
Common Stock: Par Value $0.01, 2,000,000 Shares Authorized, 811,933 and
823,651 Issued and Outstanding at December 31, 2006 and 2005, respectively 8 8
Additional Paid-In Capital 89,926 95,862
Retained Earnings 43,126 29,463
Accumulated Other Comprehensive Loss (720) (1,685)
------------------------------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 132,340 123,648
------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,411,233 $1,352,989
============================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
54
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
-----------------------------------------------------------------------------------------------------------------------------
(in thousands except share and per share data)
ACCUMULATED
COMMON ADDITIONAL OTHER TOTAL
SHARES COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
OUTSTANDING STOCK CAPITAL EARNINGS LOSS EQUITY
-----------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2003 763,274 $ 8 $ 72,506 $ 37,650 ($559) $ 109,605
-----------------------------------------------------------------------------------------------------------------------------
Net Income 16,450 16,450
Cash Dividends Declared on
Common Stock ($6.85 per share) (5,723) (5,723)
5% Stock Dividend 37,429 12,838 (12,838) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (207) (207)
Repurchase of Stock (7,981) (3,107) (3,107)
Change in Net Unrealized Gains on
Derivative Instruments (68) (68)
Minimum Pension Plan Liability Adjustment 971 971
Change in Net Unrealized Loss on
Securities Available-for-Sale (1,374) (1,374)
-----------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2004 792,722 8 82,237 35,332 (1,030) 116,547
-----------------------------------------------------------------------------------------------------------------------------
Net Income 18,428 18,428
Cash Dividends Declared on
Common Stock ($7.68 per share) (6,366) (6,366)
5% Stock Dividend 38,995 17,641 (17,641) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (290) (290)
Repurchase of Stock (8,066) (4,016) (4,016)
Change in Net Unrealized Gains on
Derivative Instruments (14) (14)
Minimum Pension Plan Liability Adjustment 1,018 1,018
Change in Net Unrealized Loss on
Securities Available-for-Sale (1,659) (1,659)
-----------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2005 823,651 8 95,862 29,463 (1,685) 123,648
-----------------------------------------------------------------------------------------------------------------------------
Net Income 20,629 20,629
Cash Dividends Declared on
Common Stock ($8.55 per share) (6,966) (6,966)
Repurchase of Stock (11,718) (5,936) (5,936)
Change in Net Unrealized Gains on
Derivative Instruments (7) (7)
Change in Net Unrealized Loss on
Securities Available-for-Sale 972 972
-----------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2006 811,933 $ 8 $ 89,926 $ 43,126 $ (720) $ 132,340
=============================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
55
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
-------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
2006 2005 2004
-------------------------------------------------------------------------------------------------
NET INCOME $20,629 $18,428 $16,450
OTHER COMPREHENSIVE INCOME (LOSS)
Unrealized Gains on Derivative Instruments:
Unrealized holding gains arising during the period, net of
income tax effects of $0, $0 and $81 for the years ended
December 31, 2006, 2005 and 2004, respectively. - - 111
Less: Reclassification adjustment for realized gains
included in net income, net of related income tax effects
of $(6), $(10) and $(130) for the years ended December 31,
2006, 2005 and 2004, respectively. (7) (14) (179)
Unrealized Gains on Minimum Pension Liability Adjustment:
Unrealized gains arising during the period, net of income
tax effects of $0, $738, and $703 for the years
ended December 31, 2006, 2005 and 2004, respectively. - 1,018 971
Unrealized Losses on Securities:
Unrealized holding losses arising during the period, net
of income tax effects of $(206), $(1,605), and $(204) for the
years ended December 31, 2006, 2005 and 2004, respectively. (284) (2,211) (281)
Less: Reclassification adjustment for realized losses (gains)
included in net income, net of related income tax effects
of $912, $401, and $(793) for the years ended December 31,
2006, 2005 and 2004, respectively. 1,256 552 (1,093)
-------------------------------------------------------------------------------------------------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 965 (655) (471)
-------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME $21,594 $17,773 $15,979
=================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
56
CONSOLIDATED STATEMENT OF CASH FLOWS
--------------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
2006 2005 2004
--------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net Income $ 20,629 $ 18,428 $ 16,450
Adjustments to Reconcile Net Income to Net Cash Provided
by Operating Activities:
Provision for Loan Losses 275 425 1,275
Cumulative Effect of Accounting Change - - 224
Depreciation and Amortization 1,892 1,611 1,574
Provision for Deferred Income Taxes (1,169) (1,874) (1,837)
Net Amortization of Investment Security Premium & Discounts (166) 602 857
Net Loss (Gain) on Sale of Investment Securities 2,168 953 (1,886)
Net Gain on Sale of Property & Equipment (6) (1) (171)
Net Change in Operating Assets & Liabilities:
Net Increase in Interest Receivable and Other Assets (9,133) (2,846) (849)
Net Increase (Decrease) in Interest Payable and Other Liabilities 6,329 (245) 4,842
--------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 20,819 17,053 20,479
--------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Securities Available-for-Sale:
Purchased (72,910) (70,058) (133,854)
Sold, Matured or Called 98,041 93,179 170,934
Securities Held-to-Maturity:
Purchased (7,347) (30,622) (61,256)
Matured or Called 5,964 10,583 9,317
Net Loans Originated or Acquired (74,494) (107,216) (61,068)
Principal Collected on Loans Previously Charged Off 803 575 298
Net Additions to Premises and Equipment (4,866) (4,162) (5,384)
Proceeds from Sale of Property & Equipment 6 1 219
--------------------------------------------------------------------------------------------------------
Net Cash Used by Investing Activities (54,803) (107,720) (80,794)
--------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Net (Decrease) Increase in Demand, Interest-Bearing Transaction
and Savings Deposits (48,256) 64,055 87,352
Net Increase in Time Deposits 143,444 37,175 10,409
Net (Decrease) Increase in Federal Funds Purchased (650) 650 (1,000)
Net (Decrease) Increase in Federal Home Loan Bank Advances (51,315) 17,958 (31,039)
Stock Repurchases (5,936) (4,016) (3,107)
Cash Dividends (6,966) (6,656) (5,930)
--------------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 30,321 109,166 56,685
--------------------------------------------------------------------------------------------------------
(Decrease) Increase in Cash and Cash Equivalents (3,663) 18,499 (3,630)
Cash and Cash Equivalents at Beginning of Year 50,669 32,170 35,800
--------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 47,006 $ 50,669 $ 32,170
========================================================================================================
SUPPLEMENTARY DATA
Cash Payments Made for Income Taxes $ 12,138 $ 12,900 $ 11,650
Interest Paid $ 22,857 $ 13,345 $ 9,863
========================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
57
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was established
in 1916. The Bank's wholly owned subsidiaries include Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Farmers & Merchants
Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts
as trustee on deeds of trust originated by the Bank.
The Company's other subsidiaries include F & M Bancorp, Inc. and FMCB Statutory
Trust I. F & M Bancorp, Inc. was created in March 2002 to protect the name F & M
Bank. During 2002, the Company completed a fictitious name filing in California
to begin using the streamlined name, "F & M Bank" as part of a larger effort to
enhance the Company's image and build brand name recognition. In December 2003,
the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB
Statutory Trust I is a non-consolidated subsidiary per generally accepted
accounting principles (GAAP), and was formed for the sole purpose of issuing
Trust Preferred Securities. The accounting and reporting policies of the Company
conform to accounting principles generally accepted in the United States of
America and prevailing practice within the banking industry. The following is a
summary of the significant accounting and reporting policies used in preparing
the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements of the Company have been
prepared in accordance with accounting principles generally accepted in the
United States of America for financial information and with the instructions to
Form 10-K and Article 9 of Regulation S-X.
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Significant inter-company
transactions have been eliminated in consolidation.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
Cash and Cash Equivalents
For purposes of the Consolidated Statement of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a level yield of
interest over the estimated remaining period until maturity. Losses, reflecting
a decline in value judged by the Company to be other than temporary, are
recognized in the period in which they occur.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability
58
management strategy. These securities are reported at fair value with aggregate
unrealized gains or losses excluded from income and included as a separate
component of shareholders' equity, net of related income taxes. Fair values are
based on quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Investment securities are evaluated for impairment on at least a quarterly basis
and more frequently when economic or market conditions warrant such an
evaluation to determine whether a decline in their value is other than
temporary. Management utilizes criteria such as the magnitude and duration of
the decline and the intent and ability of the Company to retain its investment
in the securities for a period of time sufficient to allow for an anticipated
recovery in fair value, in addition to the reasons underlying the decline, to
determine whether the loss in value is other than temporary. The term "other
than temporary" is not intended to indicate that the decline is permanent, but
indicates that the prospects for a near-term recovery of value is not
necessarily favorable, or that there is a lack of evidence to support a
realizable value equal to or greater than the carrying value of the investment.
Once a decline in value is determined to be other than temporary, the value of
the security is reduced and a corresponding charge to earnings is recognized.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income; thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheet is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate, or the observable or estimated market price of the loan or on the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on non-accrual status with income reported accordingly. Cash payments are
first applied as a reduction of the principal balance until collection of the
remaining principal and interest can be reasonably assured. Thereafter, interest
income is recognized as it is collected in cash.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is reduced
by charge-offs and increased by provisions charged to operating expense and by
recoveries on loans previously charged off. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly basis,
management reviews the credit quality of the loan portfolio and considers many
factors in determining the adequacy of the allowance at the balance sheet date.
The factors evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, current levels of problem loans and delinquencies, credit quality
trends, collateral values, loan volumes and concentration, seasoning of the loan
portfolio, specific industry conditions, recent loss experience, duration of the
current business cycle, bank regulatory examination results and findings of the
Company's internal credit examiners.
59
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures." These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4
to these Consolidated Financial Statements.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. In addition, the Federal Deposit Insurance Corporation
and the California Department of Financial Institutions, as an integral part of
their examination process, review the allowance for loan losses. These agencies
may require additions to the allowance for loan losses based on their judgment
about information available at the time of their examinations.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate, which is included in other assets, is comprised of properties
no longer utilized for business operations and property acquired through
foreclosure in satisfaction of indebtedness. These properties are recorded at
fair value less estimated selling costs upon acquisition. Revised estimates to
the fair value less cost to sell are reported as adjustments to the carrying
amount of the asset, provided that such adjusted value is not in excess of the
carrying amount at acquisition. Initial losses on properties acquired through
full or partial satisfaction of debt are treated as credit losses and charged to
the Allowance for Loan Losses at the time of acquisition. Subsequent declines in
value from the recorded amounts, routine holding costs, and gains or losses upon
disposition, if any, are included in non-interest income or expense as incurred.
Income Taxes
The Company uses the liability method of accounting for income taxes. This
method results in the recognition of deferred tax assets and liabilities that
are reflected at currently enacted income tax rates applicable to the period in
which the deferred tax assets or liabilities are expected to be realized or
settled. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes. The deferred
provision for income taxes is the result of the net change in the deferred tax
asset and deferred tax liability balances during the year. This amount combined
with the current taxes payable or refundable results in the income tax expense
for the current year.
Dividends and Earnings Per Share
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded.
No stock dividend was declared during 2006. The Board of Directors declared a 5%
stock dividend in each of the years 2005 and 2004. Common stock shareholders
received one share of common stock for every 20 shares of common stock owned.
Fractional shares were not issued. For common stock share lots of less than 20
shares, a cash dividend in the amount of $22.62 and $17.15 per share was paid in
lieu of the stock dividend for each of the years 2005 and 2004, respectively.
Total cash dividends during 2006 were $6,966,000 or $8.55 per share of common
stock, an increase of 11.3% from $6,366,000 or $7.68 per share in 2005. In 2004,
cash dividends totaled $5,723,000 or $6.85 per share. Prior periods have been
restated where applicable for stock dividends paid.
60
Earnings per share for the years ending December 31, 2006, 2005 and 2004 were
$25.25, $22.24 and $19.68, respectively, and were computed by dividing net
income by the weighted average number of common shares outstanding for the
period. The weighted average number of shares outstanding for the three years
ending December 31, 2006, 2005 and 2004 were 817,044, 828,537 and 835,746,
respectively. Prior periods have been restated where applicable for stock
dividends paid.
Segment Reporting
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related Information" requires that public companies report
certain information about operating segments. It also requires that public
companies report certain information about their products and services, the
geographic areas in which they operate, and their major customers. The Company
is a holding company for a community bank which offers a wide array of products
and services to its customers. Pursuant to its banking strategy, emphasis is
placed on building relationships with its customers, as opposed to building
specific lines of business. As a result, the Company is not organized around
discernable lines of business and prefers to work as an integrated unit to
customize solutions for its customers, with business line emphasis and product
offerings changing over time as needs and demands change. Therefore, the Company
only reports one segment.
Derivative Instruments and Hedging Activities
Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative
Instruments and Certain Hedging Activities" as amended by the Statement of
Financial Accounting Standards, No. 138, establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. All derivatives,
whether designated in hedging relationships or not, are required to be recorded
on the balance sheet at fair value. Changes in the fair value of those
derivatives are accounted for depending on the intended use of the derivative
and the resulting designation under specified criteria. If the derivative is
designated as a fair value hedge, the changes in the fair value of the
derivative and of the hedged item attributable to the hedged risk are recognized
in earnings. If the derivative is designated as a cash flow hedge, designed to
minimize interest rate risk, the effective portions of the change in the fair
value of the derivative are recorded in other comprehensive income (loss), net
of related income taxes. Ineffective portions of changes in the fair value of
cash flow hedges are recognized in earnings.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income
(loss). The Company was not utilizing any derivative instruments as of December
31, 2006.
Comprehensive Income
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income (loss) includes
net income and changes in fair value of its available-for-sale investment
securities, minimum pension liability adjustments and cash flow hedges.
Evaluating the Effects of Potential Misstatements
In September 2006, the SEC ("SEC") issued Staff Accounting Bulletin ("SAB") No.
108 Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements, which provides interpretive
guidance on how registrants should quantify financial statement misstatements.
Under SAB 108 registrants are required to consider both a "rollover" method
which focuses primarily on the income statement impact of misstatements and the
"iron curtain" method which focuses primarily on the balance sheet impact of
misstatements. The transition provisions of SAB 108 permit a registrant to
adjust retained earnings for the cumulative effect of immaterial errors relating
to prior years. The Company was required to adopt SAB 108 in the fourth quarter
of 2006.
61
Historically, the Company evaluated uncorrected differences utilizing the
rollover approach. Under SAB 108 management must assess materiality using both
the rollover method and the iron-curtain method. The adoption of this accounting
standard did not have a material effect on the Company's financial position or
results of operations.
2. INVESTMENT SECURITIES
The amortized cost, fair values and unrealized gains and losses of the
securities available-for-sale are as follows:
(in thousands)
Amortized Gross Unrealized Fair/Book
------------------------
December 31, 2006 Cost Gains Losses Value
----------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 11,224 $ 59 $ 9 $ 11,274
Mortgage-Backed Securities 110,568 109 1,292 109,385
Other 12,075 - 107 11,968
----------------------------------------------------------------------------------------------------
Total $ 133,867 $ 168 $ 1,408 $ 132,627
====================================================================================================
Amortized Gross Unrealized Fair/Book
------------------------
December 31, 2005 Cost Gains Losses Value
----------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 30,867 $ - $ 941 $ 29,926
Obligations of States and Political Subdivisions 15,433 170 27 15,576
Mortgage-Backed Securities 108,553 - 2,120 106,433
Other 6,094 - - 6,094
----------------------------------------------------------------------------------------------------
Total $ 160,947 $ 170 $ 3,088 $ 158,029
====================================================================================================
Included with the 2006 available-for-sale "Other Securities Fair/Book Value"
total of $11.9 million was $7.7 million of FHLB stock. Included with the 2005
available-for-sale "Other Securities Fair/Book Value" total of $6.1 million was
$5.8 million of FHLB stock.
The book values, estimated fair values and unrealized gains and losses of
investments classified as held-to-maturity are as follows: (in thousands)
Book Gross Unrealized Fair
------------------------
December 31, 2006 Value Gains Losses Value
----------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 30,539 $ - $ 735 $ 29,804
Obligations of States and Political Subdivisions 69,910 319 334 69,895
Mortgage-Backed Securities 8,677 - 365 8,312
Other 2,114 7 - 2,121
----------------------------------------------------------------------------------------------------
Total $ 111,240 $ 326 $ 1,434 $ 110,132
====================================================================================================
Book Gross Unrealized Fair
------------------------
December 31, 2005 Value Gains Losses Value
----------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 30,644 $ - $ 721 $ 29,923
Obligations of States and Political Subdivisions 66,260 151 840 65,571
Mortgage-Backed Securities 10,881 - 449 10,432
Other 2,126 8 - 2,134
----------------------------------------------------------------------------------------------------
Total $ 109,911 $ 159 $ 2,010 $ 108,060
====================================================================================================
Fair values are based on quoted market prices or dealer quotes. If a quoted
market price or dealer quote is not available, fair value is estimated using
quoted market prices for similar securities.
The remaining principal maturities of debt securities as of December 31, 2006
and 2005 are shown in the following tables. Mortgage-Backed Securities are
presented based on expected maturities. Expected maturities may differ from
contractual maturities as borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
62
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 2006 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 2,590 $ 6,436 $ - $ 2,248 $ 11,274
Mortgage-Backed Securities - - - 109,385 109,385
Other 11,968 - - - 11,968
------------------------------------------------------------------------------------------------------
Total $14,558 $ 6,436 $ - $ 111,633 $132,627
======================================================================================================
2005 Totals $11,141 $ 32,171 $ 43,483 $ 71,234 $158,029
======================================================================================================
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 2005 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ - $ 19,935 $ 10,604 $ - $ 30,539
Obligations of States and Political Subdivisions 3,769 8,533 10,214 47,394 69,910
Mortgage-Backed Securities - - 8,677 - 8,677
Other - - 133 1,981 2,114
------------------------------------------------------------------------------------------------------
Total $ 3,769 $ 28,468 $ 29,628 $ 49,375 $111,240
======================================================================================================
2005 Totals $ 1,249 $ 26,774 $ 35,752 $ 46,136 $109,911
======================================================================================================
The following tables show those investments with gross unrealized losses and
their market value aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position at the
dates indicated.
Less Than 12 Months 12 Months or More Total
------------------------------------------------------------------
December 31, 2006 Fair Unrealized Fair Unrealized Fair Unrealized
(in thousands) Value Loss Value Loss Value Loss
-----------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ - $ - $29,804 $ 735 $ 29,804 $ 735
Obligations of States and Political
Subdivisions 10,520 40 19,435 304 29,955 344
Mortgage-Backed Securities 66,583 589 32,785 1,067 99,368 1,656
Other 3,893 107 - - 3,893 107
-----------------------------------------------------------------------------------------------------------
Total $ 80,996 $ 736 $82,024 $ 2,106 $163,020 $ 2,842
===========================================================================================================
Less Than 12 Months 12 Months or More Total
------------------------------------------------------------------
December 31, 2005 Fair Unrealized Fair Unrealized Fair Unrealized
(in thousands) Value Loss Value Loss Value Loss
-----------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 25,220 $ 796 $34,629 $ 866 $ 59,849 $ 1,662
Obligations of States and Political
Subdivisions 41,036 465 13,118 402 54,154 867
Mortgage-Backed Securities 91,808 1,676 25,057 893 116,865 2,569
-----------------------------------------------------------------------------------------------------------
Total $158,064 $ 2,937 $72,804 $ 2,161 $230,868 $ 5,098
===========================================================================================================
As of December 31, 2006, the Company held 200 investment securities of which 37
were in a loss position for less than twelve months and 48 were in a loss
position and had been in a loss position for twelve months or more. Management
periodically evaluates each investment security for other than temporary
impairment relying primarily
63
on industry analyst reports and observations of market conditions and interest
rate fluctuations. Management believes it will be able to collect all amounts
due according to the contractual terms of the underlying investment securities.
Securities of U.S. Government Agencies and Obligations of States and Political
Subdivisions
The unrealized losses on the Company's investments in U.S. government agencies
and obligations of states and political subdivisions were caused by interest
rate increases. The contractual terms of these investments do not permit the
issuer to settle the securities at a price less than the amortized cost of the
investment. Because the Company has the ability and intent to hold these
investments until a recovery of fair value, which may be maturity, the Company
does not consider these investments to be other-than-temporarily impaired at
December 31, 2006.
Mortgage-Backed Securities
The unrealized losses on the Company's investment in mortgage-backed securities
were caused by interest rate increases. The contractual cash flows of these
investments are guaranteed by an agency of the U.S. government. Accordingly, it
is expected that the securities would not be settled at a price less than the
amortized cost of the Company's investment. Because the decline in market value
is attributable to changes in interest rates and not credit quality, and because
the Company has the ability and intent to hold these investments until a
recovery of fair value, which may be maturity, the Company does not consider
these investments to be other-than-temporarily impaired at December 31, 2006.
Marketable Equity Securities (shown in the 2006 table in the "Other" category)
The Company's investment in marketable equity securities consists primarily of
investments in common stock. The current fair value is 2.7% less than cost as a
result of normal fluctuations in general market conditions. The duration of the
unrealized loss is less than 12 months. The Company has the ability and intent
to hold these investments until a recovery of fair value and does not consider
these investments to be other-than-temporarily impaired at December 31, 2006.
Proceeds from sales of securities available-for-sale were as follows:
(in thousands) Gross Gross Gross
Proceeds Gains Losses
-----------------------------------------------
2006 $ 63,760 $ 1 $ 2,169
2005 64,635 163 1,116
2004 74,775 1,977 91
As of December 31, 2006, securities carried at $196,459,000 were pledged to
secure public deposits, FHLB borrowings and other government agency deposits as
required by law. This amount at December 31, 2005 was $150,741,000.
3. LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans as of December 31, consisted of the following:
(in thousands) 2006 2005
-------------------------------------------------------------------
Real Estate $ 516,606 $432,378
Real Estate Construction 95,378 110,235
Home Equity 67,132 69,013
Agricultural 183,589 170,657
Commercial 165,412 174,530
Consumer and Other 21,222 18,958
-------------------------------------------------------------------
Subtotal 1,049,339 975,771
Less: Deferred Loan Origination Fees (2,427) (2,514)
-------------------------------------------------------------------
Total Loans $1,046,912 $973,257
===================================================================
Non-Performing Loans $ 54 $ 694
===================================================================
64
Changes in the allowance for loan losses consisted of the following:
(in thousands)
2006 2005 2004
------------------------------------------------------------------------
Balance, January 1 $17,860 $17,727 $17,220
Provision Charged to Operating Expense 275 425 1,275
Recoveries of Loans Previously Charged Off 803 575 298
Loans Charged Off (839) (867) (955)
Reclassification Adjustment* - - (111)
------------------------------------------------------------------------
Balance, December 31 $18,099 $17,860 $17,727
========================================================================
*As of December 31, 2004, the Company reclassified $111,000 of the Allowance for
Loan Losses that pertained to commitments under commercial and standby letters
of credit to the "Other Liabilities" section of the Consolidated Balance Sheet.
All impaired loans have been assigned a related allowance for credit losses. As
of December 31, 2006 and 2005, the total recorded investment in impaired loans
was $39,000 and $606,000, respectively. The related allowance for impaired loans
was $10,000 and $135,000 for the years ended 2006 and 2005, respectively. The
average balance of impaired loans was $250,000, $412,000 and $1.6 million for
the years ended 2006, 2005 and 2004, respectively. There was no interest income
reported on impaired loans in 2006, 2005 and 2004. Interest income forgone on
loans placed on nonaccrual status was $15,000, $50,000 and $30,000 for the years
ended December 31, 2006, 2005 and 2004, respectively. A portion of pledged loans
totaling $225,569,000 were used to secure Federal Home Loan Bank advances of
$46,730,000 and the unused commitments.
4. PREMISES AND EQUIPMENT
Premises and equipment as of December 31, consisted of the following:
(in thousands) 2006 2005
-------------------------------------------------------------------
Land and Buildings $24,248 $22,049
-------------------------------------------------------------------
Furniture, Fixtures and Equipment 16,984 16,557
Leasehold Improvements 2,257 1,167
-------------------------------------------------------------------
Subtotal 43,489 39,773
Less: Accumulated Depreciation and Amortization 22,993 22,251
-------------------------------------------------------------------
Total $20,496 $17,522
===================================================================
Depreciation and amortization on premises and equipment included in occupancy
and equipment expense amounted to $1,892,000, $1,611,000 and $1,574,000 for the
years ended December 31, 2006, 2005 and 2004, respectively. Total rental expense
for premises was $375,000, $268,000 and $265,000 for the years ended December
31, 2006, 2005 and 2004, respectively. Rental income was $116,000, $109,000 and
$115,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
5. OTHER REAL ESTATE
The Bank reported no other real estate at December 31, 2006 and 2005. Other real
estate includes property no longer utilized for business operations and property
acquired through foreclosure proceedings. These properties are carried at the
lower of cost or fair value less selling costs determined at the date acquired.
Losses arising from properties acquired through foreclosure are charged against
the allowance for loan losses. Subsequent declines in value, routine holding
costs and net gains or losses on disposition are included in other operating
expense as incurred.
65
6. TIME DEPOSITS
Time Deposits of $100,000 or more as of December 31, were as follows:
(in thousands)
2006 2005
---------------------------------------------------------
Balance $340,287 $207,976
=========================================================
At December 31, 2006, the scheduled maturities of time deposits were as follows:
Scheduled
(in thousands) Maturities
---------------------------------------------------------
2007 $ 475,938
2008 16,199
2009 5,775
2010 619
2011 961
---------------------------------------------------------
Total $ 499,492
=========================================================
7. INCOME TAXES
Current and deferred income tax expense (benefit) provided for the years ended
December 31, consisted of the following:
(in thousands) 2006 2005 2004
---------------------------------------------------------------
Current
Federal $ 9,443 $ 8,826 $ 8,071
State 3,539 3,278 3,228
---------------------------------------------------------------
Total Current 12,982 12,104 11,299
---------------------------------------------------------------
Deferred
Federal (950) (1,508) (1,379)
State (219) (366) (458)
---------------------------------------------------------------
Total Deferred (1,169) (1,874) (1,837)
---------------------------------------------------------------
Total Provision for Taxes* $11,813 $10,230 $ 9,462
===============================================================
*The Provision for Taxes for 2004 includes the $163,000 tax impact associated
with the cumulative effect of change in accounting principle shown net of tax on
the Consolidated Statement of Income.
The total provision for income taxes differs from the federal statutory rate as
follows:
(in thousands)
2006 2005 2004
Amount Rate Amount Rate Amount Rate
-----------------------------------------------------------------------------------------------
Tax Provision at Federal Statutory Rate $11,355 35.0% $10,030 35.0 % $ 9,069 35.0 %
Interest on Obligations of States
and Political Subdivisions
Exempt from Federal Taxation (1,062) (3.3)% (1,081) (3.7) % (769) (3.0)%
State and Local Income Taxes,
Net of Federal Income Tax Benefit 2,158 6.7 % 1,893 6.6 % 1,801 6.9 %
Bank Owned Life Insurance (675) (2.1)% (636) (2.2) % (645) (2.5)%
Other, Net 37 0.1% 24 0.0 % 6 0.0 %
-----------------------------------------------------------------------------------------------
Total Provision for Taxes $11,813 36.4% $10,230 35.7 % $ 9,462 36.4 %
===============================================================================================
66
The components of the net deferred tax assets as of December 31 are as follows:
(in thousands) 2006 2005
-------------------------------------------------------------------------
Deferred Tax Assets
Allowance for Loan Losses $ 7,670 $ 7,569
Accrued Liabilities 2,214 1,650
Deferred Compensation 3,372 2,335
State Franchise Tax 1,249 1,147
Unrealized Losses on Securities Available-for-Sale 522 708
Interest on Non-Accrual Loans 6 255
-------------------------------------------------------------------------
Total Deferred Tax Assets $15,033 $13,664
-------------------------------------------------------------------------
Deferred Tax Liabilities
Premises and Equipment $ (444) $ (427)
Securities Accretion (zero coupon securities) (877) (572)
Other (510) (446)
-------------------------------------------------------------------------
Total Deferred Tax Liabilities (1,831) (1,445)
-------------------------------------------------------------------------
Net Deferred Tax Assets $13,202 $12,219
=========================================================================
The net deferred tax assets are reported in Interest Receivable and Other Assets
on the Company's Consolidated Balance Sheet.
8. SHORT TERM BORROWINGS
As of December 31, 2006 and 2005, the Company had unused lines of credit
available for short term liquidity purposes of $405 million and $346 million,
respectively. Federal Funds purchased and advances from the Federal Reserve Bank
are generally issued on an overnight basis. There were no Federal Funds
purchased at December 31, 2006 and $650,000 at December 31, 2005.
9. FEDERAL HOME LOAN BANK ADVANCES
The Company's advances from the Federal Home Loan Bank of San Francisco consist
of the following as of December 31,
(in thousands) 2006 2005
-------------------------------------------------------------------------------------------------------------
5.35% note payable due February 4, 2008 with interest due quarterly, callable February 2, $ - $25,000
2003 and quarterly thereafter.
5.38% note payable due August 12, 2008 with interest due quarterly, callable August 12, - 15,000
2003 and quarterly thereafter.
5.60% amortizing note, interest and principal payable monthly with final maturity of 802 847
September 25, 2018.
4.28% fixed rate credit advance, interest payable weekly with a maturity of January 4, - 58,000
2008*
5.38% fixed rate credit advance, interest payable at month end and maturity of January 11, 25,000 -
2007
5.34% fixed rate credit advance, interest payable daily with a maturity of January 2, 2007 21,730 -
-------------------------------------------------------------------------------------------------------------
Total $47,532 $98,847
=============================================================================================================
*While this borrowing had a maturity in 2008, the Company prepaid it in 2006.
In accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the Company and by agency
and mortgage-backed securities, with carrying values of $1,840,000.
67
A portion of pledged loans totaling $225,569,000 were used to secure Federal
Home Loan Bank advances of $46,730,000 and the unused commitments.
10. SHAREHOLDERS' EQUITY
From 1975 through 2005, the Company issued an annual 5% stock dividend. In 2006
the stock dividend was discontinued. Earnings and cash dividends per share
amounts have been restated where applicable for stock dividends.
During the second quarter of 2004, the Board of Directors of Farmers & Merchants
Bancorp approved a resolution authorizing the repurchase, from time to time, of
outstanding shares of the common stock of the Company. Repurchases will be made
on the open market or through private transactions. When the Company repurchases
shares in private transactions the price is determined based upon the most
recent transactions that have occurred between third party shareholders. This
repurchase program was announced in a press release dated June 21, 2004. The
aggregate price to be paid by the Company for all repurchased stock will not
exceed $10,000,000 and the program will expire on May 31, 2007. On April 4,
2006, the Board unanimously approved expanding the repurchase program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.Repurchases under the program will continue to be made on the open market
or through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired.
Dividends from the Bank constitute the principal source of cash to the Company.
The Company is a legal entity separate and distinct from the Bank. Under
regulations controlling California state chartered banks, the Bank is, to some
extent, limited in the amount of dividends that can be paid to shareholders
without prior approval of the California Department of Financial Institutions.
These regulations require approval if total dividends declared by a state
chartered bank in any calendar year exceed the bank's net profits for that year
combined with its retained net profits for the preceding two calendar years. As
of December 31, 2006, the Bank could declare dividends of $19,376,000 without
approval of the California Department of Financial Institutions.
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios set
forth in the following table of Total and Tier 1 capital to risk-weighted assets
(as defined in the regulations), and of Tier 1 capital to average assets (as
defined in the regulations). Management believes, as of December 31, 2006, that
the Company and the Bank meet all capital adequacy requirements to which they
are subject.
In addition, the most recent notification from the FDIC categorized the Bank as
well capitalized under the regulatory framework for prompt corrective action. To
be categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the
following tables. There are no conditions or events since that notification that
management believes have changed the Bank's category.
68
Well Capitalized
Regulatory Capital Under Prompt
(in thousands) Actual Requirements Corrective Action
December 31, 2006 Amount Ratio Amount Ratio Amount Ratio
---------------------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $ 152,118 11.69% $ 104,101 8.0% $ 130,126 10.0%
Total Consolidated Capital to Risk Weighted Assets $ 159,336 12.17% $ 104,698 8.0% N/A N/A
Tier 1 Bank Capital to Risk Weighted Assets $ 135,827 10.44% $ 52,051 4.0% $ 78,076 6.0%
Tier 1 Consolidated Capital to Risk Weighted Assets $ 142,954 10.92% $ 52,349 4.0% N/A N/A
Tier 1 Bank Capital to Average Assets $ 135,827 9.93% $ 54,736 4.0% $ 68,420 5.0%
Tier 1 Consolidated Capital to Average Assets $ 142,954 10.40% $ 54,979 4.0% N/A N/A
December 31, 2005 Amount Ratio Amount Ratio Amount Ratio
---------------------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $ 148,139 12.14% $ 97,606 8.0% $ 122,008 10.0%
Total Consolidated Capital to Risk Weighted Assets $ 150,648 12.32% $ 97,805 8.0% N/A N/A
Tier 1 Bank Capital to Risk Weighted Assets $ 132,854 10.89% $ 48,803 4.0% $ 73,205 6.0%
Tier 1 Consolidated Capital to Risk Weighted Assets $ 135,333 11.07% $ 48,903 4.0% N/A N/A
Tier 1 Bank Capital to Average Assets $ 132,854 10.25% $ 51,852 4.0% $ 64,815 5.0%
Tier 1 Consolidated Capital to Average Assets $ 135,333 10.42% $ 51,936 4.0% N/A N/A
11. EMPLOYEE BENEFIT PLANS
Pension Plan
The Company, through the Bank, sponsored a defined benefit Pension Plan (the
Plan) that covered substantially all full-time employees of the Company.
Effective June 9, 2001 the Plan was amended to freeze the benefit accruals in
the Plan. With the exception of employees who had reached age 55 and who had
accumulated 10 years of Plan service, the effect of the amendment was to freeze
the participants' monthly pension benefit.
In February 2005 the Board of Directors terminated the Plan. Benefits for those
employees who were still accruing benefits under the Plan were frozen on April
30, 2005 when the Plan was amended to halt all future benefit accruals. Those
employees now participate in the mandatory contributions to the Company's Profit
Sharing Plan.
The Company filed Form 500, Standard Termination Notice for Single Employer
Plan, with the Pension Benefit Guaranty Corporation (the "PBGC") on October 21,
2005. The Company did not receive a Notice of Noncompliance from the PBGC within
sixty days, so it distributed all benefits to all participants prior to December
31, 2005.
The Company filed Form 5310, Application for Determination of Terminating Plan,
with the Internal Revenue Service on September 22, 2005. The Company received a
favorable determination letter from the Internal Revenue Service on June 19,
2006.
Because of the Company's decision to terminate the Plan in 2005, it elected to
accelerate the recognition of gain/loss over a two year amortization period
effective January 1, 2004, to match the remaining life of the Plan. This change
in amortization period resulted in a cumulative adjustment in the amount of
$387,000 ($224,000, net of tax).
The following schedule states the change in benefit obligations for the year
ended December 31, 2005.
(in thousands) 2005
-----------------------------------------------------------------
Benefit Obligation at Beginning of Year $ 5,508
Service Cost 53
Interest Cost 258
Benefits Paid (767)
Increase Due to Actuarial Loss and Assumption Change 320
Settlement Payments (5,372)
-----------------------------------------------------------------
Total Benefit Obligation at End of Year $ -
=================================================================
69
The Change in Plan Assets are as follows:(in thousands) 2005
-----------------------------------------------------------------
Fair Value of Plan Assets at Beginning of Year $ 4,080
Employer Contribution 1,945
Benefits Paid (6,139)
Actual Return on Plan Assets 114
-----------------------------------------------------------------
Total Fair Value of Plan Assets at End of Year $ -
=================================================================
The components of the net periodic benefit costs are as follows:
(in thousands) 2005 2004
--------------------------------------------------------------------------------
Service Cost $ 53 $ 47
Interest Cost 258 255
Expected Return on Plan Assets (114) (114)
Amortization of :
Unrecognized Prior Service Cost - -
Unrecognized Net Loss 947 1,569
--------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $ 1,144 $ 1,757
One-Time Charge Due to Plan Termination 1,229 -
--------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $ 2,373 $ 1,757
================================================================================
(Decrease) /Increase in Minimum Liability Included in Other
Comprehensive Income $(1,756) $(1,674)
================================================================================
Weighted-average assumptions used to determine benefit obligations at December
31, 2005.
2005
------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 4.89%
Rate of Compensation Increase 4.00%
================================================
Weighted-average assumptions used to determine net benefit cost for years ended
December 31,
2005 2004
-------------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 4.89% 5.12%
Expected Return on Plan Assets 3.00% 3.00%
Rate of Compensation Increase 4.00% 4.00%
=======================================================
The Company's Pension Plan had no weighted-average assets for the year ended
December 31, 2006 and the weighted-average asset allocation for the year ended
December 31, 2005, by asset category was 91% in savings deposits and 9% in other
deposits.
Profit Sharing Plan
The Company, through the Bank, sponsors a Profit Sharing Plan for substantially
all full-time employees of the Company with one or more years of service.
Participants receive up to two annual employer contributions, one is
discretionary and the other is mandatory. The discretionary contributions to the
Profit Sharing Plan are determined annually by the Board of Directors. The
discretionary contributions totaled $775,000, $725,000 and $660,000 for the
years ended December 31, 2006, 2005 and 2004, respectively. The mandatory
contributions to the Profit Sharing Plan are made according to a predetermined
set of criteria. Mandatory contributions totaled $727,000, $693,000 and $645,000
for the years ended December 31, 2006, 2005 and 2004, respectively. Company
employees are permitted, within limitations imposed by tax law, to make pretax
contributions to the 401(k) feature of the Profit Sharing Plan. The Company does
not match employee contributions within the 401(k) feature of the Profit Sharing
Plan and the
70
Company can terminate the Profit Sharing Plan at any time. Benefits pursuant to
the Profit Sharing Plan vest 0% during the first year of participation, 25% per
full year thereafter and after five years such benefits are fully vested.
Indexed Retirement Plan and Life Insurance Arrangements
The Company, through the Bank, sponsors an Indexed Retirement Plan for certain
employees. The Indexed Retirement Plan is a defined contribution supplemental
executive retirement plan and was developed to supplement the Company's Profit
Sharing Plan which, as a qualified plan, has a ceiling on benefits as set by the
Internal Revenue Service.
The Company made contributions to the Indexed Retirement Plan of $856,000,
$802,000 and $751,000 for the years ended December 31, 2006, 2005 and 2004,
respectively. The Company's total accrued liability under the Indexed Retirement
Plan was $2.83 million and $1.94 million as of December 31, 2006 and 2005,
respectively. The balance in each participant's account is 0% vested during the
first five years of employment and becomes fully vested after five years of
employment.
The Company has purchased single premium life insurance policies on the lives of
the Indexed Retirement Plan participants as well as certain other employees of
the Company. These policies provide: (1) financial protection to the Company in
the event of the death of a key employee and; (2) since the interest earned on
the cash surrender value of the policies is tax exempt as long as the policies
are used to finance employee benefits, significant income to the Company to
offset the expense associated with the Indexed Retirement Plan and other
employee benefit plans. As compensation to each employee for agreeing to allow
the Company to purchase an insurance policy on his or her life, split dollar
agreements have been entered into with those employees. These agreements provide
for a division of the life insurance death proceeds between the Company and each
employee's designated beneficiary or beneficiaries.
The Company earned tax exempt interest on the life insurance policies of $1.6
million for each of the years ended December 31, 2006, 2005 and 2004. As of
December 31, 2006 and 2005, the total cash surrender value of the insurance
policies was $38.4 million and $36.8 million, respectively.
Deferred Bonus and Executive Retention Plans
The Company, through the Bank, sponsors Deferred Bonus and Executive Retention
Plans for certain employees. Both plans grant bonuses based on the long-term
cumulative profitability and increase in market value of the Company. The
Company made contributions to both plans of $1.4 million, $966,000 and $248,000
for the years ended December 31, 2006, 2005 and 2004, respectively. Benefits
pursuant to the Deferred Bonus Plan vest 0% during the first year of
participation, 25% per full year thereafter and after five years such benefits
are fully vested. Benefits pursuant to the Executive Retention Plan vest 10% per
year beginning in 2005 and after ten years are fully vested. The Company's total
accrued liability under the Deferred Bonus and Executive Retention Plans was
$3.6 million and $2.1 million as of December 31, 2006 and 2005, respectively.
12. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, "Disclosure about Fair
Value of Financial Instruments." The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. The use of assumptions and various valuation
techniques, as well as the absence of secondary markets for certain financial
instruments, will likely reduce the comparability of fair value disclosures
between financial institutions. In some cases, book value is a reasonable
estimate of fair value due to the relatively short period of time between
origination of the instrument and its expected realization.
71
The following table summarized the book value and estimated fair value of
financial instruments as of December 31:
2006 2005
Carrying Estimated Carrying Estimated
ASSETS:(in thousands) Amount Fair Value Amount Fair Value
---------------------------------------------------------------------------------------------------
Cash and Cash Equivalents $ 47,006 $ 47,006 $ 50,669 $ 50,669
Investment Securities Held-to-Maturity 111,240 110,132 109,911 108,060
Investment Securities Available-for-Sale 132,627 132,627 158,029 158,029
Loans, Net of Deferred Loan Origination Fees 1,046,912 1,025,363 973,257 971,763
Cash Surrender Value of Life Insurance Policies 38,444 38,444 36,799 36,799
Accrued Interest Receivable 8,537 8,537 7,880 7,880
LIABILITIES:
Deposits:
Non-Interest Bearing 295,142 295,142 325,745 325,745
Interest-Bearing 903,386 902,019 777,595 707,892
Federal Funds Purchased - - 650 650
Federal Home Loan Bank Advances 47,532 47,555 98,847 99,522
Subordinated Debentures 10,310 10,281 10,310 10,365
Accrued Interest Payable 3,897 3,897 2,133 2,133
The methods and assumptions used to estimate the fair value of each class of
financial instrument listed in the table above are explained below.
Cash and Cash Equivalents: The carrying amounts reported in the balance sheet
for cash and due from banks and federal funds sold are a reasonable estimate of
fair value.
Investment Securities: Fair values for investment securities are based on quoted
market prices, where available. If quoted market prices are not available, fair
values are based on quoted market prices of comparable instruments.
Loans: For variable-rate loans that reprice frequently and with no significant
change in credit risk, fair values are based on carrying values. The fair values
for fixed-rate loans are estimated using discounted cash flow analyses, using
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality. The carrying amount of accrued interest receivable
approximates its fair value.
Cash Surrender Value of Life Insurance Policies: The fair value of life
insurance policies are based on cash surrender values at each reporting date as
provided by the insurers.
Deposit Liabilities: The fair value of demand deposits, interest bearing
transaction accounts and savings accounts is the amount payable on demand. The
fair value of fixed-maturity certificates of deposit is estimated by discounting
expected future cash flows utilizing interest rates currently being offered for
deposits of similar remaining maturities. The carrying amount of accrued
interest payable approximates its fair value.
Borrowings: The fair value of federal funds purchased and other short-term
borrowings is approximated by the book value. The fair value for Federal Home
Loan Bank borrowings is determined using discounted future cash flows.
Subordinated Debentures: Fair values of subordinated debentures were determined
based on the current market value of like-kind instruments of a similar maturity
and structure.
Limitations: Fair value estimates presented herein are based on pertinent
information available to management as of December 31, 2006 and 2005. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been comprehensively
revalued for purposes of these financial statements since that date, and
therefore, current estimates of fair value may differ significantly from the
amounts presented above.
72
13. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company uses derivative instruments to limit its exposure to changes in
interest rates. The Company has developed a Hedging Policy to provide guidelines
that address instruments to be used, authority limits, implementation
guidelines, guidelines for evaluating hedge alternatives, reporting
requirements, and the credit worthiness of the instrument's counterparty.
The Company reviews compliance with these guidelines annually with the ALCO
Committee and the Board of Directors. The guidelines may change as the Company's
business needs dictate.
In January of 2004, the Company terminated an interest rate swap agreement with
a notional amount of $12 million and maturity of December 8, 2006. As a result
of this termination, the Company recorded a deferred gain of $112,500 to be
amortized over the original remaining life of the interest rate swap as follows:
$37,500 in 2004, $37,500 in 2005 and $37,500 in 2006.
As required, the Company records in the balance sheet the interest rate swaps at
fair value. Because the transactions meet the criteria for a cash-flow hedge,
changes in fair value are reported in other comprehensive income (loss). In the
event that a portion of the hedge becomes ineffective, the ineffective portion
of the derivative's change in fair value will be immediately recognized in
earnings.
14. COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company is a party to financial
instruments with off-balance sheet risk to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These instruments include commitments to extend credit, letters of credit and
financial guarantees that are not reflected in the Consolidated Balance Sheet.
The Company's exposure to credit loss in the event of nonperformance by the
other party with regard to standby letters of credit, undisbursed loan
commitments and financial guarantees is represented by the contractual notional
amount of those instruments. Commitments to extend credit are agreements to lend
to a customer as long as there is no violation of any condition established in
the contract. The Company uses the same credit policies in making commitments
and conditional obligations as it does for recorded balance sheet items. The
Company may or may not require collateral or other security to support financial
instruments with credit risk. Evaluations of each customer's creditworthiness
are performed on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to
guarantee performance of or payment for a customer to a third party. The Company
had standby letters of credit outstanding of $10,929,000 at December 31, 2006,
and $11,541,000 at December 31, 2005. Outstanding standby letters of credit had
original terms ranging from 1 to 34 months with final expiration in 2009.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Undisbursed loan commitments totaled
$442,544,000 and $447,685,000 as of December 31, 2006 and 2005, respectively.
Since many of these commitments are expected to expire without fully being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements.
The Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 2006 were
$475,000, $353,000, $353,000, $310,000, and $269,000 for the years 2007 to 2011
and $860,000 thereafter.
In the ordinary course of business, the Company becomes involved in litigation
arising out of its normal business activities. Management, after consultation
with legal counsel, believes that the ultimate liability, if any, resulting from
the disposition of such claims would not be material in relation to the
financial position of the Company.
The Company may be required to maintain average reserves on deposit with the
Federal Reserve Bank primarily based on deposits outstanding. There were no
reserve requirements during 2006 or 2005.
73
15. RECENT ACCOUNTING DEVELOPMENTS
In June 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in
Income Taxes - an Interpretation of FASB Statement 109 (FIN 48). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in a
company's financial statements in accordance with FASB Statement No. 109,
Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and
measurement standard for the financial statement recognition and measurement of
an income tax position taken or expected to be taken in a tax return. In
addition, FIN 48 provides guidance on derecognition, classification, interest
and penalties, accounting in interim periods, disclosure and transition.
The Company presently recognizes income tax positions based on management's
estimate of whether it is reasonably possible that a liability has been incurred
for unrecognized income tax benefits by applying FASB Statement No. 5,
Accounting for Contingencies. The provisions of FIN 48 will be effective for the
Company on January 1, 2007 and are to be applied to all tax positions upon
initial application of this standard. Only tax positions that meet the
more-likely-than-not recognition threshold at the effective date may be
recognized or continue to be recognized upon adoption. The cumulative effect of
applying the provisions of FIN 48 will be reported as an adjustment to the
opening balance of retained earnings for the fiscal year of adoption. Management
does not expect the adoption of FIN 48 to have a material impact on the
Company's financial position or results of operations.
In September 2006, the FASB issued Statement No. 157 (SFAS 157), "Fair Value
Measurements." SFAS 157 defines fair value, establishes a framework for
measuring fair value and expands disclosures about fair value measurements. SFAS
157 applies whenever other standards require (or permit) assets or liabilities
to be measured at fair value but does not expand the use of fair value in any
new circumstances. In this standard, the FASB clarifies the principle that fair
value should be based on the assumptions market participants would use when
pricing the asset or liability. In support of this principle, SFAS 157
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. The provisions of SFAS 157 are effective for
financial statements issued for fiscal years beginning after November 15, 2007
and interim periods within those fiscal years. Management is in the process of
evaluating the impact the adoption of SFAS 157 will have on the results of
operations.
In September 2006, the FASB ratified the consensuses reached by the Emerging
Issues Task Force (the Task Force) on Issue No. 06-5 (EITF 06-5) "Accounting for
the Purchases of Life Insurance - Determining the Amount that Could be Realized
in Accordance with FASB Technical Bulletin No.85-4" (FTB 85-4). FTB 85-4
indicates that the amount of the asset included in the balance sheet for life
insurance contracts within its scope should be "the amount that could be
realized under the insurance contract as of the date of the statement of
financial position." Questions arose in applying the guidance in FTB 85-4 to
whether "the amount that could be realized" should consider 1) any additional
amounts included in the contractual terms of the insurance policy other than the
cash surrender value and 2) the contractual ability to surrender all of the
individual-life policies (or certificates in a group policy) at the same time.
EITF 06-5 determined that "the amount that could be realized" should 1) consider
any additional amounts included in the contractual terms of the policy and 2)
assume the surrender of an individual-life by individual-life policy (or
certificate by certificate in a group policy. Any amount that is ultimately
realized by the policy holder upon the assumed surrender of the final policy (or
final certificate in a group policy) shall be included in the "amount that could
be realized." An entity should apply the provisions of EITF 06-5 through either
a change in accounting principle through a cumulative-effect adjustment to
retained earnings as of the beginning of the year of adoption or a change in
accounting principle through retrospective application to all prior periods. The
provisions of EITF 06-5 are effective for fiscal years beginning after December
15, 2006. Management is in the process of evaluating the impact the adoption of
EITF 06-5 will have on the results of operations.
In September 2006, the FASB ratified the consensuses reached by the Task Force
on Issue No. 06-4 (EITF 06-4) "Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements." A question arose when an employer enters into an endorsement
split-dollar life insurance arrangement related to whether the employer should
recognize a liability for the future benefits or premiums to be provided to the
employee. EITF 06-4 indicates that an employer should recognize a liability for
future benefits and that a liability for the benefit obligation has not been
settled through the purchase of an endorsement type policy. An entity should
apply the provisions of EITF 06-4 either through a change in accounting
principle through a cumulative-effect adjustment to retained earnings as of the
beginning of the year of adoption or a change in accounting principle through
retrospective application to all prior periods. The provisions of EITF 06-4 are
effective
74
for fiscal years beginning after December 15, 2007. Management is in the process
of evaluating the impact the adoption of EITF 06-4 will have on the results of
operations.
16. PARENT COMPANY FINANCIAL INFORMATION
The financial information below is presented as of December 31, 2006 and
December 31, 2005.
Farmers & Merchants Bancorp
Condensed Balance Sheets
(in thousands) 2006 2005
---------------------------------------------------------------------------------
Cash $ 386 $ 556
Investment in Farmers & Merchants Bank of Central California 135,169 131,170
Investment Securities 4,203 310
Capital Leases 826 519
Other Assets 2,336 1,630
---------------------------------------------------------------------------------
TOTAL ASSETS $142,920 $134,185
=================================================================================
Subordinated Debentures $ 10,310 $ 10,310
Liabilities 270 227
Shareholders' Equity 132,340 123,648
---------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $142,920 $134,185
=================================================================================
Farmers & Merchants Bancorp
Condensed Income Statements
Year Ended December 31,
(in thousands) 2006 2005 2004
------------------------------------------------------------------------------------------------------------
Equity in Undistributed Earnings in Farmers & Merchants Bank of Central
California $ 2,973 $ 9,160 $ 9,243
Dividends from Subsidiary 18,600 10,000 7,350
Interest Income 67 59 27
Other Expenses, Net (1,695) (1,327) (285)
Tax Benefit 684 536 115
------------------------------------------------------------------------------------------------------------
NET INCOME $ 20,629 $ 18,428 $ 16,450
============================================================================================================
75
Farmers & Merchants Bancorp
Condensed Statements of Cash Flows
Year Ended December 31,
(in thousands) 2006 2005 2004
----------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Income $ 20,629 $ 18,428 $ 16,450
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Equity in Undistributed Net Earnings from Subsidiary (2,973) (9,160) (9,243)
Gain on Sale of Securities - (143) (1,095)
Net Increase in Other Assets (767) (522) (109)
Net Increase (Decrease) in Other Liabilities 43 (136) 189
----------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 16,932 8,467 6,192
----------------------------------------------------------------------------------------------------------------------
Investing Activities:
Investment in Bank Subsidiary - - (3,180)
Securities Purchased (3,893) - -
Securities Sold or Matured - 251 1,815
Change in Capital Leases (307) 266 (451)
----------------------------------------------------------------------------------------------------------------------
Net Cash Used by Investing Activities (4,200) 517 (1,816)
----------------------------------------------------------------------------------------------------------------------
Financing Activities:
Stock Repurchased (5,936) (4,016) (3,107)
Cash Dividends (6,966) (6,656) (5,930)
----------------------------------------------------------------------------------------------------------------------
Net Cash Used by Financing Activities (12,902) (10,672) (9,037)
----------------------------------------------------------------------------------------------------------------------
Increase in Cash and Cash Equivalents (170) (1,688) (4,661)
Cash and Cash Equivalents at Beginning of Year 556 2,244 6,905
----------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 386 $ 556 $ 2,244
======================================================================================================================
17. LONG-TERM SUBORDINATED DEBENTURES
In December 2003, the Company formed a wholly owned Connecticut statutory
business trust, FMCB Statutory Trust I ("Statutory Trust I"), which issued
$10,000,000 of guaranteed preferred beneficial interests in the Company's junior
subordinated deferrable interest debentures (the "Trust Preferred Securities").
These debentures qualify as Tier 1 capital under Federal Reserve Board
guidelines. All of the common securities of Statutory Trust I are owned by the
Company. The proceeds from the issuance of the common securities and the Trust
Preferred Securities were used by FMCB Statutory Trust to purchase $10,310,000
of junior subordinated debentures of the Company, which carry a floating rate
based on three-month LIBOR plus 2.85%. The debentures represent the sole asset
of Statutory Trust I. The Trust Preferred Securities accrue and pay
distributions at a floating rate of three-month LIBOR plus 2.85% per annum of
the stated liquidation value of $1,000 per capital security. The Company has
entered into contractual arrangements which, taken collectively, fully and
unconditionally guarantee payment of: (i) accrued and unpaid distributions
required to be paid on the Trust Preferred Securities; (ii) the redemption price
with respect to any Trust Preferred Securities called for redemption by
Statutory Trust I; and (iii) payments due upon a voluntary or involuntary
dissolution, winding up or liquidation of Statutory Trust I. The Trust Preferred
Securities are mandatorily redeemable upon maturity of the subordinated
debentures on December 17, 2033, or upon earlier redemption as provided in the
indenture. The Company has the right to redeem the subordinated debentures
purchased by Statutory Trust I, in whole or in part, on or after December 17,
2008. As specified in the indenture, if the subordinated debentures are redeemed
prior to maturity, the redemption price will be the principal amount and any
accrued but unpaid interest. Additionally, if the Company decided to defer
interest on the subordinated debentures, the Company would be prohibited from
paying cash dividends on the Company's common stock.
76
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains controls and procedures designed to ensure that all
relevant information is recorded and reported in all filings of financial
reports. Such information is reported to the Company's management, including its
Chief Executive Officer and its Chief Financial Officer to allow timely and
accurate disclosure based on the definition of "disclosure controls and
procedures" in Rule 13a-15(e). In designing these controls and procedures,
management recognizes that they can only provide reasonable assurance of
achieving the desired control objectives. Management also evaluated the
cost-benefit relationship of possible controls and procedures.
Under the supervision and with the participation of management, including the
Company's Chief Executive Officer and Chief Financial Officer, the Company
conducted an evaluation of the effectiveness of our internal control over
financial reporting as of December 31, 2006 based on the framework in "Internal
Control - Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based upon that evaluation, management
concluded that our internal control over financial reporting was effective as of
December 31, 2006.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
Management's report on internal control over financial reporting is set forth on
page 49 in "Item 8. Financial Statements and Supplementary Data," and is
incorporated herein by reference. Management's assessment of the effectiveness
of the Company's internal control over financial reporting has been audited by
Perry-Smith LLP, the independent registered public accounting firm that audited
the Company's 2006 Consolidated Financial Statements, as stated in its report,
which is set forth on page 50 in "Item 8. Financial Statements and Supplementary
Data," and is incorporated herein by reference.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Set forth below is certain information regarding the Executive Officers of the
Company and/or Bank:
NAME AND POSITION(S) AGE PRINCIPAL OCCUPATION DURING THE PAST FIVE YEARS
-------------------- --- -----------------------------------------------
Kent A. Steinwert 54 President & Chief Executive Officer of the Company and
President Bank.
& Chief Executive Officer
of the Company and Bank
Richard S. Erichson 59 Executive Vice President & Senior Credit Officer of the
Executive Vice President Company and Bank.
& Senior Credit Officer
of the Company and Bank
77
Deborah E. Hodkin 44 Executive Vice President & Chief Administrative Officer of
Executive Vice President & Chief the Company and Bank.
Administrative Officer and Secretary
of the Company and Bank
Chris C. Nelson 52 Executive Vice President & Head of Retail Banking of the
Executive Vice President & Head of Bank.
Retail Banking of the Bank
Stephen W. Haley 53 Executive Vice President & Chief Financial Officer of the
Executive Vice President Company and Bank since April 2003, prior thereto, President
& Chief Financial Officer of the and Chief Operating Officer of Community West Bancshares.
Company and the Bank
Kenneth W. Smith 47 Executive Vice President & Head of Business Banking of the
Executive Vice President & Head of Bank since January 2004, prior thereto, Senior Vice President
Business Banking of the Bank and Credit Administrator of the Bank.
Also, see "Election of Directors" and "Compliance with Section 16(a) of the
Exchange Act" in the Company's definitive proxy statement for the 2007 Annual
Meeting of Shareholders as filed with the Commission and which is incorporated
herein by reference.
The Company has adopted a Code of Conduct which complies with the Code of Ethics
requirements of the Securities and Exchange Commission. A copy of the Code of
Conduct is posted on the Company's website. The Company intends to disclose
promptly any amendment to, or waiver from any provision of, the Code of Conduct
applicable to senior financial officers, and any waiver from any provision of
the Code of Conduct applicable to Directors, on its website. The Company's
website address is www.fmbonline.com.
-----------------
During 2006, there were no changes in procedures for the nomination of
Directors.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K is incorporated by reference
from the information contained in the Company's definitive proxy statement for
the 2007 Annual Meeting of Shareholders which will be filed pursuant to
Regulation 14A.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K is incorporated by reference
from the information contained in the Company's definitive proxy statement for
the 2007 Annual Meeting of Shareholders which will be filed pursuant to
Regulation 14A. The Company does not have any equity compensation plans which
require disclosure under Item 201(d) of Regulation S-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
The information required by Item 13 of Form 10-K is incorporated by reference
from the information contained in the Company's definitive proxy statement for
the 2007 Annual Meeting of Shareholders which will be filed pursuant to
Regulation 14A.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 of Form 10-K is incorporated by reference
from the information contained in the Company's definitive proxy statement for
the 2007 Annual Meeting of Shareholders which will be filed pursuant to
Regulation 14A.
78
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) Financial Statements. Incorporated herein by reference, are listed
in Item 8 hereof.
(2) Financial Statement Schedules. None
(b) See Index to Exhibits on Page 79
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Farmers & Merchants Bancorp
(Registrant)
By /s/ Stephen W. Haley
-------------------------------
Dated: March 9, 2007 Stephen W. Haley
Executive Vice President &
Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities indicated on March 9, 2007.
/s/ Kent A. Steinwert
------------------------------------- President and Chief Executive Officer
Kent A. Steinwert (Principal Executive Officer)
/s/ Stephen W. Haley
------------------------------------- Executive Vice President & Chief
Stephen W. Haley Financial Officer
(Principal Financial and Accounting
Officer)
/s/ Ole R. Mettler /s/ James E. Podesta
------------------------------------- -------------------------------------
Ole R. Mettler, Chairman James E. Podesta, Director
/s/ Stewart Adams, Jr. /s/ Kevin Sanguinetti
------------------------------------- -------------------------------------
Stewart Adams, Jr., Director Kevin Sanguinetti, Director
/s/ Ralph Burlington /s/ Carl Wishek, Jr.
------------------------------------- -------------------------------------
Ralph Burlington, Director Carl Wishek, Jr., Director
/s/ Edward Corum, Jr. /s/ Calvin Suess
------------------------------------- -------------------------------------
Edward Corum, Jr., Director Calvin Suess, Director
/s/ Robert F. Hunnell
-------------------------------------
Robert F. Hunnell, Director
79
INDEX TO EXHIBITS
-----------------
Exhibit No. Description
---------- -----------
3(i) Amended and Restated Certificate of Incorporation of Farmers & Merchants Bancorp, filed on
Registrant's Form 8-K dated April 30, 1999, is incorporated herein by reference.
3(ii) By-Laws of Farmers & Merchants Bancorp, filed on Registrant's Form 8-K dated April 30, 1999,
Is incorporated herein by reference.
10.1 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Kent A. Steinwert, filed on Registrant's Form 10-K for the year ended December
31, 2004, is incorporated herein by reference.
10.2 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Chris C. Nelson, filed on Registrant's Form 10-K for the year ended December 31,
2004, is incorporated herein by reference.
10.3 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Deborah E. Hodkin, filed on Registrant's Form 10-K for the year ended December
31, 2004, is incorporated herein by reference.
10.4 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Kenneth W. Smith, filed on Registrant's Form 10-K for the year ended December
31, 2004, is incorporated herein by reference.
10.5 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Richard S. Erichson, filed on Registrant's Form 10-K for the year ended December
31, 2004, is incorporated herein by reference.
10.6 Employment Agreement dated January 1, 2005, between Farmers & Merchants Bank of Central
California and Stephen W. Haley, filed on Registrant's Form 10-K for the year ended December
31, 2004, is incorporated herein by reference.
10.15 2005 Deferred Bonus Plan of Farmers & Merchants Bank of Central California executed May 3,
2005, filed on Registrant's Form 10-Q for the quarter ended March 31, 2005, is incorporated
herein by reference.
10.16 Executive Retention Plan of Farmers & Merchants Bank of Central California executed May 3,
2005, filed on Registrant's Form 10-Q for the quarter ended March 31, 2005, is incorporated
herein by reference.
10.17 Amended and Restated Indexed Retirement Plan of Farmers & Merchants Bank of Central
California adopted as of March 7, 2006, filed on Registrant's Form 10-K for the year ended
December 31, 2005, is incorporated herein by reference.
10.18 Deferred Compensation Plan of Farmers & Merchants Bank of Central California, executed
October 17, 2006, filed on the Registrants Form 10-Q for the quarter ended September 30, 2006,
is incorporated herein by reference.
14 Code of Conduct of Farmers & Merchants Bancorp, filed on Registrant's Form 10-K for the year
ended December 31, 2003, is incorporated herein by reference.
18 Letter regarding change in accounting principle, filed on Registrant's Form 10-K for the year
ended December 31, 2004, is incorporated herein by reference.
21 Subsidiaries of the Registrant, filed on Registrant's Form 10-K for the year ended December 31,
2003, is incorporated herein by reference.
31(a) Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31(b) Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32 Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
80