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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 0-26570
1ST INDEPENDENCE FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 61-1284899
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
104 South Chiles Street
Harrodsburg, Kentucky 40330-1620
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (502)753-0500
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 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 |_| Non-accelerated filer |X|
Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act). Yes|_| No |X|
The registrant had 1,987,658 shares of common stock outstanding at
October 28, 2006.
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1st INDEPENDENCE FINANCIAL GROUP, INC.
FORM 10-Q
For the Quarter Ended September 30, 2006
INDEX
Part I - Financial Information
Item 1. Financial Statements Page Number
-----------
Condensed Consolidated Balance Sheets as of September 30, 2006
(unaudited) and December 31, 2005 3
Condensed Consolidated Statements of Operations for the three months
and nine months ended September 30, 2006 and 2005 (unaudited) 4
Condensed Consolidated Statements of Comprehensive Income for
the three months and nine months ended September 30, 2006 and 2005
(unaudited) 5
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 2006 and 2005 (unaudited) 6
Notes to Condensed Consolidated Financial Statements (unaudited) 7-10
Item 2. Management's Discussion and Analysis of Financial Condition 11-16
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk 17
Item 4. Controls and Procedures 17
Part II - Other Information
Item 1. Legal Proceedings 18
Item 1A. Risk Factors 18-24
Item 6. Exhibits 24
Signatures 25
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
1ST INDEPENDENCE FINANCIAL GROUP, INC.
Condensed Consolidated Balance Sheets
(in thousands except share data)
(Unaudited)
September 30, December 31,
2006 2005
--------------- --------------
Assets
Cash and and due from banks $ 3,851 $ 4,327
Interest-bearing demand deposits 5,671 5,886
Federal funds sold 10,104 11,350
--------------- --------------
Cash and cash equivalents 19,626 21,563
Inerest-bearing deposits 100 100
Available-for-sale securities at fair value 15,913 16,140
Held-to-maturity securities, fair value of $1,923 and
$1,974 at September 30, 2006 and December 31, 2005, respectively 1,901 1,975
Loans held for sale 588 1,278
Loans, net of allowance for loan losses of $3,569 and
$2,911 at September 30, 2006 and December 31, 2005, respectively 271,469 266,978
Premises and equipment, net 8,104 8,215
Federal Home Loan Bank (FHLB) stock 2,302 2,688
Bank owned life insurance 3,384 3,235
Goodwill 11,142 11,142
Interest receivable and other assets 3,680 2,873
--------------- --------------
Total assets $ 338,209 $ 336,187
=============== ==============
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand $ 16,002 $ 15,570
Savings, NOW and money market 66,869 51,167
Time 182,661 197,586
--------------- --------------
Total depositsotal deposits 265,532 264,323
Short-term borrowings 20,919 18,747
Long-term debt 10,279 13,279
Interest payable and other liabilities 1,635 1,577
--------------- --------------
Total liabilitiesl liabilities 298,365 297,926
--------------- --------------
Commitments and contingencies - -
Stockholders' equity
Preferred stock, $0.10 par value, 500,000 shares authorized, no
shares issued or outstanding - -
Common stock, $0.10 par value, 5,000,000 shares authorized,
1,987,658 shares and 1,951,408 shares outstanding at
September 30, 2006 and December 31, 2005, respectively 295 292
Additional paid-in capital 39,683 39,236
Retained earnings 14,856 13,849
Unearned ESOP compensation (313) (380)
Unearned compensation on restricted stock - (24)
Accumulated other comprehensive (loss) (102) (137)
Treasury stock, at cost, common,
969,835 shares and 969,835 shares at September 30, 2006 and
December 31, 2005, respectively (14,575) (14,575)
--------------- --------------
Total stockholders' equity 39,844 38,261
--------------- --------------
Total liabilities and stockholders' equity $ 338,209 $ 336,187
=============== ==============
See notes to condensed consolidated financial statements.
1ST INDEPENDENCE FINANCIAL GROUP, INC.
Condensed Consolidated Statements of Operations
(in thousands except per share data)
(Unaudited) (Unaudited)
Three months ended Nine months ended
September 30 September 30
--------------------------- --------------------------
2006 2005 2006 2005
----------- ---------- ---------- -----------
Interest and dividend income
Interest and fees on loans $ 5,373 $ 4,459 $ 15,461 $ 12,256
Interest on securities
Taxable 164 166 478 537
Tax exempt 46 28 137 80
Interest on federal funds sold 101 36 251 179
Dividends 38 36 119 103
Interest on deposits with financial institutions 75 41 209 94
----------- ---------- ---------- -----------
Total interest and dividend income 5,797 4,766 16,655 13,249
----------- ---------- ---------- -----------
Interest expense
Deposits 2,614 1,740 7,348 4,770
FHLB advances 301 212 711 509
Other 192 156 544 451
----------- ---------- ---------- -----------
Total interest expense 3,107 2,108 8,603 5,730
----------- ---------- ---------- -----------
Net interest income 2,690 2,658 8,052 7,519
Provision for loan losses 543 60 655 262
----------- ---------- ---------- -----------
Net interest income after provision for loan losses 2,147 2,598 7,397 7,257
----------- ---------- ---------- -----------
Noninterest income
Service charges 134 114 380 274
Gain on loan sales 277 274 703 811
Gain (loss) on sale of premises and equipment (32) (144) (32) (162)
Increase in cash value of life insurance 51 47 149 140
Net realized gains (losses) on sales of available-for-sale
securities - (129) - 4,883
Other 83 129 232 476
----------- ---------- ---------- -----------
Total noninterest income 513 291 1,432 6,422
----------- ---------- ---------- -----------
Noninterest expense
Salaries and employee benefits 1,004 1,151 3,274 3,873
Net occupancy 384 325 1,183 1,026
Data processing fees 190 169 567 453
Professional fees 219 158 521 638
Marketing 32 77 88 135
Other 371 368 1,110 1,418
----------- ---------- ---------- -----------
Total noninterest expense 2,200 2,248 6,743 7,543
----------- ---------- ---------- -----------
Income from continuing operations before income
taxes and minority interest 460 641 2,086 6,136
Income tax expense from continuing operations 111 177 616 2,079
----------- ---------- ---------- -----------
Income from continuing operations before minority
interest and discontinued operations 349 464 1,470 4,057
Income from subsidiary held for disposal - - - 6
Income tax expense from subsidiary held for disposal - - - 2
----------- ---------- ---------- -----------
Income before minority interest 349 464 1,470 4,061
Minority interest in (income) of consolidated subsidiary and
subsidiary held for disposal - (2) - (7)
----------- ---------- ---------- -----------
Net income $ 349 $ 462 $ 1,470 $ 4,054
=========== ========== ========== ===========
Income per share from continuing operations
Basic $0.18 $0.24 $0.76 $2.15
Diluted 0.18 0.24 0.75 2.11
Income per share from subsidiary held for disposal
Basic $0.00 $0.00 $0.00 $0.00
Diluted 0.00 0.00 0.00 0.00
Net income per share
Basic $0.18 $0.24 $0.76 $2.15
Diluted 0.18 0.24 0.75 2.11
Weighted average shares outstanding
Basic 1,949 1,897 1,935 1,883
Diluted 1,963 1,939 1,954 1,925
Cash dividends declared per share $0.08 $0.08 $0.24 $0.32
See notes to condensed consolidated financial statements.
1ST INDEPENDENCE FINANCIAL GROUP, INC.
Condensed Consolidated Statements of Comprehensive Income
(in thousands)
(Unaudited) (Unaudited)
Three months ended September 30, Nine months ended September 30,
--------------------------- --------------------------
2006 2005 2006 2005
----------- ------------- ----------- -----------
Net income $ 349 $ 462 $ 1,470 $ 4,054
Other comprehensive income, net of tax
Change in unrealized gains and losses on
available-for-sale securities 206 (59) 35 (549)
Less reclassification adjustment for realized gains
(losses) included in net income - (85) - 3,223
----------- ------------- ----------- -----------
Other comprehensive income (loss) 206 26 35 (3,772)
----------- ------------- ----------- -----------
Comprehensive income $ 555 $ 488 $ 1,505 $ 282
=========== ============= =========== ===========
See notes to condensed consolidated financial statements.
1ST INDEPENDENCE FINANCIAL GROUP, INC.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)
Nine months ended September 30,
----------------------------
2006 2005
------------ ----------
Cash Flows from Operating Activities:
Net income $ 1,470 $ 4,054
Adjustments to reconcile net income to net cash provided by operations:
Depreciation 539 452
Provision for loan losses 655 262
Gain on loan sales (703) (811)
Origination of loans held for sale (38,113) (47,716)
Proceeds from loans held for sale 39,506 48,791
Compensation expense on stock options 34 -
ESOP compensation 83 151
Amortization of unearned compensation on restricted stock 12 3
Amortization of premiums and discounts on securities 25 100
Deferred income taxes - 336
FHLB stock dividend (90) (70)
Amortization of loan fees (278) (237)
Amortization of intangibles, net 195 272
Net realized (gains) on available-for-sale securities - (4,883)
Loss on sale of premises and equipment 32 162
Minority interest in income from subsidiary held for disposal - 7
Increase in cash value of life insurance (148) (140)
(Income) from subsidiary held for disposal - (4)
Changes in:
(Increase) in interest receivable and other assets (771) (682)
Increase (decrease) in interest payable and other liabilities 149 (13)
------------ ----------
Net cash provided by operating activities 2,597 34
------------ ----------
Cash Flows from Investing Activities:
Purchase of interest-bearing deposits (100) -
Proceeds from maturities of interest-bearing deposits 100 -
Purchases of available-for-sale securities (1,491) (6,321)
Proceeds from maturities of available-for-sale securities 1,532 3,731
Proceeds from sales of available-for-sale securities 211 11,267
Proceeds from maturities of held-to-maturity securities 68 165
Net (increase) in loans (5,200) (32,349)
Purchases of premises and equipment (461) (3,178)
Proceeds from sales of premises and equipment - 24
Proceeds from sale of FHLB stock 476 -
Proceeds from sale of subsidiary - 2,300
------------ ----------
Net cash (used in) investing activities (4,865) (24,361)
------------ ----------
Cash Flows from Financing Activities:
Net increase in deposits 1,210 35,332
Net increase (decrease) in short-term borrowings 2,172 (4,793)
Repayment of long-term debt (3,000) (1,000)
Proceeds from exercise of stock options 412 415
Cash dividends paid (463) (601)
------------ ----------
Net cash provided by financing activities 331 29,353
------------ ----------
Net (decrease) increase in cash and cash equivalents (1,937) 5,026
Cash and cash equivalents at beginning of period 21,563 9,946
------------ ----------
Cash and cash equivalents at end of period $ 19,626 $ 14,972
============ ==========
Supplemental Cash Flow Information:
Interest paid $ 8,453 $ 5,547
Income taxes paid 985 1,680
Net increase in cash and cash equivalents of discontinued
operations (revised see note 8)
Net cash (used in) operating activities - (5)
Net cash provided by investing activities - 1,647
Net cash (used in) financing activities - (361)
------------ ----------
Net increase in cash and cash equivalents of discontinued operations - 1,281
------------ ----------
Real estate acquired in settlement of loans 181 33
See notes to condensed consolidated financial statements.
1st INDEPENDENCE FINANCIAL GROUP, INC.
Notes to Condensed Consolidated Financial Statements (Unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of 1st
Independence Financial Group, Inc. (the "Company") are presented in accordance
with the requirements of Form 10-Q and accounting principles generally accepted
in the United States of America for interim financial information. Accordingly,
they do not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements. These condensed consolidated financial statements and
notes thereto included in this report should be read in conjunction with the
consolidated financial statements and notes thereto included in the Company's
Form 10-KSB annual report for the year ended December 31, 2005 filed with the
United States Securities and Exchange Commission ("SEC"). In the opinion of
management, all adjustments necessary to make the financial statements not
misleading and to fairly present the financial position, results of operations
and cash flows for the reporting interim periods have been made and were of a
normal recurring nature. The results of operations for the period are not
necessarily indicative of the results to be expected for the full year. The
condensed consolidated balance sheet of the Company as of December 31, 2005 has
been derived from the audited consolidated balance sheet of the Company as of
that date.
The unaudited condensed financial statements include the accounts of the Company
and its wholly-owned subsidiary, 1st Independence Bank, Inc. (the "Bank"), 1st
Independence Mortgage, a division of the Bank and for periods prior to its sale
on January 28, 2005, the Company's majority-owned subsidiary Citizens Financial
Bank, Inc. ("Citizens"). As a result of the Company's sale of Citizens, the
assets, liabilities, results of operations and cash flows of Citizens have been
reported separately as discontinued operations in the Company's condensed
consolidated financial statements and previously reported amounts have been
reclassified to consistently present the discontinued operations.
2. Stock-Based Compensation
At September 30, 2006, the Company had two stock-based compensation plans. Prior
to January 1, 2006, as permitted by Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), the Company
followed the provisions of Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related Interpretations in
accounting for its stock option plans under the intrinsic value based method.
Accordingly, no stock-based compensation expense was recognized for the three
months and nine months ended September 30, 2005 for stock options issued under
the plans as all stock options granted under the plans had an exercise price
equal to the market value of the underlying common stock on the date of grant.
The following table illustrates the effect on net income and basic and diluted
net income per share had compensation expense been determined based on the fair
value of the stock options at the grant date consistent with the provisions of
SFAS No. 123 (in thousands except per share data):
Three months ended
September 30, 2005
------------------
Net income as reported $462
Less total stock-based employee compensation expense
(including forfeitures of $20) determined under fair value
method for all awards, net of related tax effects (14)
----
Pro forma net income $476
====
Basic net income per share
As reported $0.24
Pro forma 0.25
Diluted net income per share
As reported $0.24
Pro forma 0.25
Nine months ended
September 30, 2005
------------------
Net income as reported $4,054
Less total stock-based employee compensation expense
(including forfeitures of $65) determined under fair value
method for all awards, net of related tax effects (52)
------
Pro forma net income $4,106
======
Basic net income per share
As reported $2.15
Pro forma 2.18
Diluted net income per share
As reported $2.11
Pro forma 2.14
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No.123R, "Share-Based Payment"
("SFAS 123R"). This Statement requires expensing of stock options and other
share-based payments over the related vesting period and supersedes FASB's
earlier rule (the original SFAS 123) that had allowed companies to choose
between expensing stock options and showing pro forma disclosure only. SFAS 123R
permits companies to adopt its requirements using either a "modified
prospective" method, or a "modified retrospective" method. Under the "modified
prospective" method, compensation cost is recognized in the financial statements
beginning with the effective date, based on the requirements of SFAS 123R for
all share-based payments granted after that date, and based on the requirements
of SFAS 123 for all unvested awards granted prior to the effective date of SFAS
123R. Under the "modified retrospective" method, the requirements are the same
as under the "modified prospective" method but this method also permits entities
to restate financial statements of previous periods based on proforma
disclosures made in accordance with SFAS 123. Beginning in January 2006, the
Company adopted the Statement as required and elected the "modified prospective"
method and thus has not restated prior financial statements. For the three
months and nine months ended September 30, 2006, the Company recorded $8,000 and
$34,000, respectively, in employee stock-based compensation expense, which is
included in salaries and employee benefits. As of September 30, 2006, there was
$31,000 of unrecognized stock-compensation expense for previously granted
unvested options that will be recognized over a weighted-average period of 1.5
years.
3. Allowance for Loan Losses
An analysis of the changes in the allowance for loan losses for the nine months
ended September 30 follows (in thousands):
2006 2005
---- ----
Beginning balance $2,911 $2,549
Provision for loan losses 655 262
Loans charged off (1) (6)
Recoveries 4 12
------ ------
Ending balance $3,569 $2,817
====== ======
4. Net Income Per Share Computations
The following is a reconciliation of the numerator and denominator of the basic
and diluted per share computations (in thousands except per share data):
Three months ended
September 30,
2006 2005
---- ----
Income (numerator) amounts used for basic and diluted per share computations:
Income from continuing operations $349 $464
==== ====
Income from discontinued operations $ - $ -
==== ====
Net income $349 $462
==== ====
Shares (denominator) used for basic per share computations:
Weighted average shares of common stock outstanding 1,949 1,897
===== =====
Shares (denominator) used for diluted per share computations:
Weighted average shares of common stock outstanding 1,949 1,897
Plus: dilutive effect of stock options 14 42
----- -----
Adjusted weighted average shares 1,963 1,939
===== =====
Basic net income per share data:
Income from continuing operations $0.18 $0.24
===== =====
Income from discontinued operations $ - $ -
===== =====
Net income $0.18 $0.24
===== =====
Diluted net income per share data:
Income from continuing operations $0.18 $0.24
===== =====
Income from discontinued operations $ - $ -
===== =====
Net income $0.18 $0.24
===== =====
Nine months ended
September 30,
2006 2005
---- ----
Income (numerator) amounts used for basic and diluted per share computations:
Income from continuing operations $1,470 $4,057
====== ======
Income from discontinued operations $ - $ 4
====== ======
Net income $1,470 $4,054
====== ======
Shares (denominator) used for basic per share computations:
Weighted average shares of common stock outstanding 1,935 1,883
===== =====
Shares (denominator) used for diluted per share computations:
Weighted average shares of common stock outstanding 1,935 1,883
Plus: dilutive effect of stock options 19 42
----- -----
Adjusted weighted average shares 1,954 1,925
===== =====
Basic net income per share data:
Income from continuing operations $0.76 $2.15
===== =====
Income from discontinued operations $ - $ -
===== =====
Net income $0.76 $2.15
===== =====
Diluted net income per share data:
Income from continuing operations $0.75 $2.11
===== =====
Income from discontinued operations $ - $ -
===== =====
Net income $0.75 $2.11
===== =====
Options to purchase 17,000 common shares for the three months and nine months
ended September 30, 2006 were excluded from the diluted calculations above
because the exercise prices on the options were greater than the average market
price for the period.
5. Contingencies
The Company is currently a defendant in a lawsuit that asserts that the Company
made certain material misrepresentations in connection with certain statements
made in connection with its offer to purchase up to 300,000 shares of stock in a
tender offer in May 2003. The plaintiffs are seeking to recover damages in
connection with the shares they sold in the tender offer and attorneys fees.
This matter is currently scheduled for trial in July 2007. Based upon the advice
of counsel, management records an estimate of the amount of ultimate expected
loss for litigation, if any. Management has not recorded a loss provision for
this litigation as, after discussion with legal counsel, management believes the
ultimate results of this litigation will not have a material adverse effect on
the Company's financial position, results of operations or cash flows. Events
could occur that could cause the estimate of ultimate loss to differ materially
in the near term. Reference is made to Part II, Item 1 of this report on Form
10-Q for additional information.
6. Recently Issued Accounting Standards
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No.123R, "Share-Based Payment"
("SFAS 123R"). This Statement required expensing of stock options and other
share-based payments over the related vesting period beginning in 2005, and
superseded FASB's earlier rule (the original SFAS 123) that had allowed
companies to choose between expensing stock options and showing pro forma
disclosure only. The Statement required that public entities apply SFAS 123R as
of the first interim or annual reporting period that began after June 15, 2005.
However, in April 2005 the United States Securities and Exchange Commission
issued a rule that revised the required date of adoption under SFAS 123R. The
new rule allowed for public entities to adopt the provisions of SFAS 123R at the
beginning of the first fiscal year beginning after June 15, 2005. The Company
adopted the Statement in the first quarter of 2006 as required and the effects
of initial adoption were immaterial. See note 2, "Stock-Based Compensation" to
this report for additional information.
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109" ("FIN
48"). The Interpretation clarifies the accounting for uncertainty in income
taxes recognized in accordance with FASB Statement No. 109, "Accounting for
Income Taxes". FIN 48 also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition. The evaluation of a tax position in
accordance with this Interpretation is a two-step process. The first step is a
recognition process to determine whether it is more likely than not that a tax
position will be sustained upon examination, including resolution of any related
appeals or litigation processes, based on the technical merits of the position.
The second step is a measurement process whereby a tax position that meets the
more likely than not recognition threshold is calculated to determine the amount
of benefit to recognize in the financial statements. FIN 48 is effective for
fiscal years beginning after December 15, 2006 and the cumulative effect of
applying the provisions of this statement will be recognized as an adjustment to
the beginning balance of retained earnings. The Company is currently evaluating
the potential impact this Statement may have on the Company's financial position
and results of operations, but does not believe the impact of the adoption will
be material.
In September 2006, the FASB issued Statement of Financial Accounting Standards
No. 157, "Fair Value Measurements" ("SFAS 157"), which provides guidance on how
to measure assets and liabilities that use fair value. SFAS 157 will apply
whenever another US GAAP standard requires (or permits) assets or liabilities to
be measured at fair value but does not expand the use of fair value to any new
circumstances. This Statement also will require additional disclosures in both
annual and quarterly reports. SFAS 157 will be effective for financial
statements issued for fiscal years beginning after November 15, 2007, and will
be adopted by the Company beginning in the first quarter of 2008. The Company is
currently evaluating the potential impact this Statement may have on the
Company's financial position and results of operations, but does not believe the
impact of the adoption will be material.
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 was
issued in order to eliminate the diversity of practice in how public companies
quantify misstatements of financial statements, including misstatements that
were not material to prior years' financial statements. The Company will
initially apply the provisions of SAB 108 in connection with the preparation of
our annual financial statements for the year ending December 31, 2006. The
Company has evaluated the potential impact SAB 108 may have on the Company's
financial position and results of operations and the Company does not believe
the impact of the application of this guidance will be material.
7. Completion of Subsidiary Disposal
On January 28, 2005 the Company completed the sale of its entire interest in its
majority owned subsidiary, Citizens Financial Bank, Inc., to Porter Bancorp,
Inc. for $2.3 million, pursuant to a Stock Purchase Agreement, dated as of
October 22, 2004, between Porter Bancorp, Inc. and the Company. In a related
transaction, on January 28, 2005, the Company's subsidiary bank, 1st
Independence Bank, Inc., purchased a commercial building located in Louisville,
Kentucky, for $2.3 million from Ascencia Bank, Inc., an affiliate of Porter
Bancorp, Inc. See note 4, "Completion of Subsidiary Disposal" to the
consolidated financial statements included in the Company's Form 10-KSB for the
year ended December 31, 2005 for additional information.
8. Revised Cash Flows of Discontinued Operations
In 2005 the Company has separately disclosed the operating, investing and
financing portions of the cash flows attributable to its discontinued
operations, which in prior periods were reported on a combined basis as a single
amount.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This section should be read in conjunction with the condensed consolidated
financial statements and notes thereto included in Item 1 of Part I of this
report in addition to the consolidated financial statements of the Company and
the notes thereto included in the Company's Form 10-KSB for the year ended
December 31, 2005, including note 1 which describes the Company's significant
accounting policies including its use of estimates. See the caption entitled
"Application of Critical Accounting Policies" in this section for further
information.
Forward-Looking Statements
The following discussion contains statements which are forward-looking rather
than historical fact. These forward-looking statements are made pursuant to the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995
and involve known and unknown risks, uncertainties and other factors, which may
cause the Company's actual results to be materially different from any future
results, performance or achievements expressed or implied by such
forward-looking statements. Such statements are subject to certain risks and
uncertainties including among other things, changes in economic conditions in
the market areas the Company conducts business, changes in policies by
regulatory agencies, fluctuations in interest rates, demand for loans in the
market areas the Company conducts business, competition that could cause actual
results to differ materially from historical earnings and those presently
anticipated or projected and other risks as detailed in the Company's various
filings with the United States Securities and Exchange Commission. The Company
wishes to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made.
General
The Company provides commercial and retail banking services, including
commercial real estate loans, one-to-four family residential mortgage loans via
1st Independence Mortgage, home equity loans and lines of credit and consumer
loans as well as certificates of deposit, checking accounts, money-market
accounts and savings accounts within its market area. At September 30, 2006, the
Company had total assets, deposits and stockholders' equity of $338.2 million,
$265.5 million, and $39.8 million, respectively. The Company's business is
conducted principally through the Bank. Unless otherwise indicated, all
references to the Company refer collectively to the Company and the Bank.
The Company is currently a defendant in a lawsuit that asserts that the Company
made certain material misrepresentations in connection with its offer to
purchase up to 300,000 shares of stock in a tender offer in May 2003. The
plaintiffs are seeking to recover damages in connection with the shares they
sold in the tender offer and attorneys fees. This matter is currently scheduled
for trial in July 2007. Based upon the advice of counsel, management records an
estimate of the amount of ultimate expected loss for litigation, if any.
Management has not recorded a loss provision for this litigation as, after
discussion with legal counsel, management believes the ultimate result of this
litigation will not have a material adverse effect on the Company's financial
position, results of operations or cash flows. Events could occur that could
cause the estimate of ultimate loss to differ materially in the near term.
In January 2005, the Company sold its 55.8% interest in Citizens Financial Bank,
Inc., Glasgow, Kentucky ("Citizens") to Porter Bancorp, Inc., Shepherdsville,
Kentucky ("Porter Bancorp") for $2.3 million. The sale of Citizens reflected the
Company's revised strategic plan to exit the south central Kentucky market and
to focus on the growing markets of southern Indiana, central Kentucky, and
greater Louisville, Kentucky.
Application of Critical Accounting Policies
The discussion and analysis of the Company's financial condition and results of
operation is based upon the Company's unaudited condensed consolidated financial
statements, which have been prepared in conformity with accounting principles
generally accepted in the United States of America for interim financial
information and with the instructions for Form 10-Q. The preparation of
financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent 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 those estimates. The Company's most critical accounting policies require
the use of estimates relating to other than temporary impairment of securities,
the allowance for loan losses and the valuation of goodwill. See the caption
entitled "Critical Accounting Policies" in the Management's Discussion and
Analysis of Financial Condition and Results of Operations section of the
Company's Form 10-KSB for the year ended December 31, 2005 for additional
information.
Overview
Net income for the quarter ended September 30, 2006 was $349,000 or $0.18 per
diluted share compared to $462,000 or $0.24 per diluted share for the comparable
period in 2005. Net income for the nine months ended September 30, 2006 was
$1,470,000 or $0.75 per diluted share compared to $4,054,000 or $2.11 per
diluted share for the comparable period in 2005. The decrease in net income and
net income per diluted share for the nine-month period was primarily due to
after tax securities gains of $3,308,000 taken in the first quarter of 2005 and
the increase of $259,000 after taxes in the provision for loan losses in the
first nine months of 2006 compared to the first nine months of 2005. Partially
offsetting these factors was an increase in net interest income of $352,000
after taxes and an after tax charge of $235,000 recorded in the first quarter of
2005 for severance expenses related to the retirement of the Company's former
Chairman and Chief Executive Officer. Other factors were decreased professional
fees and other noninterest expense items. The decrease in net income and net
income per diluted share for the quarter was primarily due to an increase of
$319,000 after taxes in the provision for loan losses in the third quarter of
2006 compared to the same period in 2005. Partially offsetting this factor was
the decrease in the loss on sale of premises and equipment of $74,000 after
taxes in the third quarter of 2006 versus the third quarter of 2005 and the net
realized losses on sales of available-for-sale securities of $85,000 after taxes
recorded in the third quarter of 2005 while no transactions were recorded in the
third quarter of 2006. Decreases in other noninterest income and noninterest
expenses which are described more fully in following sections accounted for most
of the remaining net change.
Results of Operations
Net Interest Income
Net interest income is the most significant component of the Company's revenues.
Net interest income is the difference between interest income on
interest-earning assets (primarily loans and investment securities) and interest
expense on interest-bearing liabilities (deposits and borrowed funds). Net
interest income depends on the volume and rate earned on interest-earning assets
and the volume and rate paid on interest-bearing liabilities.
Net interest income was $2.7 million and $8.1 million, respectively, for the
three months and nine months ended September 30, 2006, which was flat and an
increase of $0.5 million or 7%, respectively, from $2.7 million and $7.5
million, respectively, for the comparable periods of 2005. On an annualized
basis, the net interest spread and net interest margin were 2.94% and 3.39%,
respectively, for the current quarter, compared to 3.21% and 3.51% for the same
period of 2005. For the nine months ended September 30, 2006 the net interest
spread and net interest margin were 3.03% and 3.45%, respectively, compared to
3.16% and 3.45% for the first half of 2005. The decrease in the net interest
margin for the third quarter 2006 compared to the third quarter of 2005 and the
net interest margin being the same for the nine months ended September 30, 2006
versus the same period in 2005 was primarily due to the reversal of $57,000 of
interest income on a $2.6 million loan which was placed on nonaccrual in August
2006 and a faster increase in interest rates on interest-bearing liabilities,
including the effect of the increasing rate on the $4.1 million of variable rate
subordinated debentures, compared to the rates on interest-earning assets.
Partially offsetting these factors were increases in the volume of net earning
assets. Changes in volume resulted in an increase in net interest income of $0.1
million and $0.8 million for the third quarter and first nine months of 2006
compared to the same periods in 2005, and changes in interest rates and the mix
resulted in a decrease in net interest income of $0.1 million and $0.2 million
for the third quarter and first nine months of 2006 versus the comparable
periods in 2005.
The Bank, like many other financial institutions, is vulnerable to an increase
in interest rates to the extent that interest-bearing liabilities mature or
reprice more rapidly than interest-earning assets. Historically, the lending
activities of commercial banks emphasized the origination of short to
intermediate term variable rate loans that are more closely matched with the
deposit maturities and repricing of interest-bearing liabilities which occur
closer to the same general time period. While having interest-bearing
liabilities that reprice more frequently than interest-earning assets is
generally beneficial to net interest income during periods of declining interest
rates, it is generally detrimental during periods of rising interest rates.
To reduce the effect of interest rate changes on net interest income, the Bank
has adopted various strategies to improve matching interest-earning asset
maturities to interest-bearing liability maturities. The principal elements of
these strategies include; originating variable rate commercial loans that
include interest rate floors; originating one-to-four family residential
mortgage loans with adjustable rate features, or fixed rate loans with short
maturities; maintaining interest-bearing demand deposits, federal funds sold,
and U.S. government securities with short to intermediate term maturities;
maintaining an investment portfolio that provides stable cash flows, thereby
providing investable funds in varying interest rate cycles; lengthening the
maturities of our time deposits and borrowings when it would be cost effective;
and attracting low cost checking and transaction accounts, which tend to be less
interest rate sensitive when interest rates increase.
The Bank measures its exposure to changes in interest rates using an overnight
upward and downward shift (shock) in the Treasury yield curve. As of September
30, 2006, if interest rates increased 200 basis points and decreased 200 points,
respectively, the Bank's net interest income would increase by 2.4% and decrease
by 3.1%, respectively.
Provision for Loan Losses
The provision for loan losses was $543,000 and $655,000 for the three months and
nine months ended September 30, 2006, compared to $60,000 and $262,000 for the
same periods in 2005. Nonperforming loans were $5.1 million at September 30,
2006 and $1.3 million at December 31, 2005, or 1.85% and 0.48%, respectively, of
total loans. The increase in the level of nonperforming loans was primarily due
the result of one loan of $2.6 million that was placed on nonaccrual status in
August 2006 in addition to several other smaller loans totaling $0.9 million
placed on nonaccrual status during the third quarter of 2006 and a $0.4 million
increase in loans delinquent over 90 days but still accruing at September 30,
2006 compared to the amount at December 31, 2005. A softening in the 1-4 family
residential real estate and real estate construction markets contributed to the
increase in nonperforming loans. The allowance for loan losses was $3.6 million
and $2.9 million at September 30, 2006 and December 31, 2005, or 1.30% and
1.08%, respectively, of total loans.
The Company maintains the allowance for loan losses at a level that it considers
to be adequate to provide for credit losses inherent in its loan portfolio.
Management determines the level of the allowance by performing a quarterly
analysis that considers concentrations of credit, past loss experience, current
economic conditions, the amount and composition of the loan portfolio (including
nonperforming and potential problem loans), estimated fair value of underlying
collateral, loan commitments outstanding, and other information relevant to
assessing the risk of loss inherent in the loan portfolio. As a result of
management's analysis, a range of the potential amount of the allowance for loan
losses is determined.
The Company will continue to monitor the adequacy of the allowance for loan
losses and make additions to the allowance in accordance with the analysis
referred to above. Because of uncertainties inherent in estimating the
appropriate level of the allowance for loan losses, actual results may differ
from management's estimate of credit losses and the related allowance.
Noninterest Income
Noninterest income was $0.5 million for the three months ended September 30,
2006, compared to $0.3 million for the same period in 2005 and $1.4 million for
the nine months ended September 30, 2006, compared to $6.4 million for the first
nine months of 2005. The significant decrease in noninterest income for the
nine-month period in 2006 compared to the same period in 2005 resulted primarily
from a $5.0 million gain on sale of Federal Home Loan Mortgage Corporation
("FHLMC") preferred stock recorded in the first quarter of 2005. The gain on
loan sales was basically flat for the third quarter of 2006 versus the third
quarter of 2005 and decreased for the first nine months of 2006 compared to the
same period in 2005 due to a slow down in secondary market mortgage activity and
lower margins in 2006. The gain on loan sales was $277,000 for the three months
ended September 30, 2006, compared to $274,000 for the comparable period in 2005
and $703,000 for the first nine months of 2006 compared to $811,000 for the
first nine months of 2005. Service charge income was $134,000 for the three
months ended September 30, 2006, compared to $114,000 for the comparable period
in 2005 and $380,000 for the first nine months of 2006 compared to $274,000 for
the first half of 2005. The Company continues to evaluate its deposit product
offerings with the intention of continuing to expand its offerings to the
consumer and business depositor. During March 2005, the Bank began offering
products which include overdraft privileges on certain individual deposit
products and cash management services for business depositors. Both of these
products are fee-based and should result in further increases in service charge
income. The Bank also introduced a new deposit product known as "ATM Advantage"
during September 2005. This product offers unlimited use of competitor's ATM
networks with reimbursement of all foreign and surcharge fees. The product does
not pay interest but requires a minimum balance to avoid a monthly service
charge. This product could reduce service charge income but the effect would be
offset by more noninterest bearing deposits which should contribute to
additional net interest income. Factors contributing to the decrease in other
noninterest income for both the third quarter and nine-month period was the
Company's decision to exit the title insurance business at the end of November
2005 and a decrease in fees due to reduced activity relating to secondary market
mortgage lending and effecting the nine-month period only was a one time gain of
$32,000 on long-term portfolio loans sold in the first quarter of 2005. The
Company's title insurance company had approximately $70,000 and $201,000 of
title insurance revenue for the three months and nine months ended September 30,
2005, respectively.
Noninterest Expense
Noninterest expense was $2.2 million for both the quarter ended September 30,
2006 and 2005 and $6.7 million for the nine months ended September 30, 2006
compared to $7.5 million for the first nine months of 2005. Contributing to the
decrease was a decrease in salaries and employee benefits due to the $356,000
which the Company accrued during the first quarter of 2005 for the severance
expense relating to the retirement of the Company's former Chairman and Chief
Executive Officer, a reduction in the commissions related to reduced activity in
mortgage loan sales, a reduction in incentive accruals and a reduction in
professional fees in the first nine months of 2006 compared to the first nine
months of 2005 due to a reduced amount of services required notwithstanding that
professional fees were higher in the third quarter of 2006 compared to the third
quarter of 2005 due to certain previously deferred fees being expensed in the
third quarter of 2006. Other factors impacting the nine-month period only
included a higher level of other noninterest expenses in the first quarter of
2005 primarily related to integration items associated with the merger with
Independence Bancorp, the Citizens disposal in January 2005 and the expenses
relating to the title insurance company that was sold which was previously
mentioned. Partially offsetting those factors was an increase in net occupancy
expenses due to the Bank's purchase of a building, located in Louisville,
Kentucky to accommodate expansion. In April 2005, the Bank moved its finance and
accounting, loan and deposit operations, and mortgage banking operations into
the building and in November 2005 established a full service branch at this
location. An additional factor offsetting the overall decrease in noninterest
expenses was an increase in data processing expenses which was primarily due to
the growth of the Bank's services and its commitment to upgrade systems
productivity and the effects of a refund received in the first quarter of 2005
from a previous third party data processing company of the Bank.
Income Tax Expense (Benefit)
The effective income tax rate on income from continuing operations was 24.1% for
the three months ended September 30, 2006 compared to 27.6% for the same period
in 2005 and 29.5% for the first nine months of 2006 compared to 33.9% for the
first nine months of 2005. The decrease in the effective tax rate for the
quarter and nine-month periods is primarily due to an increase in the percentage
of tax exempt interest income compared to income from continuing operations.
Financial Condition
The Company's total assets were $338.2 million at September 30, 2006 compared to
$336.2 million at December 31, 2005, an increase of 2.0 million or 0.6%. Net
loans increased $4.5 million, loans held for sale went down $0.7 million and
interest receivable and other assets increased $0.8 million while cash and cash
equivalents decreased $1.9 million, investments decreased $0.3 million and
Federal Home Loan Bank ("FHLB") stock went down $0.4 million.
Net loans were $271.5 million at September 30, 2006, compared to $267.0 million
at December 31, 2005, an increase of $4.5 million or 1.7%. The increases in
loans were in the real estate construction and real estate commercial loan
portfolios, which increased $10.7 million or 21% and $1.0 million or 2%,
respectively. The increases were primarily a result of lending activity in the
Louisville, Kentucky metro market. All loan categories increased or remained the
same as a percentage of total loans, except residential real estate loans, which
decreased from approximately 48% to 44% of total loans and commercial loans
which decreased from 9% to 8% of total loans. The decrease in residential real
estate loans as a percentage of total loans is primarily due to those loans now
being sold in the secondary market through 1st Independence Mortgage, a division
of the Bank, rather than being retained for the Company's loan portfolio. The
Company continues to identify opportunities to cross sell its other products,
including home equity and consumer loans for its loan portfolio resulting from
customer relationships established through the origination of loans by 1st
Independence Mortgage.
Deposits increased $1.2 million or less than 0.5% to $265.5 million at September
30, 2006 compared to $264.3 million at December 31, 2005. This slight increase
was largely attributable to increases in savings, NOW and money market deposits
of $15.7 million and demand deposits of $0.4 million which more than offset a
$14.9 million decrease in time deposits. The increase in savings, NOW and money
market deposits resulted primarily from the effects of a general marketing
campaign during the first nine months of 2005 focusing on existing products and
print advertisements only. As previously mentioned, during September 2005 the
Company introduced a new deposit product known as "ATM Advantage" as part of its
efforts to continue to grow core deposits. This new product offers unlimited use
of competitor's ATM networks with reimbursement of all foreign and surcharge
fees. The product does not pay interest but requires a minimum balance to avoid
a monthly service charge.
Short-term borrowings increased $2.2 million or 11.6% to $20.9 million at
September 30, 2006, compared to $18.7 million at December 31, 2005. The Company
uses short-term borrowings, primarily short-term FHLB advances, to fund
short-term liquidity needs and manage net interest margin.
Off-Balance Sheet Arrangements
In the normal course of operations, the Company engages in financial
transactions that contain credit, interest rate, and liquidity risk that are not
recorded in the financial statements such as loan commitments and performance
letters of credit. As of September 30, 2006, unused loan commitments and
performance letters of credit were $44,169,000 and $2,146,000, respectively.
Since many of the unused loan commitments are expected to expire or be only
partially used, the total amount of commitments does not necessarily represent
future cash requirements.
Liquidity and Capital Resources
Liquidity to meet borrowers' credit and depositors' withdrawal demands is
provided by maturing assets, short-term liquid assets that can be converted to
cash and the ability to attract funds from depositors. Additional sources of
liquidity include brokered deposits, advances from the FHLB and other short-term
borrowings, such as federal funds purchased and securities sold under repurchase
agreements.
At September 30, 2006 and December 31, 2005, brokered deposits were $35.3
million and $59.6 million, respectively. The weighted average cost and maturity
of brokered deposits were 4.93% and four months at September 30, 2006 compared
to 3.90% and nine months at December 31, 2005. The Company plans to continue
using brokered deposits for the foreseeable future to support loan demand when
pricing for brokered deposits is more favorable than short-term borrowings.
At September 30, 2006 and December 31, 2005, the Bank had total FHLB advances
outstanding of $21.0 million and $22.0 million, respectively, with $1.0 million
and $4.0 million, respectively, included in long-term debt in the accompanying
condensed consolidated balance sheet and the remaining amount included in
short-term borrowings. Additionally, the Bank had $40.0 million of unused
commitments under its line of credit with the FHLB and sufficient collateral to
borrow an additional $61.5 million.
The Company's liquidity depends primarily on dividends paid to it as sole
shareholder of the Bank. At September 30, 2006, the Bank may pay up to $7.3
million in dividends to the Company without regulatory approval, subject to the
ongoing capital requirements of the Bank.
The Company has $9.3 million of subordinated debentures outstanding, which are
included in long-term debt in the accompanying condensed consolidated balance
sheet with $4.1 million of the debentures being variable rate obligations with
interest rates that reprice quarterly, and are tied to the three-month London
Interbank Offering Rate ("LIBOR") plus 3.15%. At September 30, 2006 the rate on
the variable rate obligations was 8.52% compared to 7.67% at September 30, 2005.
The remaining $5.2 million of debentures carry a fixed interest rate of 6.4%
until March 26, 2008 when the debentures become variable rate obligations that
reprice quarterly at the three-month LIBOR rate plus 3.15%.
Stockholders' equity increased $1.5 million from $38.3 million at December 31,
2005 to $39.8 million at September 30, 2006. The significant drivers of the
change were net income of $1.5 million, cash dividends declared of $0.5 million
($0.24 per share) and an increase of $0.5 million relating to stock option and
ESOP plan transactions.
Bank holding companies and their subsidiary banks are required by regulators to
meet risk based capital standards. These standards, or ratios, measure the
relationship of capital to a combination of balance sheet and off-balance sheet
risks. The following table presents these ratios as of September 30, 2006 and
December 31, 2005 for the Consolidated Company and the Bank along with the
regulator's minimum ratio to be considered well capitalized.
To Be Well
September 30, 2006 December 31, 2005 Capitalized
------------------ ----------------- -----------
Total risk-based capital to risk-weighted assets
Consolidated company 15.6% 15.1% 10.0%
Bank 14.4 13.6 10.0
Tier 1 capital to risk-weighted assets
Consolidated company 14.4 13.1 6.0
Bank 13.1 12.5 6.0
Tier 1 capital to average assets
Consolidated company 11.3 10.2 5.0
Bank 10.4 9.7 5.0
Regulatory Matters
On July 20, 2006, the Bank received its most recent Community Reinvestment Act
("CRA") Performance Evaluation prepared as of May 15, 2006. The Bank was
assigned a "Needs to Improve" rating due in part to the Bank's low level of
residential lending to low and moderate income borrowers within the Louisville,
Kentucky Metropolitan Statistical Area. Management has taken appropriate steps
to improve the residential lending issues cited by the Federal Deposit Insurance
Corporation ("FDIC") during the CRA Performance Evaluation. By statute, a bank
with a "less than satisfactory" CRA rating has limitations on certain future
business activities until the CRA rating improves. Management does not believe
these limitations will have any material affect on the Bank's current business
plan.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Information required by this item is included in Item 2, "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
As required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), the Company's management carried out an evaluation, with
the participation of the Company's Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the Company's disclosure controls and
procedures as of the end of the quarter ended September 30, 2006. Based upon
that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective to
ensure that information required to be disclosed by the Company in its reports
that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the United States
Securities and Exchange Commission's rules and forms.
(b) Changes in Internal Control over Financial Reporting
There have not been any changes in the Company's internal control over financial
reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act)
during the quarter ended September 30, 2006 that have materially affected, or
are reasonably likely to materially affect, the Company's internal control over
financial reporting.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
The Company, from time to time, is a party to ordinary routine litigation, which
arises in the normal course of business, such as claims to enforce liens,
condemnation proceedings on properties in which the Company holds security
interests, claims involving the making and servicing of real property loans, and
other issues incident to its business. Except as discussed below, there were no
potentially material lawsuits or other legal proceedings pending or known to be
contemplated against the Company at September 30, 2006.
On or about May 28, 2004, a complaint was filed in the Circuit Court of
Anderson County in the Commonwealth of Kentucky by Larry Sutherland, Judy
Sutherland, John Henry Disponett, Brenda Disponett, Todd Hyatt, Lois Ann
Disponett, Sue Saufley, and Hugh Coomer. Soon thereafter, an amended complaint
was filed which added Lois Hawkins and Norma K. Barnett as plaintiffs. The
lawsuit arises from offers to purchase securities made by the Company in
connection with an offer to purchase up to 300,000 shares of its stock in a
tender offer on or about May 28, 2003. The Plaintiffs allege that the Company
made certain material misrepresentations in connection with certain statements
made in the tender offer. The Plaintiffs are seeking to recover compensatory and
punitive damages in connection with the shares it sold in the tender offer and
their attorneys' fees. Discovery in the matter is currently underway. On April
14, 2006 a partial summary judgment was entered against the plaintiffs. In the
partial summary judgment, the Circuit Court held that the only remedy available
to the plaintiffs is the return of the stock upon the tender of the
consideration received by the plaintiffs in exchange for the stock. Subsequent
to the partial summary judgment, the plaintiffs amended their complaint to
allege certain additional material misrepresentations had been made by the
Company. This matter is currently scheduled for trial in July 2007. Based upon
the advice of counsel, management records an estimate of the amount of ultimate
expected loss for litigation, if any. Management, after discussion with legal
counsel, believes the ultimate result of this litigation will not have a
material adverse effect on the Company's financial position, results of
operations or cash flows. However, events could occur that could cause any
estimate of ultimate loss to differ materially in the near term.
Item 1A. Risk Factors
Risks Related to our Business
We are subject to extensive regulation that could limit or restrict our
activities and impose financial requirements or limitations on the conduct of
our business, which limitations or restrictions could adversely affect our
profitability.
As a bank holding company, we are primarily regulated by the Board of
Governors of the Federal Reserve System. Our subsidiary is primarily
regulated by the FDIC and the Kentucky Office of Financial Institutions.
Our compliance with Federal Reserve Board, FDIC and Kentucky banking
regulations is costly. A failure to comply with the banking regulations may
limit our growth and restrict certain of our activities, including payment
of dividends, mergers and acquisitions, investments, loans and interest
rates charged, interest rates paid on deposits and locations of offices. We
are also subject to the capital requirements of our regulators.
The laws and regulations applicable to the banking industry could change at
any time, and we cannot predict the effects of these changes on our
business and profitability. Because government regulation greatly affects
our business and financial results, our cost of compliance could adversely
affect our ability to operate profitably and a failure to comply could
limit our ability to implement our business strategy. See the caption
entitled "Regulatory Matters" included in the Management's Discussion and
Analysis of Financial Condition and Results of Operations section of this
report, which is Part I Item 2 of this report, for further information.
Our business strategy includes the continuation of growth plans, and our
financial condition and results of operations could be negatively affected if
we fail to grow.
We have grown rapidly in terms of branch expansion, total assets, net
loans, and deposits. We may not be able to continue to grow at the same
rate that we have grown in the past. We currently serve our customers
through a network of eight banking offices, consisting of two full-service
banking locations in Louisville, Kentucky, and one full-service banking
location in each of New Albany, Jeffersonville, and Clarksville, Indiana.
We also have one full-service banking location in Harrodsburg, Kentucky,
Lawrenceburg, Kentucky, and Marengo, Indiana. Our business strategy calls
for continued expansion and the opening of additional branches during the
next three to five years. We have not yet attempted to establish branches
in any of the other counties in Kentucky or southern Indiana. Our branch
expansion strategy entails other risks, including:
o the entrance into new markets where we lack experience;
o the experience of unexpected competition;
o the introduction of new products and services into our business
with which we have no prior experience;
o the time and costs of evaluating new markets, hiring
experienced local management and opening new offices;
o the ability to implement and improve our operational, credit,
financial, management and other internal risk controls and
processes and our reporting systems and procedures;
o the ability to manage a growing number of client relationships;
o the ability to recruit and retain additional experienced
bankers to accommodate growth;
o the ability to maintain controls and procedures sufficient to
accommodate an increase in expected loan volume and
infrastructure;
o the diversion of our management's attention from our existing
businesses as a result of our growth strategy;
o the additional expenditures our asset growth may require to
expand our administrative and operational infrastructure; and
o the ability to maintain cost controls and asset quality while
attracting additional loans and deposits on favorable terms.
The occurrence of any of these factors could have an adverse effect on our
financial condition. We can provide no assurance that we will be able to
overcome the risks associated with growth or any other problems encountered
in executing our growth strategy.
Our recent results do not indicate our future results, and may not provide
guidance to assess the risk of an investment in our common stock.
We are unlikely to sustain our historical rate of growth, and may not even
be able to expand our business at all. Further, our recent growth may
distort some of our historical financial ratios and statistics. In the
future, we may not have the ability to find suitable expansion
opportunities. Various factors, such as economic conditions, regulatory and
legislative considerations and competition, may also impede or prohibit our
ability to expand our market presence. If we are not able to successfully
grow and expand our business, our financial condition and results of
operations could be adversely affected.
Our business would be harmed if we lost the services of any of our senior
management team and are unable to recruit or retain suitable replacements.
We believe that our success to date and our prospects for future success
depend significantly on the efforts of our senior management team, which
includes N. William White, our President and Chief Executive Officer, R.
Michael Wilbourn, our Executive Vice President and Chief Financial Officer,
Gregory A. DeMuth, our Executive Vice President and the Chief Lending
Officer of the Bank, David M. Hall, our Executive Vice President-Retail
Banking of the Bank, Kathy Beach, our Executive Vice President and Chief
Operations Officer, Alan D. Shepard, our Executive Vice President and Chief
Credit Officer of the Bank and certain of our senior bankers. We have $0.5
million of key-man life insurance on both Mr. White and Mr. Wilbourn. There
is no assurance, however, that $0.5 million would be enough to compensate
us for the loss of Mr. White or Mr. Wilbourn. We do not have key-man
insurance on any other officer of the Company or the Bank. In addition to
their skills and experience as bankers, these persons provide us with
extensive community ties upon which our competitive strategy is based.
A significant portion of our loan portfolio is secured by real estate, and
events that negatively impact the real estate market could hurt our business.
A significant portion of our loan portfolio is secured by real estate. The
real estate collateral in each case provides an alternate source of
repayment in the event of default by the borrower and may deteriorate in
value during the time the credit is extended. A weakening of the real
estate market in our market areas could result in an increase in the number
of borrowers who default on their loans and a reduction in the value of the
collateral securing their loans, which in turn could have an adverse effect
on our profitability and asset quality. If we are required to liquidate the
collateral securing a loan to satisfy the debt during a period of reduced
real estate values, our earnings and capital could be adversely affected.
Acts of nature, including hurricanes, tornados, earthquakes, fires and
floods, which may cause uninsured damage and other loss of value to real
estate that secures these loans, may also negatively impact our financial
condition. Additionally, a slowdown in real estate activity in the markets
we serve may also negatively impact our financial condition.
An economic downturn, either nationally or in the local market area, could
adversely affect our financial condition, results of operations and cash flows.
Deterioration in local, regional, national or global economic conditions
could result in, among other things, an increase in loan delinquencies, a
change in the housing turnover rate or a reduction in the level of
available wholesale deposits. If the communities in which we operate do not
grow, or if the prevailing local or national economic conditions are
unfavorable, our business strategy may not succeed. A weakening of the
employment market in our primary market area could result in an increase in
the number of borrowers who default on their loans. Further, the banking
industry is affected by general economic conditions such as inflation,
interest rates, recession, unemployment and other factors beyond our
control. Moreover, we cannot give any assurance that we will benefit from
any market growth or favorable economic conditions in our primary market
areas even if they do occur.
Our cost of funds for banking operations may increase as a result of general
economic conditions, interest rates and competitive pressures.
Our cost of funds for banking operations may increase as a result of
general economic conditions, interest rates and competitive pressures. In
the past, the Bank has relied heavily on brokered certificates of deposits
and borrowings for the funds necessary for banking operations. As a general
matter, deposits are a cheaper source of funds than brokered certificates
of deposit or borrowings, because interest rates paid for deposits are
typically less than interest rates charged for brokered certificates of
deposit or borrowings. Our business strategy includes funding more of our
operations with deposits; however, we cannot provide any assurances that we
will be able attract sufficient deposits.
Competition from other financial institutions and others may adversely affect
our profitability.
The banking business generally, and because of its desirability and the
opportunities for growth, the Louisville, Kentucky and southern Indiana
market area in particular, is highly competitive, and we experience strong
competition from many other financial institutions. We compete with
commercial banks, credit unions, savings and loan associations, mortgage
banking firms, consumer finance companies, securities brokerage firms,
insurance companies, money market funds and other financial institutions,
which operate in our primary market area and elsewhere.
We compete with these institutions to make loans and to attract new
customers and in pricing loans and deposits. Many of our competitors are
well-established and much larger financial institutions and can offer
customers more attractive pricing terms. While we believe we can and do
successfully compete with these other financial institutions in our
markets, we may face a competitive disadvantage as a result of our smaller
size.
We also compete with private lenders, mezzanine and venture capital firms
and angel investors in some of our lending divisions, including our
community redevelopment lending and mezzanine financing divisions. Many of
these competitors are subject to minimal or no regulation and may be able
to make accommodations for customers that we are unable to make.
We are currently subject to claims regarding the merger of Independence Bancorp
with Harrodsburg First Financial Bancorp, Inc. that could result in substantial
defense, judgment or settlement costs.
On or about May 28, 2004, a complaint was filed in the Circuit Court of
Anderson County in the Commonwealth of Kentucky by Larry Sutherland, Judy
Sutherland, John Henry Disponett, Brenda Disponett, Todd Hyatt, Lois Ann
Disponett, Sue Saufley, and Hugh Coomer. Soon thereafter, an amended
complaint was filed which added Lois Hawkins and Norma K. Barnett as
plaintiffs. The lawsuit arises from offers to purchase securities made by
us in connection with an offer to purchase up to 300,000 shares of our
stock in a tender offer on or about May 28, 2003. The Plaintiffs allege
that we made certain material misrepresentations in connection with certain
statements made in the tender offer. The Plaintiffs are seeking to recover
compensatory and punitive damages in connection with the shares they sold
in the tender offer and their attorneys' fees. Discovery in the matter is
currently underway.
On April 14, 2006 a partial summary judgment was entered against the
plaintiffs. In the partial summary judgment, the Circuit Court held that
the only remedy available to the plaintiffs is the return of the stock upon
the tender of the consideration received by the Plaintiffs in exchange for
the stock. Subsequent to the partial summary judgment, the plaintiffs
amended their complaint to allege certain additional material
misrepresentations had been made by the Company. This matter is currently
scheduled for trial in July 2007. If we are ultimately unsuccessful in this
litigation, it may have a negative effect on our results of operations or
cash flows.
Risks Related to Our Industry
Our profitability is vulnerable to interest rate fluctuations.
Most of our assets and liabilities are monetary in nature, and thus subject
us to significant risks from changes in interest rates. Consequently, our
results of operations can be significantly affected by changes in interest
rates and our ability to manage interest rate risk. Changes in market
interest rates, or changes in the relationships between short-term and
long-term market interest rates, or changes in the relationship between
different interest rate indices can affect the interest rates charged on
interest-earning assets differently than the interest paid on
interest-bearing liabilities. This difference could result in an increase
in interest expense relative to interest income or a decrease in interest
rate spread. In addition to affecting our profitability, changes in
interest rates can impact the valuation of our assets and liabilities. A
discussion of how we measure our exposure to interest rate changes is
provided in Part I, Item II of this Form 10-Q.
We could suffer loan losses from a decline in credit quality.
We could sustain losses if borrowers, guarantors or related parties fail to
perform in accordance with the terms of their loans. We have adopted
underwriting and credit monitoring procedures and policies, including the
establishment and review of the allowance for credit losses, that we
believe 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 and financial condition.
If our allowance for loan losses is not sufficient to cover actual loan losses,
our earnings could decrease.
We manage our credit exposure through careful monitoring of loan applicants
and loan concentrations in particular industries, and through loan approval
and review procedures. We have established an evaluation process designed
to determine the adequacy of our allowance for loan losses. While this
evaluation process uses historical and other objective information, the
classification of loans and the establishment of loan losses is an estimate
based on experience, judgment and expectations regarding our borrowers, the
economies in which we and our borrowers operate, as well as the judgment of
our regulators.
There is no precise method of predicting loan losses, so we cannot assure
you that our loan loss allowance will be sufficient to absorb future loan
losses or prevent a material adverse effect on our business, financial
condition or results of operations.
Failure to achieve and maintain effective internal controls in accordance with
Section 404 of the Sarbanes-Oxley Act could have a material adverse effect on
our ability to report our financial results timely and accurately and on our
stock price.
Section 404 of the Sarbanes-Oxley Act requires annual assessments of the
effectiveness of our internal controls over financial reporting and a
report by our independent registered public accounting firm addressing
these assessments. We are required to complete our initial assessment by
the filing of our Form 10-K for the year ended December 31, 2007. During
the course of our assessment, we may identify deficiencies in our internal
controls over financial reporting which we may not be able to remediate in
time to meet this deadline. A failure to maintain adequate internal
controls may result in material misstatements in our financial statements
and a failure to meet our reporting obligations. As result investors may
lose confidence in our reported financial information and our stock price
could decline.
Our operations could be interrupted if our network or computer systems fail or
experience a security breach.
Our computer systems and network infrastructure could be vulnerable to
unforeseen problems. Our operations are dependent upon our ability to
protect our computer equipment against damage from fire, power loss,
telecommunications failure or a similar catastrophic event. Any damage or
failure that causes an interruption in our operations could result in a
loss of customers and thereby have a material adverse effect on our
business, operating results and financial condition.
Risks Relating to an Investment in Our Common Stock
Additional growth may require us to raise additional capital in the future, but
that capital may not be available when it is needed, which could adversely
affect our financial condition and results of operations.
We are required by federal and state regulatory authorities to maintain
adequate levels of capital to support our operations. We anticipate that
our current capital resources will satisfy our capital requirements for the
foreseeable future. We may at some point, however, need to raise additional
capital to support our continued growth. Our ability to raise capital, if
needed, will depend on conditions in the capital markets at that time,
which are outside our control, and on our financial performance.
Accordingly, we cannot assure you of our ability to raise capital, if
needed, on terms acceptable to us. If we cannot raise capital when needed,
our ability to implement our business strategy could be materially
impaired.
Our stock price may fluctuate and be volatile.
The prices at which our common stock has traded may not be indicative of
future market prices. The trading price of our common stock has, in the
past, and could continue in the future to fluctuate significantly.
Volatility in our stock price could result from the following factors,
among others:
o variations in quarterly operating results;
o changes in financial estimates by securities analysts;
o the operating and stock price performance of other companies
in the banking industry; and
o general stock market or economic conditions.
The stock market in recent years has experienced price and volume
fluctuations that have often been unrelated or disproportionate to the
operating performance of affected companies.
Our ability to pay dividends is limited, and we may be unable to pay future
dividends if we decide to do so.
Our ability to continue our current dividends is limited by regulatory
restrictions, by the bank's ability to pay dividends to us based on its
capital position and profitability, and by our need to maintain sufficient
capital to support the bank's operations. The ability of the bank to pay
dividends to us is limited by its obligations to maintain sufficient
capital and by other restrictions on its dividends that are applicable to
banks that are regulated by the FDIC. If the bank does not satisfy these
regulatory requirements it will be unable to pay dividends to us and we
will be unable to pay dividends on our common stock to you.
The holders of our junior subordinated debentures have rights that are senior
to those of our common shareholders.
At the time of the merger of Harrodsburg First Financial Bancorp and
Independence Bancorp, Harrodsburg First Financial Bancorp had $5.2 million
of trust preferred securities outstanding and Independence Bancorp had $4.1
million of trust preferred securities outstanding. Payments of the
principal and interest on the trust preferred securities are conditionally
guaranteed by us. Further, the accompanying junior subordinated debentures
that were issued by Harrodsburg First Financial Bancorp and Independence
Bancorp are senior to our shares of common stock. As of September 30, 2006,
we had approximately $9.3 million of junior subordinated debentures
outstanding. We have the right to defer payment of interest on the junior
subordinated debentures for a period not exceeding 20 consecutive quarters.
If we defer, or fail to make, interest payments on the junior subordinated
debentures, we will be prohibited, subject to certain exceptions, from
paying cash dividends on our common stock until we pay all deferred
interest and resume interest payments on the junior subordinated
debentures.
We have implemented anti-takeover devices that could make it more difficult for
another company to purchase us, even though such a purchase may increase
shareholder value.
In many cases, shareholders would receive a premium for their shares if we
were purchased by another company. However, state and federal law and our
certificate of incorporation and bylaws make it difficult for anyone to
purchase us without approval of our board of directors. For example, our
articles of incorporation divide the board of directors into three classes
of directors serving staggered three-year terms with approximately
one-third of the board of directors elected at each annual meeting of
shareholders. The classification of directors makes it more difficult for
shareholders to change the composition of the board of directors. As a
result, at least two annual meetings of shareholders would be required for
the shareholders to change a majority of the directors, whether or not a
change in the board of directors would be beneficial and whether or not a
majority of shareholders believe that such a change would be desirable. In
addition, our certificate of incorporation provides that in no event shall
any record owner of any outstanding common stock which is beneficially
owned, directly or indirectly, by a person who beneficially owns in excess
of 10% of the then outstanding shares of common stock be entitled or
permitted to any vote with respect to the shares held in excess of the 10%
limit. Consequently, a takeover attempt may prove difficult, and
shareholders may not realize the highest possible price for their
securities.
Item 6. Exhibits
(a) Exhibits
31.1 Rule 13a-14(a) / 15d-14(a) Certification of Principal
Executive Officer ("Section 302 Certifications").
31.2 Rule 13a-14(a) / 15d-14(a) Certification of Principal
Financial Officer ("Section 302 Certifications").
32.1 Section 1350 Certifications ("Section 906
Certifications").
SIGNATURES
Pursuant to the requirements 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.
1st INDEPENDENCE FINANCIAL GROUP, INC.
Date: October 31,2006 By: /s/ R. Michael Wilbourn
-----------------------
R. Michael Wilbourn
Executive Vice President
and Chief Financial Officer
Exhibit Index
Exhibit
Number Description
31.1 Rule 13a-14(a) / 15d-14(a) Certification of Principal
Executive Officer ("Section 302 Certifications").
31.2 Rule 13a-14(a) / 15d-14(a) Certification of Principal
Financial Officer ("Section 302 Certifications").
32.1 Section 1350 Certifications ("Section 906
Certifications").