UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Commission File Number: 000-49733
FIRST INTERSTATE BANCSYSTEM, INC.
(406) 255-5390(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common stock without par value per share
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. [ ü ] Yes [ ] 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 the 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. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [ ü ] No
The aggregate market value (appraised minority value) of the registrant’s common stock held by non-affiliates as of the last business day of the registrant’s most recently completed second fiscal quarter, June 30, 2003, was $15,553,382.
The number of shares outstanding of the registrant’s common stock as of January 31, 2004 was 7,908,805.
Documents Incorporated by Reference
The registrant intends to file a definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held May 14, 2004. The information required by Part III of this Form 10-K is incorporated by reference from such Proxy Statement.
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TABLE OF CONTENTS
PART I
Item 1. Business
The Company
First Interstate BancSystem, Inc. (“FIBS” and collectively with its subsidiaries, the “Company”), incorporated in Montana in 1971, is a financial holding company registered under the Bank Holding Company Act of 1956, as amended. FIBS is headquartered in Billings, Montana. As of December 31, 2003, the Company had assets of $3.9 billion, deposits of $3.2 billion and total stockholders’ equity of $274 million, making it the largest banking organization in Montana and Wyoming.
FIBS operates a wholly-owned bank subsidiary, First Interstate Bank (the “Bank”), with 59 banking offices in 31 Montana and Wyoming communities. The Bank, a Montana corporation organized in 1916, delivers a comprehensive range of loan, deposit and investment products and mortgage banking and trust services to meet the needs of individual customers, businesses and municipalities.
The Company conducts various other financial-related business activities through wholly-owned nonbank subsidiaries. i_Tech Corporation (“i_Tech”) provides technology services to the Bank and other non-affiliated customers in Montana, Wyoming, Idaho, Washington, Oregon, South Dakota and Colorado. Additionally, i_Tech’s ATM network provides processing support for over 2,100 ATM locations in 38 states. First Interstate Statutory Trust (“FIST”), incorporated under Delaware law in 2003, was formed for the exclusive purpose of issuing mandatorily redeemable trust preferred securities and using the proceeds to purchase a junior subordinated debenture issued by FIBS. FI Reinsurance, Ltd. (“FIR”), domiciled in Nevis Island, West Indies, was formed in 2001 to underwrite, as reinsurer, credit-related life and disability insurance.
The Company is the licensee under a trademark license agreement granting it an exclusive, nontransferable license to use the “First Interstate” name and logo in Montana, Wyoming and surrounding states.
Community Banking Philosophy
The banking industry continues to experience change with respect to regulatory matters, consolidation, consumer needs and economic and market conditions. The Company believes that it can best address this changing environment through its “Strategic Vision.” The Company’s Strategic Vision emphasizes providing its customers full service commercial and consumer banking at a local level using a personalized service approach while improving internal efficiencies and serving and strengthening the communities in which the Bank is located through community service activities.
The Company grants significant autonomy to its banking offices in delivering and pricing products at a local level in response to market considerations and customer needs. This autonomy enables the banking offices to remain competitive and enhances the relationships between the banking offices and the customers they serve. The Company also emphasizes accountability, however, by establishing performance and incentive standards that are tied to net income and other success measures at the individual banking office and market level. The Company believes this combination of autonomy and accountability allows the banking offices to provide personalized customer service while remaining attentive to financial performance.
The Company has centralized certain products and business activities to provide consistent service levels to customers Company-wide, to gain efficiency in management of those products and activities and to ensure regulatory compliance. Centralized products and activities include trust, investment, wire transfer, credit card, technology and escrow services, mortgage servicing and selected operational activities.
Growth Strategy
The Company’s growth strategy includes growing internally and expanding into new and complementary markets when appropriate opportunities arise. The Company believes it has an infrastructure in place that will allow for growth and provide economies of scale into the future.
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Much of the Company’s growth in recent years has resulted from de novo branch openings. The Company has opened nine new banking offices in Montana and Wyoming since 2000. The Company intends to continue to expand its presence in the Montana and Wyoming markets through the opening of new banking offices.
In January 2003, the Company acquired Silver Run Bancorporation, Inc. (“SRBI”), a bank holding company with one banking office. At the date of acquisition, SRBI had loans of $36 million and deposits of $42 million. For additional information regarding the acquisition, see “Notes to Consolidated Financial Statements – Acquisitions” included in Part IV, Item 15.
The Bank
The Company’s banking offices are located in communities of approximately 1,000 to 100,000 people, but serve larger market areas due to the limited number of financial institutions in other nearby communities. The Company believes that the communities served provide a stable core deposit and funding base, as well as economic diversification across a number of industries, including agriculture, energy, mining, timber processing, tourism, government services, education and medical services.
Centralized Services
FIBS provides policy and management direction and specialized staff support services for the Bank to enable it to serve its markets more effectively. These services include credit administration, finance and accounting, human asset management and other support services. Additionally, the Company’s technology subsidiary, i_Tech, provides centralized technology support services to the Bank.
Credit Administration. FIBS assists the Bank in identifying, measuring and monitoring loan concentrations, problem loans and loan portfolio trends. FIBS also controls the risk inherent in the Bank’s loan portfolio through training of Bank personnel; evaluating and implementing periodic modifications to the Bank’s loan policy and lending limits; and, assisting the Bank in determining the loan loss reserve including specific reserve allocations.
Finance and Accounting. FIBS provides financial and accounting services to the Bank, including establishment of accounting policies and procedures; development and preparation of regulatory and management reports; investment portfolio analysis; and, asset/liability and capital management.
Human Asset Management. Through its human asset management group, FIBS provides the Bank with personnel and compensation policies; administration of incentive compensation and employee benefit plans; and, assistance in recruitment, hiring and training of Bank employees.
Other Support Services. FIBS provides other support services for the Bank including legal, compliance, internal auditing, general administration and various other services.
Technology Services. i_Tech provides technology services to the Bank, including system support of the general ledger, investment security, loan, deposit, web banking, imaging, management reporting and cash management systems. i_Tech also manages the Company’s wide-area network and the ATM network used by the Bank and provides item proof and capture services. These technology services are performed through the use of computer hardware owned by the Bank and leased to i_Tech and software licensed by i_Tech.
Lending Activities
FIBS has comprehensive credit policies establishing Company-wide underwriting and documentation standards to assist Bank management in the lending process and limit risk to the Company. The credit policies establish lending authorities based on the experience level and authority of the personnel located in each branch and market. The policies also establish thresholds at which loan requests must be approved by the Company’s credit committee and/or the Bank’s board of directors.
The Bank offers short and long-term real estate, consumer, commercial, agricultural and other loans to individuals and businesses in its market areas. While each loan must meet minimum underwriting standards established in the Company’s credit policies, lending officers are granted certain levels of autonomy in approving and pricing loans to assure that the banking offices are responsive to competitive issues and community needs in each market area.
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Real Estate Loans. The Bank provides interim and permanent financing for both single-family and multi-unit properties, medium-term loans for commercial, agricultural and industrial property and/or buildings and equity lines of credit secured by real estate. The Bank originates variable and fixed rate real estate mortgages, generally in accordance with the guidelines of Fannie Mae and Federal Home Loan Mortgage Corporation. Loans originated in accordance with these guidelines are generally sold in the secondary market. Real estate loans not sold in the secondary market are typically secured by first liens on the financed property and generally mature in less than 15 years.
Consumer Loans. The Bank’s consumer loans include personal loans, credit card loans and equity lines of credit. Personal loans are generally secured by automobiles, boats and other types of personal property and are made on an installment basis. Credit cards are offered to individual and business customers in the Company’s market areas. Equity lines of credit are generally floating rate and are secured by real property. Approximately 53% of the Company’s consumer loans are indirect dealer paper that is created when the Company purchases consumer loan contracts advanced for the purchase of automobiles, boats and other consumer goods from consumer product dealers.
Commercial Loans. The Bank provides a mix of variable and fixed rate commercial loans. The loans are typically made to small and medium-sized manufacturing, wholesale, retail and service businesses for working capital needs and business expansions. Commercial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with business operations as the primary source of repayment, but also include collateralization by inventory, accounts receivable, equipment and/or personal guarantees.
Agricultural Loans. The Bank’s agricultural loans generally consist of short and medium-term loans and lines of credit that are generally used for crops, livestock, equipment and general operating purposes. Agricultural loans are generally secured by assets such as livestock or equipment and are repaid from the operations of the farm or ranch. Agricultural loans generally have maturities of five years or less, with operating lines for one production season.
For additional information about the Company’s loan portfolio, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Loans.”
Funding Sources
The Bank offers traditional depository products including checking, savings and time deposits. Additional funding sources include federal funds purchased for one day periods; repurchase agreements with primarily commercial depositors; time deposits brokered outside the Company’s market areas; and, short-term borrowings from the Federal Home Loan Bank of Seattle (“FHLB”). Deposits at the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to statutory limits.
Under repurchase agreements, the Company sells investment securities held by the Company to a customer under an agreement to repurchase the investment securities at a specified time or on demand. The Company does not, however, physically transfer the investment securities. As of December 31, 2003, all outstanding repurchase agreements were due in one day.
For additional information on the Banks’ funding sources, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Deposits,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Other Borrowed Funds,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Federal Funds Sold and Securities Sold Under Repurchase Agreements,” included in Part II, Item 7.
Competition
Commercial banking is highly competitive. The Bank competes with other commercial banks for deposits, loans and trust accounts and with savings and loan associations, savings banks and credit unions for deposits and loans. In addition, the Bank competes with other institutions including personal loan companies, mortgage banking companies, finance companies, insurance companies, securities firms, mutual funds and certain government agencies as well as major retailers, all actively engaged in providing various types of loans and other financial services.
While historically the technology services industry has been highly decentralized, there is an accelerating trend toward consolidation resulting in fewer companies competing over larger geographic regions. i_Tech’s competitors vary in size and include national, regional and local operations.
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Employees
At December 31, 2003, the Company employed 1,617 full-time equivalent employees. None of the Company’s employees are covered by a collective bargaining agreement. The Company considers its employee relations to be good.
Regulation and Supervision
Financial holding companies and commercial banks are subject to extensive regulation under both federal and state law. Set forth below is a summary description of certain laws that relate to the regulation of FIBS and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
First Interstate BancSystem, Inc.
As a bank holding company and financial holding company, FIBS is subject to regulation under the Bank Holding Company Act of 1956, as amended, and to supervision and regulation by the Federal Reserve.
Under Federal Reserve 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 Federal Reserve’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. 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 Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both.
FIBS is required to obtain the prior approval of the Federal Reserve for the acquisition of 5% or more of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Prior approval of the Federal Reserve is also required for the merger or consolidation of FIBS and another bank holding company.
Under the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”), FIBS, as a financial holding company, may engage in certain business activities that are determined by the Federal Reserve to be financial in nature or incidental to financial activities as well as all activities authorized to bank holding companies generally. In most circumstances, FIBS must notify the Federal Reserve of its financial activities within a specified time period following its initial engagement in each business or activity. If the type of proposed business or activity has not been previously determined by the Federal Reserve to be financially related or incidental to financial activities, FIBS must receive the prior approval of the Federal Reserve before engaging in the activity.
FIBS may engage in authorized financial activities provided that it remains a financial holding company and meets certain regulatory standards of being well-capitalized and well-managed. If FIBS fails to meet the well-capitalized or well-managed regulatory standards, it may be required to cease its financial holding company activities or, in certain circumstances, to divest of the Bank. FIBS does not currently engage in significant financial holding company businesses or activities not otherwise permitted to bank holding companies generally.
Under the GLB Act, if FIBS engages in certain financial activities currently authorized to financial holding companies generally, FIBS, or its affiliates, may become subject to additional laws and regulations relating to the particular activity, such as certain state and federal securities laws and regulations. FIBS may also become subject to supervision or examination by additional regulatory authorities granted regulatory authority over the activity under the GLB Act, such as the Securities and Exchange Commission (“SEC”) or state securities regulatory authorities.
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The Bank is subject to numerous laws and regulations generally applicable to financial institutions and financial services. The extensive regulation of the Bank limits both the activities in which the Bank may engage and the conduct of the permitted activities. Further, the laws and regulations impose reporting and information collection obligations on the Bank. The Bank incurs significant costs relating to compliance with the various laws and regulations and the collection and retention of information.
The Bank is subject to the supervision of and regular examination by the Federal Reserve, the State of Montana, Division of Banking and Financial Institutions and, with respect to its activities in Wyoming, the State of Wyoming, Department of Audit. If any of the foregoing regulatory agencies determines that the financial condition, capital resources, asset quality, earning prospects, management, liquidity or other aspects of a bank’s operations are unsatisfactory or that a bank or its management is violating or has violated any law or regulation, various remedies are available to such agencies. These 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 a bank, to assess civil monetary penalties, to remove officers and directors and to terminate a bank’s deposit insurance, which would result in a revocation of a bank’s charter. The Bank has not been the subject of any such actions by regulatory agencies.
The FDIC insures the deposits of the Bank in the manner and to the extent provided by law. For this protection, the Bank pays a semiannual statutory assessment. See “Premiums for Deposit Insurance” herein. The Bank is subject to the Federal Deposit Insurance Act and FDIC regulations relating to the deposit insurance.
Restrictions on Transfers of Funds to FIBS and the Bank
Large portions of FIBS’s revenues are, and will continue to be, dividends paid by the Bank. The Bank is limited, under both state and federal law, in the amount of dividends that may be paid from time to time. In general, the Bank is limited, without the prior consent of its state and federal banking regulators, to paying dividends that do not exceed the current year net profits together with retained earnings from the two preceding calendar years.
A state or federal banking regulator may impose, by regulatory order or agreement of the Bank, specific regulatory dividend limitations or prohibitions in certain circumstances. The Bank is not subject to a specific regulatory dividend limitation other than generally applicable limitations. In addition to regulatory dividend limitations, the Bank dividends are, in certain circumstances, limited by covenants in FIBS’s debt instruments.
Financial and other transactions between the Bank and FIBS or any FIBS affiliate are also limited under applicable state and federal law. Among other things, the Bank may not lend funds to, or otherwise extend credit to or for the benefit of, FIBS or FIBS affiliates, except on specified types and amounts of collateral and other terms required by state and federal law. In addition, the Federal Reserve has authority to define and limit, from time to time, the transactions between banks and their affiliates. The Federal Reserve issued Regulation W, which became effective April 1, 2003. Regulation W imposes significant additional limitations on transactions in which the Bank may engage with FIBS or FIBS affiliates in addition to the limits under the federal statutes.
Effect of Government Policies and Legislation
Banking depends on interest rate differentials. In general, the difference between the interest rate paid by the Bank on deposits and borrowings and the interest rate received by the Bank on loans extended to customers and on investment securities comprises a major portion of the Bank’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Bank. Accordingly, the earnings and potential growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve. The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States government securities, by adjusting the required level of reserves for financial institutions subject to the Federal Reserve’s reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
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From time to time, legislation is enacted which has the effect of imposing additional operating restrictions and increasing the cost of doing business, as has been the case with recently enacted laws regarding anti-terrorism and consumer privacy. New legislation may also limit or expand permissible activities or affect the competitive balance between banks and other financial service providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial service providers are frequently made in Congress, in the Montana and Wyoming legislatures and before various bank regulatory and other professional agencies. The likelihood of major legislative changes and the impact such changes might have on FIBS or the Bank are impossible to predict.
Capital Standards
The federal banking agencies have adopted minimum capital requirements for insured banks that are applicable to the Bank. In addition, the Federal Reserve has adopted minimum capital requirements that are applicable to FIBS. The capital requirements are intended to, among other things, provide a means for evaluating the capital adequacy and soundness of the institutions. The federal banking agencies may also set higher capital requirements for particular institutions in specified circumstances under federal laws and regulations.
At December 31, 2003, the Bank and FIBS each met the “well-capitalized” requirements applicable to the respective institution. The “well-capitalized” standard is the highest level of the minimum capital requirements established by the federal agencies. Neither the Bank nor FIBS is subject to a minimum capital requirement other than those applicable to banks or bank holding companies generally.
For more information concerning the capital ratios of FIBS, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital Resources” and “Notes to Consolidated Financial Statements – Regulatory Capital” included in Part IV, Item 15.
Compliance and Safety and Soundness Standards
The federal banking agencies have adopted guidelines establishing standards for safety and soundness, asset quality and earnings, as required by the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”). These standards are designed to identify potential concerns and ensure that action is taken to address those concerns before they pose a risk to the deposit insurance fund. If a federal banking agency determines that an institution fails to meet any of these standards, the agency may require the institution to submit an acceptable plan to achieve compliance with the standard. If the institution fails to submit an acceptable plan within the time allowed by the agency or fails in any material respect to implement an accepted plan, the agency must, by order, require the institution to correct the deficiency.
Premiums for Deposit Insurance
Deposits in the Bank are insured by the FDIC in accordance with the Federal Deposit Insurance Act (the “FDIA”). Insurance premiums are assessed semiannually by the FDIC at a level sufficient to maintain the insurance reserves required under the FDIA and relevant regulations. The insurance premium charged to a bank is determined based upon risk assessment criteria, including relevant capital levels, results of bank examinations by state and federal regulators and other information. The Bank currently is assessed the most favorable deposit insurance premiums under the risk-based premium system.
Community Reinvestment Act and Fair Lending Developments
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities or in authorizing expansion activities by the Bank and FIBS.
In connection with its assessment of CRA performance, the appropriate bank regulatory agency assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank received an “outstanding” rating on its most recent examination.
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Risk Factors
Asset Quality
A significant source of risk for the Company arises from the possibility that losses will be sustained by the Bank because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. These loans may be unsecured or secured, depending on the nature of the loan. With respect to secured loans, the collateral securing the repayment of these loans includes a wide variety of diverse real and personal property which may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. The Company has adopted underwriting and credit monitoring procedures and policies, including the establishment and review of the allowance for loan losses, that management believes are appropriate to mitigate the risk of loss by assessing the likelihood of nonperformance and the value of available collateral, monitoring loan performance and diversifying the Company’s credit portfolio. Such policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business – Lending Activities.”
Interest Rate Risk
Banking companies’ earnings depend largely on the relationship between the yield on earning assets, primarily loans and investments, and the cost of funds, primarily deposits and borrowings. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest earning assets and interest bearing liabilities and the level of non-performing assets. Fluctuations in interest rates affect the demand of customers for the Company’s products and services. The Company is subject to interest rate risk to the degree that its interest bearing liabilities reprice or mature more slowly or more rapidly or on a different basis than its interest earning assets. Significant fluctuations in interest rates could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Interest Rate Risk Management.”
Changes in the Value of Goodwill, Other Intangible Assets and Mortgage Servicing Assets
The Company had goodwill of $37.6 million, other intangible assets of $3.4 million and net mortgage servicing assets of $14.4 million as of December 31, 2003. Under current accounting standards, the Company is not required to amortize goodwill but rather must evaluate goodwill for impairment at least annually. If deemed impaired at any point in the future, an impairment charge representing all or a portion of goodwill will be recorded to current earnings in the period in which the impairment occurred. The capitalized value of other intangible assets is amortized to earnings over their estimated lives. The capitalized value of net mortgage servicing assets is amortized to earnings over the period of estimated servicing income. Other intangible assets and mortgage servicing assets are also subject to periodic impairment reviews. If these assets are deemed impaired at any point in the future, an impairment charge will be recorded to current earnings in the period in which the impairment occurred. For additional information regarding goodwill, other intangible assets and mortgage servicing assets, see “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included in Part IV, Item 15.
Breach of Information Security and Technology Dependence
The Company depends upon data processing, software, communication and information exchange on a variety of computing platforms and networks and over the internet. Despite instituted safeguards, the Company cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Company’s wholly-owned subsidiary, i_Tech, provides technology services to the Bank and other non-affiliated customers. In addition, the Company relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Company could be exposed to claims from customers. Any of these results could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
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Economic Conditions; Limited Geographic Diversification
The Company’s banking operations are located in Montana and Wyoming. As a result of the geographic concentration of its operations, the Company’s results depend largely upon economic conditions in these areas. Although markets served by the Company are economically diverse, a deterioration in economic conditions could adversely impact the quality of the Company’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Ability of the Company to Execute Its Business Strategy
The financial performance and profitability of the Company will depend on its ability to execute its business strategy and manage its future growth. Although the Company believes that it has substantially integrated recently acquired banks into the Company’s operations, there can be no assurance that unforeseen issues relating to the assimilation or prior operations of these banks, including the emergence of any material undisclosed liabilities, will not materially adversely affect the Company. In addition, any future acquisitions or other future growth may present operating and other problems that could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. The Company’s financial performance will also depend on the Company’s ability to maintain profitable operations through implementation of its Strategic Vision. Moreover, the Company’s future performance is subject to a number of factors beyond its control, including pending and future federal and state banking legislation, regulatory changes, unforeseen litigation outcomes, inflation, lending and deposit rate changes, interest rate fluctuations, increased competition and economic conditions. Accordingly, there can be no assurance that the Company will be able to continue the growth or maintain the level of profitability it has recently experienced.
Dependence on Key Personnel
The Company’s success depends to a significant extent on the management skills of its existing executive officers and directors, many of whom have held officer and director positions with the Company for many years. The loss or unavailability of any of its key executives or directors, including Thomas W. Scott, Chairman of the Board of Directors, Lyle R. Knight, President and Chief Executive Officer, Terrill R. Moore, Executive Vice President and Chief Financial Officer, or Ed Garding, Executive Vice President and Chief Credit Officer, could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See Part III, Item 10, “Directors and Executive Officers of Registrant.”
National competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Bank. Moreover, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and the GLB Act have increased competition in the financial services industry generally and in the Bank’s markets, including competition from larger, multi-state financial holding companies and their bank and nonbank affiliates. There can be no assurance that the Company will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business – Competition” and “Business – Regulation and Supervision.”
Government Regulation and Monetary Policy
The Company and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Company conducts its banking business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit holders of the Company’s securities. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Company. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company, and any unfavorable change in these conditions could have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity. See “Business – Regulation and Supervision.”
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Control by Affiliates
The directors and executive officers of the Company beneficially own 63.0% of the outstanding common stock of the Company. Many of these directors and executive officers are members of the Scott family, which collectively owns 78.6% of the outstanding common stock. By virtue of such ownership, these affiliates are able to control the election of directors and the determination of the Company’s business, including transactions involving any merger, share exchange, sale of assets outside the ordinary course of business and dissolution.
Lack of Trading Market; Market Prices
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 91.4% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 8.6% without such restrictions. FIBS has a right of first refusal to repurchase the restricted stock at fair market value currently determined as the minority appraised value per share based upon the most recent quarterly appraisal available to FIBS. Additionally, restricted stock held by officers, directors and employees of the Company may be called by the Company under certain conditions. All stock not subject to such restrictions may be sold at a price per share that is acceptable to the shareholder. FIBS has no obligation to purchase restricted or unrestricted stock, but has historically purchased such stock. During 2003, the Company repurchased 18,011 shares of its unrestricted stock from participants in the Savings and Profit Sharing Plan for Employees of First Interstate BancSystem, Inc. (“Savings Plan”) and 48,961 shares of its restricted stock from shareholders. All shares were repurchased at the most recent minority appraised value at the repurchase date.
The appraised minority value of the FIBS common stock represents the estimated fair market valuation of a minority block of such stock, taking into account adjustments for the lack of marketability of the stock and other factors. This value does not represent an actual trading price between a willing buyer and seller of the FIBS common stock in an informed, arm’s-length transaction. As such, the appraised minority value is only an estimate as of a specific date, and there can be no assurance that such appraisal is an indication of the actual value holders of FIBS common stock may realize with respect to shares held by them. Moreover, the estimated fair market value of the FIBS common stock may be materially different at any date other than the valuation dates.
FIBS has no obligation, by contract, policy or otherwise to purchase stock from any shareholder desiring to sell or to create any market for the stock. Historically, it has been the practice of FIBS to repurchase common stock to maintain a shareholder base with restrictions on sale or transfer of the stock. In the last three calendar years (2001-2003), FIBS repurchased a total of 252,262 shares of common stock, 191,248 of which were restricted by shareholder agreements. FIBS repurchased the stock at the most recent appraised minority value at the repurchase date, in accordance with the shareholder agreements. FIBS’s repurchases of stock are subject to corporate law and regulatory restrictions that could prevent stock repurchases. See also Part II, Item 5, “Market for Registrant’s Common Equity and Related Stockholder Matters.”
Website Access to United States Securities and Exchange Commission Filings
All reports filed electronically by the Company with the SEC, including the annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as amendments to those reports, are accessible at no cost through the Company’s website at www.firstinterstatebank.com. These filings are also accessible on the SEC’s website at www.sec.gov.
Item 2. Properties
The Company is the anchor tenant in a commercial building in which the Company’s principal executive offices are located in Billings, Montana. The building is owned by a joint venture partnership in which the Bank is one of the two partners, owning a 50% interest in the partnership. As of December 31, 2003, the Company leased approximately 68,879 square feet of space for operations in the building. The Company also leases space for operations, technology services and 24 banking offices in 32 buildings. All other banking offices are located in Company-owned facilities.
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Item 3. Legal Proceedings
In the normal course of business, the Company is named or threatened to be named as a defendant in various lawsuits. In the opinion of management, following consultation with legal counsel, the pending lawsuits are without merit or, in the event the plaintiff prevails, the ultimate liability or disposition thereof will not have a material adverse effect on the Company’s business, financial condition, results of operations or liquidity.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Description of FIBS Capital Stock
The authorized capital stock of FIBS consists of 20,000,000 shares of common stock without par value, of which 7,912,699 shares were outstanding as of December 31, 2003, and 100,000 shares of preferred stock without par value, none of which were outstanding as of December 31, 2003.
Common Stock
Each share of the common stock is entitled to one vote in the election of directors and in all other matters submitted to a vote of shareholders. Accordingly, holders of a majority of the shares of common stock entitled to vote in any election of directors may elect all of the directors standing for election if they choose to do so, subject to the rights of the holders of the preferred stock. Voting for directors is noncumulative.
Subject to the preferential rights of any preferred stock that may at the time be outstanding, each share of common stock has an equal and ratable right to receive dividends when, if and as declared by the Board of Directors out of assets legally available therefor. In the event of a liquidation, dissolution or winding up of the Company, the holders of common stock will be entitled to share equally and ratably in the assets available for distribution after payments to creditors and to the holders of any preferred stock that may at the time be outstanding. Holders of common stock have no conversion rights or preemptive or other rights to subscribe for any additional shares of common stock or for other securities. All outstanding common stock is fully paid and non-assessable.
The common stock of FIBS is not actively traded, and there is no established trading market for the stock. There is only one class of common stock, with 91.4% of the shares subject to contractual transfer restrictions set forth in shareholder agreements and 8.6% held by 16 shareholders without such restrictions, including the Company’s 401(k) plan which holds 77.6% of the unrestricted shares. See also Part I, Item 1, “Risk Factors – Lack of Trading Market; Market Prices.”
Quarter-end minority appraisal values for the past two years, determined by Alex Sheshunoff & Co. Investment Banking, are as follows:
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As of December 31, 2003, options for 691,931 shares of the FIBS common stock were outstanding at various exercise prices, ranging from $12.40 to $46.00. The aggregate cash proceeds to be received by FIBS upon exercise of all options outstanding at December 31, 2003 would be $29.4 million, or a weighted average exercise price of $42.55 per share.
Resale of FIBS stock may be restricted pursuant to the Securities Act of 1933 and applicable state securities laws. In addition, most shares of FIBS stock are subject to shareholder’s agreements:
Purchases of FIBS common stock made through the Company’s Savings Plan are not restricted by Shareholder Agreements, due to requirements of Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code. However, since the Savings Plan does not allow distributions “in kind,” any distributions from an employee’s account in the Savings Plan will allow, and may require, the Financial Services Group of the Bank (the “Plan Trustee”), to sell the FIBS stock. While FIBS has no obligation to repurchase the stock, it is likely that FIBS will repurchase FIBS stock sold by the Savings Plan. Any such repurchases would be upon terms set by the Plan Trustee and accepted by FIBS.
There are 613 record shareholders of FIBS as of December 31, 2003, including the Company’s Savings Plan as trustee for 527,969 shares held on behalf of 1,087 individual participants in the plan. Of such participants, 291 individuals also own shares of FIBS stock outside of the plan. The Plan Trustee votes the shares based on the instructions of each participant. In the event the participant does not provide the Plan Trustee with instructions, the Plan Trustee votes those shares in accordance with voting instructions received from a majority of the participants in the plan.
Dividends
It is the policy of FIBS to pay a dividend to all common shareholders quarterly. Dividends are declared and paid in the month following the calendar quarter. The dividend amount is periodically set by the FIBS Board of Directors. The FIBS Board of Directors has no current intention to change its dividend policy, but no assurance can be given that the Board may not, in the future, change or eliminate the payment of dividends.
Historical quarterly dividends for 2002 and 2003 are as follows:
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Dividend Restrictions
For a description of restrictions on the payment of dividends, see “Regulation and Supervision – Restrictions on Transfers of Funds to FIBS and the Bank.”
Preferred Stock
The authorized capital stock of FIBS includes 100,000 shares of preferred stock. The FIBS Board of Directors is authorized, without approval of the holders of common stock, to provide for the issuance of preferred stock from time to time in one or more series in such number and with such designations, preferences, powers and other special rights as may be stated in the resolution or resolutions providing for such preferred stock. FIBS Board of Directors may cause FIBS to issue preferred stock with voting, conversion and other rights that could adversely affect the holders of the common stock or make it more difficult to effect a change of control of the Company.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information as of December 31, 2003, regarding the Company’s equity compensation plans.
Equity Compensation Plans
Sales of Unregistered Securities
During 2003, the Company issued 3,591 unregistered shares of its common stock to 62 senior officers valued at an aggregate of $161,595 as part of the incentive bonuses paid to them. These issuances were made in reliance upon the “no sale” provisions of Section 2(a)(3) of the Securities Act of 1933, and upon the exemption from registration (to the extent applicable) under Section 4(2) of the Securities Act of 1933. Also during 2003, the Company issued 1,500 unregistered shares of its common stock to Lyle R. Knight, the Company’s President and then Chief Operating Officer, for $46.00 per share, the minority appraised value of the common stock on the date of issuance. This issuance was made in reliance upon the exemption from registration under Section 4(2) of the Securities Act of 1933.
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Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data with respect to the Company’s consolidated financial position as of December 31, 2003 and 2002 and its results of operations for the fiscal years ended December 31, 2003, 2002 and 2001, has been derived from the consolidated financial statements of the Company included in Part IV, Item 15. This data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and such consolidated financial statements, including the notes thereto.
Five Year Summary(Dollars in thousands except share and per share data)
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
Certain statements contained in this document including, without limitation, statements containing the words “believes,” “anticipates,” “expects,” and words of similar import, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such statements. Such factors include, among others, the following: general economic and business conditions in those areas in which the Company operates; demographic changes; competition; fluctuations in interest rates; changes in business strategy or development plans; changes in governmental regulation; credit quality; the availability of capital to fund the expected expansion of the Company’s business; and, other factors referenced in this document, including, without limitation, information under the caption “Business – Risk Factors” in Part I, Item 1. Given these uncertainties, shareholders and prospective investors are cautioned not to place undue reliance on such forward-looking statements. The Company disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.
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Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. The most significant accounting policies followed by the Company are presented in “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included in Part IV, Item 15. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. The Company has identified two policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using difference assumptions. These policies relate to the allowance for loan losses and the valuation of mortgage servicing assets.
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. For additional information regarding the allowance for loan losses, its relation to the provision for loan losses and risk related to asset quality, see “Business – Risk Factors – Asset Quality” included in Part I, Item 1; and, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Provision for Loan Losses” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Allowance for Loan Losses.”
Mortgage servicing assets are initially recorded at fair value and are amortized in proportion to and over the period of estimated servicing income. The Company utilizes the expertise of a third party consultant to evaluate mortgage servicing assets for impairment. In evaluating the mortgage servicing assets, the consultant uses discounted cash flow modeling techniques, which require estimates regarding the amount and timing of expected future cash flows, including assumptions about loan repayment rates, costs to service, as well as interest rate assumptions that contemplate the risk involved. Management believes the modeling techniques and assumptions used by the consultant are reasonable. Determining the value of mortgage servicing assets is considered a critical accounting estimate because of the assets’ sensitivity to changes in estimates and assumptions used. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. For additional information regarding mortgage servicing assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Mortgage Servicing Assets.”
Financial Overview
The following discussion and analysis is intended to provide greater details of the results of operations and financial condition of the Company. The following discussion should be read in conjunction with the information under Part II, Item 6, “Selected Consolidated Financial Data” and the Company’s consolidated financial statements, including the notes thereto, and other financial data appearing elsewhere in this document.
Results of Operations
Increases in the Company’s earnings during recent years have been effected through a successful combination of acquisitions and internal growth. Internal growth experienced by the Company is reflected by an increased volume of customer loans and deposits, without giving effect to acquisitions. The Company’s internal growth has largely been accomplished through a combination of effective offering and promotion of competitively priced products and services and the opening of several de novo banking offices. Net income was $40.8 million, or $5.15 per diluted share, in 2003 as compared to $34.5 million, or $4.41 per diluted share, in 2002 and $31.2 million, or $3.94 per diluted share, in 2001.
Net Interest Income
Net interest income, the largest source of the Company’s operating income, is derived from interest, dividends and fees received on interest earning assets, less interest expense incurred on interest bearing liabilities. Interest earning assets primarily include loans and investment securities. Interest bearing liabilities include deposits and various forms of indebtedness.
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The following table presents, for the periods indicated, condensed average balance sheet information for the Company, together with interest income and yields earned on average interest earning assets and interest expense and rates paid on average interest bearing liabilities.
Average Balance Sheets, Yields and Rates
Net interest income on a fully-taxable equivalent (“FTE”) basis increased 3.4% to $143.6 million in 2003 from $138.8 million in 2002 primarily due to loan and deposit growth. The net yield on interest earning assets of 4.37% in 2003 decreased 29 basis points from 4.66% in 2002 primarily due to decreases in the spread between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. In addition, historically low interest rates have led to significant prepayments of higher yielding investment securities, which have been redeployed at current market rates.
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Net FTE interest income increased 8.4% to $138.8 million in 2002 from $128.1 million in 2001 primarily due to loan and deposit growth combined with increases in the spread between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. The net yield on interest earning assets remained stable at 4.66% in 2002 and 2001.
The most significant impact on the Company’s net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest earning assets and interest bearing liabilities. The volume of loans, investment securities and other interest earning assets, compared to the volume of interest bearing deposits and indebtedness, combined with the interest rate spread, produces changes in the net interest income between periods.
The table below sets forth, for the periods indicated, a summary of the changes in interest income and interest expense resulting from estimated changes in average asset and liability balances (volume) and estimated changes in average interest rates (rate). Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percent changes in average volume and average rate as they compare to each other.
Analysis of Interest Changes Due To Volume and Rates(Dollars in thousands)
Provision for Loan Losses
The provision for loan losses creates an allowance for loan losses known and inherent in the loan portfolio at each balance sheet date. The Company performs a quarterly assessment of the risks inherent in its loan portfolio, as well as a detailed review of each significant asset with identified weaknesses. Based on this analysis, the Company records a provision for loan losses in order to maintain the allowance for loan losses at assessed levels. Periodically, provisions are made for loans, or groups of loans, where the probable loss can be identified and reasonably determined, while the balance of the provision for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. Fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses. Ultimate loan losses may vary from current estimates. For additional information concerning the provision for loan losses, see “Critical Accounting Policies” herein.
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The provision for loan losses increased 7.2% to $9.9 million in 2003 from $9.2 million in 2002 primarily due to the application of historical loan loss rates to loan portfolio gradings and management’s assessment of risk associated with higher levels of criticized loans, current economic conditions in the agriculture and hotel/motel market sectors and the detection of potentially damaging livestock disease in the Company’s market areas. The provision for loan losses increased 17.2% to $9.2 million in 2002 from $7.8 million in 2001 primarily due to increases in problem loans, softening economic conditions in the Company’s market areas and slowing regional and national economies.
Noninterest Income
Principal sources of noninterest income include other service charges, commissions and fees; service charges on deposit accounts; technology services revenues; and, income from fiduciary activities, comprised principally of fees earned on trust assets. Noninterest income increased 15.2% to $70.2 million in 2003 from $60.9 million in 2002 and 16.8% to $60.9 million in 2002 from $52.1 million in 2001. Increases in noninterest income are a function of changes in each of the principal categories, as discussed below.
Other service charges, commissions and fees primarily include origination and processing fees on real estate loans held for sale; mortgage servicing fee income; gains on loans sold; credit card fee income; brokerage revenues; debit card interchange fee income; and, ATM service charge revenues. Other service charges, commissions and fees increased 44.2% to $30.5 million in 2003 from $21.1 million in 2002 and 25.7% to $21.1 million in 2002 from $16.8 million in 2001. Fueled by historically low residential lending rates, revenues from the origination and sale of residential real estate loans account for approximately 63% of the 2003 and 2002 increases over the previous year. The remaining increases in 2003 and 2002 are primarily attributable to additional fee income from higher volumes of credit and debit card transactions; increases in mortgage servicing revenues due to higher volumes of mortgage loans serviced; and, increases in brokerage revenues.
Services charges on deposit accounts increased 11.9% to $17.6 million in 2003 from $15.7 million in 2002 primarily due to increases in service fee rates for account overdraft processing and check stop payments effective during the second and third quarters of 2003. Additionally, the current low interest rate environment has reduced earnings credits on business checking deposit accounts resulting in increased check processing revenues in 2003 as compared to 2002. Services charges on deposit accounts increased 7.6% to $15.7 million in 2002 from $14.6 million in 2001 primarily due to increases in business checking account fees.
Technology services revenues increased 4.1% to $11.5 million in 2003 from $11.0 in 2002 primarily due to higher ATM transaction volumes. Technology services revenues increased 7.7% to $11.0 million in 2002 from $10.2 million in 2001 primarily due to additional products provided to existing core data and item processing customers, the implementation of new item processing pricing schedules and higher ATM transaction volumes.
Revenues from fiduciary activities are largely dependent on the fair value of assets under trust management. Revenues from fiduciary activities increased 9.1% to $5.1 million in 2003 from $4.7 million in 2002 primarily due to increases in the market value of underlying assets. Revenues from fiduciary activities of $4.7 million in 2002 were flat as compared to 2001.
Other income primarily includes increases in bank-owned life insurance revenues, check printing income, agency stock dividends and gains on sales of fixed assets. Exclusive of a one-time gain of $1.2 million on the sale of a branch banking office recorded in third quarter 2002, other income increased 26.7% to $5.6 million in 2003 from $4.4 million in 2002. This increase is principally due to a full year of revenues from bank-owned life insurance acquired in August 2002.
Exclusive of one-time reinsurance revenues of $1.3 million (offset by corresponding one-time charges of $1.1 million recorded in other expense), other income increased 27.4% to $5.6 million in 2002 as compared to 2001 primarily due to a $1.2 million gain on the sale of net assets of a banking office and increases in the cash surrender value of life insurance resulting from the third quarter 2002 purchase of $50 million of bank-owned life insurance.
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The Company recorded net losses of $75,000 on sales of investment securities during 2003 as compared to net gains on sales of $2.5 million in 2002 and $145,000 in 2001. Net investment securities gains and losses were primarily used to offset impairment charges and reversals related to capitalized mortgage servicing assets recorded during the same periods.
The Company recorded net OREO expense of $93,000 in 2003 as compared to net OREO income of $179,000 in 2002 and net OREO expense of $130,000 in 2001. Variations in net OREO income or expense during the periods is primarily the result of fluctuations in gains and losses on sales of OREO. OREO income or expense is directly related to prevailing economic conditions and could vary significantly should an unfavorable shift occur in the economic conditions of the Company’s markets.
Noninterest Expense
Noninterest expense increased 3.1% to $137.9 million in 2003 from $133.8 million in 2002 and 11.3% to 133.8 million in 2002 from $120.2 million in 2001. Significant components of these increases are discussed below.
Exclusive of the deferral of salary, wage and benefit expense associated with the origination of loans, salaries, wages and employee benefits expenses increased 11.2% to $77.8 million in 2003 from $70.0 million in 2002 and 13.6% to $70.0 million in 2002 from $61.6 million in 2001 primarily due to inflationary wage increases and higher staffing levels to support internal growth and new branch banking offices opened or acquired. Increases in 2002 as compared to 2001 were partially offset by a $473,000 decrease in compensation expense related to outstanding stock options.
Occupancy expense increased 2.3% to $10.8 million in 2003 from $10.6 million in 2002 primarily due to higher depreciation and maintenance expense associated with the upgrade of existing facilities. Occupancy expense increased 10.4% to $10.6 million in 2002 from $9.6 million in 2001 primarily due to additional rent expense associated with internal growth and higher maintenance and repair expenses associated with upgrades of existing facilities.
Furniture and equipment expense decreased less than 1.0% to $13.1 million in 2003 from $13.2 million in 2002 primarily due to decreases in maintenance expense. Furniture and equipment expense increased 7.4% to $13.2 million in 2002 from $12.3 million in 2001 primarily due to depreciation and maintenance expenses associated with the upgrade of existing facilities, the addition of new facilities and technology upgrades.
FDIC insurance premiums were $468,000 in 2003, $456,000 in 2002 and $442,000 in 2001. FDIC insurance rates in 2003, 2002 and 2001 reflect the Company’s well-capitalized rating.
Core deposit intangibles amortization expense decreased 4.9% to $1.2 million in 2003 from $1.3 million in 2002 and 10.7% to $1.3 million in 2002 from $1.4 million in 2001 primarily due to scheduled decreases based on the Company’s amortization method.
Other expenses primarily include advertising and public relations costs; legal, audit and other professional fees; office supply, postage, freight, telephone and travel expenses; other losses; mortgage servicing assets amortization expense; and, impairment charges or reversals related to capitalized mortgage servicing assets and long-lived assets pending disposition. Other expenses increased 5.9% to $42.3 million in 2003 from $40.0 million in 2002. During 2003, the Company recorded a $1.9 million charge to expense for unamortized debt issuance costs associated with trust preferred securities redeemed in April 2003 and additional amortization expense of $1.2 million on capitalized mortgage servicing assets due to growth and continuing reassessment of expected prepayments of the underlying loans. In addition, during 2003 the Company recorded fraud losses of $561,000, accrued $400,000 for a building repair and incurred additional loan costs of $642,000 that were not passed through to customers. These increases were partially offset by fluctuations in impairment charges related to capitalized mortgage servicing assets and long-lived assets pending disposition. The Company recorded impairment charges related to capitalized mortgage servicing assets of $1.0 million in 2003 as compared to $2.8 million in 2002. Additionally, during 2002 the Company recorded impairment charges of $1.3 million on equipment disposed of in 2003.
Exclusive of one-time reinsurance expenses of $1.1 million recorded in 2001, other expenses increased 26.3% to $40.0 million in 2002 as compared to 2001. During 2002, the Company recorded impairment of $2.8 million on mortgage servicing assets and accelerated amortization on the remaining mortgage servicing rights resulting in additional amortization expense of $1.6 million. In addition, the Company recorded impairment charges of $1.3 million on equipment pending disposition. The remaining increase in 2002 as compared to 2001 is primarily due to higher public relation, donation, travel and unreimbursed loan expenses combined with normal inflationary expense increases.
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Income Tax Expense
The Company’s effective federal tax rate was 29.8% for the years ended December 31, 2003 and 2002 and 30.7% for the year ended December 31, 2001. State income tax applies only to pretax earnings of entities operating within Montana, Colorado and Idaho. The Company’s effective state tax rate was 5.6%, 6.1% and 5.8% for years ended December 31, 2003, 2002 and 2001, respectively.
Business Line Results
The Company is managed along two primary lines of business, Community Banking and Technology Services. Community Banking encompasses commercial and consumer banking services provided to individual customers, businesses and municipalities. These services primarily include the acceptance of deposits, extension of credit and fee-based investment services, mortgage origination and mortgage servicing.
Technology Services encompasses services provided by i_Tech to affiliated and non-affiliated customers including core application data processing, ATM processing support, item proof and capture, wide area network services and system support.
For additional information regarding the Company’s business lines, see “Notes to Consolidated Financial Statements – Business Line Reporting” included in Part IV, Item 15.
The following table summarizes net income (loss) by line of business for the years indicated:
Community Banking net income increased 8.9% to $44.3 million in 2003 from $40.6 million in 2002 primarily due to growth in net interest income; higher revenues from the origination, sale and servicing of residential real estate loans; and, increases in service charges on deposit accounts due to service fee rate increases implemented in 2003. In addition, impairment charges related to capitalized mortgage servicing assets decreased to $1.0 million in 2003 as compared to $2.8 million in 2002. These increases in net income were partially offset by additional amortization expense related to capitalized mortgage servicing assets of $1.2 million, fraud losses of $571,000; a $400,000 expense accrual for building repairs; increases of $699,000 in the provision for loan losses; and, inflationary increases in other operating expenses. In addition, Community Banking recorded losses on the sale of investment securities of $75,000 in 2003 as compared to gains of $2.5 million in 2002.
Community Banking net income increased 7.9% to $40.6 million in 2002 from $37.7 million in 2001 primarily due to internal growth in net interest income and increases in revenues from the origination and sale of residential real estate loans. Additionally, Community Banking recorded gains of $2.3 million on sales of investment securities and $1.2 million on the sale of the net assets of a banking office. Increases in net interest and noninterest income were partially offset by increases in provision for loan losses of $1.7 million, recognition of impairment of $2.8 million on capitalized mortgage servicing rights and an acceleration in amortization of remaining mortgage servicing rights of $1.6 million. In addition, salary and benefits, occupancy, furniture and equipment and other expenses increased in 2002 primarily due to inflation and additional costs associated with internal growth. Expense increases were partially offset by the discontinuation of amortization of goodwill.
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Technology Services net income increased 39.2% to $4.4 million in 2003 from $3.2 million in 2002 primarily due to increases in core data processing revenues from affiliates. Technology Services net income increased 3.8% to $3.2 million in 2002 from $3.1 million in 2001 primarily due to increases in core data processing revenues and higher ATM transaction volumes. These increases were partially offset by decreases in interest income, inflationary expense increases and higher travel expense.
Other includes the net funding cost of FIBS, compensation expense or benefit related to stock-based employee compensation, the operating results of nonbank subsidiaries except i_Tech and intercompany eliminations. Other net losses decreased 15.1% to $7.9 million in 2003 from $9.3 million in 2002 primarily due to lower interest expense on long-term debt and a subordinated debenture/trust preferred securities reissued in 2003, increases in management fees from affiliates and the write-down of long-lived assets pending disposal during the third quarter of 2002. These decreases were partially offset by the write-off of $1.9 million of unamortized debt issuance costs associated with trust preferred securities redeemed in April 2003.
Other net losses decreased 2.3% to $9.3 million in 2002 from $9.5 million in 2001 primarily due to decreases in interest expense on long-term debt, lower provisions for loan losses and decreases in compensation expense related to outstanding stock options. These cost savings were partially offset by impairment charges of $1.3 million related to equipment pending disposition.
Financial Condition
Total assets increased 9.0% to $3,880 million as of December 31, 2003 from $3,559 million as of December 31, 2002 primarily due to internal growth in loans. Asset growth was primarily funded by increases in customer deposits.
Loans
Total loans increased 14.2% to $2,555 million as of December 31, 2003 from $2,237 million as of December 31, 2002. Approximately $35.7 million of the increase is due to the acquisition of a bank holding company and its bank subsidiary during 2003. The remaining increase is due to internal growth, primarily in loans secured by commercial real estate and construction loans. Total loans increased 5.4% to $2,237 million as of December 31, 2002 from $2,122 million as of December 31, 2001. Loan growth in 2003 and 2002 is primarily the result of expansion in the Company’s market presence through a combination of marketing activities and branch openings.
The Company’s loan portfolio consists of a mix of real estate, consumer, commercial, agricultural and other loans, including fixed and variable rate loans. Fluctuations in the loan portfolio are directly related to the economies of the communities served by the Company. Thus, the Company’s borrowers could be adversely impacted by a downturn in local economies that could have a material adverse effect on the borrowers’ abilities to repay their loans.
The following table presents the composition of the Company’s loan portfolio as of the dates indicated:
Loans Outstanding
[Additional columns below]
[Continued from above table, first column(s) repeated]
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The following table presents the maturity distribution of the Company’s loan portfolio and the sensitivity of the loans to changes in interest rates as of December 31, 2003:
Maturities and Interest Rate Sensitivities
For additional information concerning the Company’s loan portfolio and its credit administration policies, see Part I, Item 1, “Business — Lending Activities.”
Investment Securities
The Company’s investment portfolio is managed to attempt to obtain the highest yield while meeting the Company’s risk tolerance and liquidity needs and satisfying pledging requirements for deposits of state and political subdivisions and securities sold under repurchase agreements. The portfolio is comprised of mortgage-backed securities, U.S. government agency securities, tax exempt securities, corporate securities and mutual funds. Federal funds sold are additional investments that are classified as cash equivalents rather than as investment securities. Investment securities classified as available-for-sale are recorded at fair value, while investment securities classified as held-to-maturity are recorded at amortized cost. Unrealized gains or losses, net of the deferred tax effect, on available-for-sale securities are reported as increases or decreases in accumulated other comprehensive income or loss, a component of stockholders’ equity.
Investment securities increased less than 1% to $800 million as of December 31, 2003 from $799 million as of December 31, 2002. During 2003, available-for-sale investment securities were sold to offset mortgage servicing asset impairment adjustments recorded during the same period. Proceeds from investment security sales and prepayments of mortgage-backed securities were used to fund loan growth or were reinvested in securities. Investment securities increased 15.3% to $799 million as of December 31, 2002 from $693 million as of December 31, 2001 primarily due to investment of funds generated through internal deposit growth.
The following table sets forth the book value, percentage of total investment securities and average yield for the Company’s investment securities as of December 31, 2003:
Securities Maturities and Yield
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Securities Maturities and Yield (continued)
(1) Average yields have been calculated on a FTE basis.
The maturities noted above reflect $203,372 of investment securities at their final maturities although they have call provisions within the next year. Mortgage-backed securities, and to a limited extent other securities, have uncertain cash flow characteristics that present additional interest rate risk to the Company in the form of prepayment or extension risk primarily caused by changes in market interest rates. This additional risk is generally rewarded in the form of higher yields. Maturities of mortgage-backed securities presented above are based on current prepayment assumptions.
As of December 31, 2002, the Company had U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities and mutual funds with carrying values of $241,457, $82,818, $5,770, $428,954 and $40,293, respectively.
As of December 31, 2001, the Company had U.S. Treasury securities, U.S. Government agency securities, tax exempt securities, corporate securities, mortgage-backed securities, equity securities and mutual funds with carrying values of $22,564, $169,925, $83,327, $16,747, $354,310, $175 and $46,130, respectively.
For additional information concerning investment securities, see “Notes to Consolidated Financial Statements – Investment Securities” included in Part IV, Item 15.
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Premises and Equipment
Premises and equipment increased 21.0% to $112 million as of December 31, 2003 from $93 million as of December 31, 2002. Approximately 30% of the increase relates to new main frame hardware and software placed into service in 2003. The remaining increase is primarily due to the acquisition of a bank holding company and its bank subsidiary and the construction of new branch banking offices or the remodel of existing branch banking offices during 2003. Premises and equipment increased 1.7% to $93 million as of December 31, 2002 from $91 million as of December 31, 2001.
Mortgage Servicing Assets
The Company recognizes the rights to service mortgage loans for others whether acquired or internally originated. Net mortgage servicing assets increased 71.4% to $14 million as of December 31, 2003 from $8 million as of December 31, 2002 and 33.0% to $8 million as of December 31, 2002 from $6 million as of December 31, 2002 primarily due to internal loan origination. Impairment reserves for mortgage servicing assets were $5 million as of December 31, 2003, compared to $4 million as of December 31, 2002 and $1 million as of December 31, 2001. For additional information regarding the Company’s mortgage servicing assets, see “Notes to Consolidated Financial Statements – Mortgage Servicing Assets” included in Part IV, Item 15.
Other Assets
Other assets primarily include restricted equity securities of government agencies and the cash surrender value of life insurance policies. Other assets increased 9.0% to $92 million as of December 31, 2003 from $85 million as of December 31, 2002 primarily due to timing differences arising in operational suspense accounts in the ordinary course of business. Other assets increased 113.3% to $85 million as of December 31, 2002 from $40 million as of December 31, 2001 primarily due to the purchase of $50 million of bank-owned life insurance. This increase was partially offset by the redemption of equity securities issued by the FHLB. For additional information on the Company’s insurance policies, see “Notes to Consolidated Financial Statements – Cash Surrender Value of Life Insurance” included in Part IV, Item 15.
Deposits
The Company emphasizes developing total client relationships with its customers in order to increase its core deposit base, which is the Company’s primary funding source. The Company’s deposits consist primarily of noninterest bearing and interest bearing demand, savings, IRA and time deposit accounts. Deposits increased 8.4% to $3,157 million as of December 31, 2003 from $2,912 million as of December 31, 2002. Approximately $42 million of the increase is due to the acquisition of a bank holding company and its bank subsidiary during 2003. The remaining increase is the result of internal growth, with the most significant growth occurring in noninterest bearing deposits. Deposits increased 8.9% to $2,912 million as of December 31, 2002 from $2,673 million as of December 31, 2001 due to internal growth occurring primarily in interest bearing demand and savings deposits
In addition to deposits, the Company also uses other traditional funding sources to support its earning asset portfolio including other borrowed funds consisting primarily of tax deposits due to the federal government, repurchase agreements with commercial depositors and, on a seasonal basis, federal funds purchased.
For additional information concerning customer deposits, including its use of repurchase agreements, see Part I, Item 1, “Business – Funding Sources” and “Notes to Consolidated Financial Statements – Deposits” included in Part IV, Item 15.
Other Borrowed Funds
Other borrowed funds decreased 10.5% to $7 million as of December 31, 2003 from $8 million as of December 31, 2002 and remained stable at $8 million as of December 31, 2002 and 2001. Fluctuations in other borrowed funds are generally due to timing of tax deposits made by customers and the subsequent withdrawal of funds by the federal government. For additional information on other borrowed funds as of December 31, 2003 and 2002, see “Notes to Consolidated Financial Statements – Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
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Federal Funds Purchased and Securities Sold Under Repurchase Agreements
The following table sets forth certain information regarding federal funds purchased and repurchase agreements as of the dates indicated:
Long-Term Debt
The Company’s long-term debt is comprised principally of fixed rate notes with the FHLB, an unsecured revolving term loan and unsecured subordinated notes. Long-term debt increased 101.3% to $48 million as of December 31, 2003 from $24 million as of December 31, 2002 primarily due to advances on fixed rate, four and seven year borrowings from the FHLB during 2003. Long-term debt decreased 31.1% to $24 million as of December 31, 2002 from $34 million as of December 31, 2001 primarily due to principal paydowns. For additional information on long-term debt as of December 31, 2002 and 2001, see “Notes to Consolidated Financial Statements – Long-Term Debt and Other Borrowed Funds” included in Part IV, Item 15.
Subordinated Debenture Held by Deconsolidated Subsidiary Trust (Trust Preferred Securities)
The Company adopted the provisions of Financial Accounting Standards Board Revised Interpretation No. 46 (“FIN 46”) effective December 31, 2003. Upon adoption, the Company deconsolidated its investment in a variable interest subsidiary trust formed for the exclusive purpose of issuing capital trust preferred securities and using the proceeds to purchase a junior subordinated debenture issued by FIBS. The deconsolidation resulted in an increase in the Company’s debt obligation of $1 million, which represents the Company’s ownership in the subsidiary trust. For additional information on the subordinated debenture held by the deconsolidated subsidiary trust and the capital trust preferred securities, see “Notes to Consolidated Financial Statements – Subordinated Debenture Held by Deconsolidated Subsidiary Trust (Trust Preferred Securities)” included in Part IV, Item 15.
Non-Performing Assets
Non-performing assets include loans past due 90 days or more and still accruing interest, nonaccrual loans, loans renegotiated in troubled debt restructurings and OREO. Management generally places loans on nonaccrual when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is reversed from income. Approximately $1.7 million, $1.7 million, $1.7 million, $1.9 million and $1.4 million of gross interest income would have been accrued if all loans on nonaccrual had been current in accordance with their original terms for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively.
Restructured loans are loans on which the Company has granted a concession on the interest rate or original repayment terms due to financial difficulties of the borrower.
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OREO consists of real property acquired through foreclosure on the collateral underlying defaulted loans. The Company initially records OREO at the lower of carrying value or fair value less estimated costs to sell by a charge against the allowance for loan losses, if necessary. Estimated losses that result from the ongoing periodic valuation of these properties are charged to earnings with a provision for losses on foreclosed property in the period in which they are identified.
The following table sets forth information regarding non-performing assets as of the dates indicated:
Non-performing assets decreased 1.3% to $33 million as of December 31, 2003 from $34 million as of December 31, 2002 primarily due to current year paydowns or charge-offs of nonaccrual loans outstanding at December 31, 2002. Non-performing assets increased 30.2% to $34 million as of December 31, 2002 from $26 million as of December 31, 2001 due to the loans of one commercial and one agricultural borrower adversely affected by drought conditions in the Company’s market areas.
In addition to the non-performing loans included in the table above, management has serious doubts as to the ability of certain borrowers to comply with the present repayment terms on performing loans, which may result in future non-performing loans. There can be no assurance that the Company has identified all of its potential non-performing loans. Furthermore, management cannot predict the extent to which economic conditions in the Company’s market areas may worsen or the full impact such conditions may have on the Company’s loan portfolio. Accordingly, there can be no assurances that other loans will not become 90 days or more past due, be placed on nonaccrual, be renegotiated or become OREO in the future.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of known and inherent risk in its loan portfolio. See “Provision for Loan Losses” herein. The allowance for loan losses is increased by provisions charged against earnings and reduced by net loan charge-offs. Loans are charged-off when management determines that collection has become unlikely. Consumer loans are generally charged off when they become 120 days past due. Other loans, or portions thereof, are charged off when they become 180 days past due unless they are well-secured and in the process of collection. Recoveries are recorded only when cash payments are received.
The allowance for loan losses is maintained at an amount to sufficiently provide for estimated losses based on management’s evaluation of known and inherent risks in its loan portfolio at each balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposures from outstanding loans. For commercial, agricultural and real estate loans, loss factors are applied based on the internal risk classifications of these loans. For certain consumer loans, loss factors are applied on a portfolio basis. Loss factors are based on peer and industry loss data which are comparable to the Company’s historical loss experience, and are reviewed on a quarterly basis, along with other factors affecting the collectibility of the loan portfolio such as changes in the size and composition of the loan portfolio, delinquency levels, actual loan loss experience, current economic conditions and detailed analyses of individual loans for which full collectibility may not be assured.
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Specific allowances are established for loans where management has determined that the probability of a loss exists and will exceed the historical loss factors specifically identified based on the internal risk classification of the loans. The allocated component of the allowance for loan losses also represents the changes in the nature and volume of the loan portfolio, overall portfolio quality, industry concentrations, current economic factors and the estimated impact of current economic conditions on historical loss rates used in the model. The unallocated component of the allowance for loan losses represents estimates of losses inherent in the portfolio that are not fully captured in the allocated allowance due to model imprecision.
Management has assessed, and will continue to assess on an on-going basis, the impact of national, regional and local economic conditions on credit risk in the loan portfolio. As of December 31, 2003, delinquency trends and classified loan levels relative to prior periods do not indicate a significant deterioration in the loan portfolio. Management continues to closely monitor credit quality and to focus on identifying potential non-performing loans and loss exposure in a timely manner.
The following table sets forth information concerning the Company’s allowance for loan losses as of the dates and for the years indicated.
The allowance for loan losses was $39 million, or 1.52% of period end loans, at December 31, 2003 as compared to $36 million, or 1.62% of period end loans, at December 31, 2002 and $34 million, or 1.61% of period end loans, at December 31, 2001. Net charge-offs of $7.6 million in 2003 increased from $7.0 million in 2002 and $6.6 million in 2001. Increases in net charge-offs in 2003 as compared to 2002 occurred primarily in agricultural loans. Increases in net charge-offs in 2002 as compared to 2001 occurred primarily in commercial and agricultural loans.
Although management believes that it has established its allowance for loan losses in accordance with accounting principles generally accepted in the United States and that the allowance for loan losses is adequate to provide for known and inherent losses in the portfolio at each balance sheet date, future provisions will be subject to on-going evaluations of the risk in the portfolio. If the economy declines or asset quality deteriorates, material additional provisions could be required.
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The allowance for loan losses is allocated to loan categories based on the relative risk characteristics, asset classifications and actual loss experience of the loan portfolio. Management has reviewed the allocations and believes the allowance for loan losses was adequate at all times during the five-year period ended December 31, 2003. The following table provides a summary of the allocation of the allowance for loan losses for specific loan categories as of the dates indicated. The allocations presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each loan category represents the total amount available for future losses that may occur within these categories. The unallocated portion of the allowance for loan losses and the total allowance is applicable to the entire loan portfolio.
Allocation of the Allowance for Loan Losses(Dollars in thousands)
During 2003, the Company enhanced its methodology for determining the allocated components of the allowance for loan losses to include a more in-depth consideration of the effect of current economic factors on historical loan losses; the effects of rapid loan growth in specific branch banking offices, particularly in commercial real estate; risk related to unfunded commitments on criticized loans; industry concentrations; and, risk related to livestock disease. This enhancement in allocation methodology resulted in the allocation of previously unallocated allowance amounts to individual loan categories. The most significant increase in allocated reserves occurred in real estate loans, which increased 64.6% to $17.9 million in 2003 from $10.9 million in 2002 primarily due significant increases in the level of internally classified commercial real estate loans combined with enhancement of the allocation methodology as discussed above.
The allocated reserve for consumer loans increased 15.4% to $5.9 million in 2002 from $5.1 million in 2001 primarily due to softening economic conditions in the Company’s market areas and continued slight deterioration in the indirect consumer loan and credit card portfolios. The allocated reserve for commercial loans increased 13.8% to $8.0 million in 2002 from $7.0 million in 2001 primarily due to the economic effects of drought conditions and a general softening of economic conditions in the Company’s market areas. The allocated reserve for agricultural loans increased 24.6% to $3.3 million in 2002 from $2.7 million in 2001 primarily due to the downgrade of loans of one borrower.
Liquidity and Cash Flow
The objective of liquidity management is to maintain the Company’s ability to meet the day-to-day cash flow requirements of its customers who either wish to withdraw funds or require funds to meet their credit needs. The Company manages its liquidity position to meet the needs of its customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of its shareholders. The Company monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position, principally through deposit receipts and check payments; loan originations, extensions and repayments; and, management of investment securities.
The Company’s current liquidity position is supported by the management of its investment portfolio, which provides a flow of reinvestable cash. Maturing balances in the Company’s loan portfolio also provide options for cash flow management. The ability to redeploy these funds is an important source of immediate to long-term liquidity. Additional sources of liquidity include customer deposits, federal funds lines, borrowings and access to capital markets. The Company does not engage in derivatives or related hedging activities.
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Net cash provided by operating activities, primarily net income, totaled $56 million in 2003, $67 million in 2002 and $48 million in 2001. Net cash used in investing activities totaled $327 million in 2003, $317 million in 2002 and $274 million in 2001. Investing activities principally include investment security transactions and net extensions of credit to customers. Net cash provided by financing activities, primarily generated through increases in customer deposits, borrowing advances or issuance of securities or stock, totaled $238 in 2003, $268 million in 2002 and $350 million in 2001. For additional information concerning cash flows, see the “Consolidated Statements of Cash Flows” included in Part IV, Item 15.
As a holding company, FIBS is a corporation separate and apart from the Bank, and therefore, provides for its own liquidity. Substantially all of FIBS’s revenues are obtained from management fees and dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to FIBS. Management of FIBS believes that such restrictions will not have an impact on the ability of FIBS to meet its ongoing cash obligations. For additional information, see Part I, Item 1, “Business – Regulation and Supervision.”
The Company’s contractual obligations as of December 31, 2003 are summarized in the following table.
Contractual Obligations(Dollars in thousands)
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Off-Balance Sheet Arrangements
During 2003, the Company entered into an off-balance sheet arrangement which includes the guarantee of distributions and payments for redemption or liquidation of trust preferred securities issued by a wholly-owned, deconsolidated subsidiary trust to the extent of funds held by the trust. Although the guarantee is not separately recorded, the obligation underlying the guarantee is fully reflected on the Company’s consolidated balance sheets as subordinated debenture held by deconsolidated subsidiary trust. The subordinated debenture currently qualifies as Tier 1 capital under the Federal Reserve capital adequacy guidelines. For additional information regarding the subordinated debenture, see “Notes to Consolidated Financial Statements – Subordinated Debenture Held by Deconsolidated Subsidiary Trust (Trust Preferred Securities)” included in Part IV, Item 15.
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. For additional information regarding the Company’s off-balance sheet arrangements, see “Notes to Consolidated Financial Statements – Financial Instruments with Off-Balance Sheet Risk” included in Part IV, Item 15.
Capital Resources
Stockholders’ equity is influenced primarily by earnings, dividends and, to a lesser extent, sales and redemptions of common stock and changes in the unrealized holding gains or losses, net of taxes, on available-for-sale investment securities. Stockholders’ equity increased 12.5% to $274 million as of December 31 2003 from $244 million as of December 31, 2002 and 9.8% to $244 million as of December 31, 2002 from $222 million as of December 31, 2001 primarily due to retention of earnings. For the years ended December 31, 2003, 2002 and 2001, the Company paid aggregate cash dividends to stockholders of $10.4 million, $10.1 million and $9.3 million, respectively. During 2003, the Company recapitalized its common stock through a $25 million transfer from retained earnings.
Pursuant to FDICIA, the Federal Reserve and FDIC have adopted regulations setting forth a five-tier system for measuring the capital adequacy of the financial institutions they supervise. At December 31, 2003, the Bank had a capital level that exceeded the well-capitalized guidelines. For additional information concerning the capital levels of the Company, see “Notes to Consolidated Financial Statements — Regulatory Matters” contained in Part IV, Item 15.
Interest Rate Risk Management
The Company’s primary earnings source is the net interest margin, which is affected by changes in the level of interest rates, the relationship between rates, the impact of interest rate fluctuations on asset prepayments and the mix of interest bearing assets and liabilities.
The ability to optimize the net interest margin is largely dependent upon the achievement of an interest rate spread that can be managed during periods of fluctuating interest rates. Interest sensitivity is a measure of the extent to which net interest income will be affected by market interest rates over a period of time. Interest rate sensitivity is related to the difference between amounts of interest earning assets and interest bearing liabilities which either reprice or mature within a given period of time. The difference is known as interest rate sensitivity gap.
The following table shows interest rate sensitivity gaps for different intervals as of December 31, 2003:
Interest Rate Sensitivity Gaps
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Interest Rate Sensitivity Gaps (continued)
Assumptions used:
As noted in footnote 3 above, interest bearing demand accounts and savings deposits are allocated based on historical analysis of their interest rate sensitivity characteristics although they are technically subject to immediate withdrawal. If these deposits were included in the three month or less category, the above table would reflect a negative three month gap of $660 million, a negative cumulative one year gap of $457 million and a positive cumulative one to five year gap of $339 million.
The balance sheet structure is primarily short-term in nature with most assets and liabilities repricing or maturing in less than five years. Management monitors the sensitivity of net interest margin by utilizing income simulation models and a traditional interest rate gap analysis. The income simulation model involves a degree of estimation based on certain assumptions management believes to be reasonable including estimated cash flows, prepayments, repricing characteristics, maturities, deposit growth and retention, and the relative sensitivity of assets and liabilities to change in market interest rates. The relative sensitivity is important to consider since the Company’s deposit base is not subject to the same degree of interest sensitivity as its assets.
The Company targets a mix of interest earning assets and deposits such that no more than 5% of the net interest margin will be at risk over a one-year period should interest rates vary one percent. As of December 31, 2003, the Company’s income simulation models predict net interest income will increase $15.6 million, or 10.2%, over the next twelve months assuming an immediate upward shift in market interest rates of 1.0% and will decrease by $15.6 million, or 10.2%, if market interest rates shift downward in the same manner. Management considers the possibility of interest rates declining by 1% during 2004 as highly unlikely. In evaluating exposure to interest rate risk, management does not view the gap amounts in the preceding table as presenting an unusually high risk potential. However, no assurances can be given that the Company is not at risk in the event of rate increases or decreases and there can be no assurance as to the actual effect changes in interest rates will have on the Company’s net interest margin.
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Recent Accounting Pronouncements
New accounting policies adopted by the Company during 2003 and the expected impact of accounting standards recently issued but not yet adopted are discussed in “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included in Part IV, Item 15.
Summary of Quarterly Results
The following table presents the Company’s unaudited quarterly results of operations for the fiscal years ended December 31, 2003 and 2002.
Quarterly Summary
(Dollars in thousands except per share data)
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Net income for the fourth quarter of 2003 was $9.9 million, or $1.24 per diluted share, compared to $11.8 million, or $1.50 per diluted share, for the third quarter of 2003 and $8.6 million, or $1.10 per diluted share, for the fourth quarter of 2002. The decline in linked-quarter results is primarily due to lower revenues from the origination and sale of residential real estate loans and additional impairment charges related to capitalized mortgage servicing assets. The improvement in year-over-year quarter results is primarily due to higher net interest income, the result of deposit and loan growth.
Net interest income for the fourth quarter of 2003 was $36.7 million, compared to $35.5 million for the third quarter of 2003 and $33.1 million for the fourth quarter of 2002. On a fully-taxable equivalent basis, the net yield on interest earning assets was 4.34% for the fourth quarter of 2003, compared to 4.28% for the third quarter of 2003 and 4.30% for the fourth quarter 2002.
Noninterest income was $16.6 million for the fourth quarter of 2003, compared to $17.3 million for the third quarter of 2003 and $16.1 million for the fourth quarter of 2002. Decreases in linked-quarter noninterest income are primarily due to lower revenues from the origination and sale of residential real estate loans. Increases in noninterest income for the fourth quarter of 2003 as compared to fourth quarter 2002 are primarily due to higher service fee rates on deposits accounts; higher debit and credit card transaction volumes; and, increases in revenues from bank-owned life insurance. These increases were partially offset by decreases in revenues from the origination and sale of residential real estate loans.
Noninterest expense for the fourth quarter of 2003 was $36.1 million, compared to $31.8 million in the third quarter of 2003 and $33.5 million in the fourth quarter of 2002. Increases in linked-quarter noninterest expense are primarily due to fluctuations in mortgage servicing asset impairment charges and reversals. Increases in year-over-year noninterest expense is primarily due to higher salary and benefits expenses.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company’s primary market risk exposure is interest rate risk. The business of the Company and the composition of its balance sheet consists of investments in interest earning assets (principally loans and investment securities) which are primarily funded by interest bearing liabilities (deposits and indebtedness). Such financial instruments have varying levels of sensitivity to changes in market interest rates. Interest rate risk results when, due to different maturity dates and repricing intervals, interest rate indices for interest earning assets decrease relative to interest bearing liabilities, thereby creating a risk of decreased net earnings and cash flow.
The following tables provide information about the Company’s market sensitive financial instruments, categorized by maturity and the instruments’ fair values at December 31, 2003 and 2002. The table constitutes a “forward-looking statement.” For a description of the Company’s policies with respect to managing risks associated with changing interest rates, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Interest Rate Risk Management.”
Although the Company characterizes some of its interest-sensitive assets as securities available-for-sale, such securities are not purchased with a view to sell in the near term. Rather, such securities may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk. See “Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies” included in Part IV, Item 15.
Market Sensitive Financial Instruments Maturities
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The prepayment projections of net loans are based on experience and do not take into account any allowance for loan losses. The expected maturities of securities are based upon contractual maturities adjusted for projected prepayments of principal and assumes no reinvestment of proceeds. The actual maturities of these instruments could vary substantially if future prepayments differ from the Company’s historical experience. All other financial instruments are stated at contractual maturities.
Item 8. Financial Statements and Supplementary Data
The following Consolidated Financial Statements of FIBS and subsidiaries are contained elsewhere herein [see Item 15(a)1]:
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There have been no changes in or disagreements with accountants on accounting and financial disclosure.
Item 9A. Controls and Procedures
Management of the Company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15 and 15d-15 of the Securities Exchange Act of 1934. As of December 31, 2003, an evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, management concluded that the Company’s disclosure controls and procedures as of December 31, 2003 were effective in ensuring that information required to be disclosed in this Annual Report on Form 10-K was recorded, processed, summarized, and reported within the time period required by the SEC’s rules and forms.
There were no changes in the Company’s internal controls over financial reporting for the quarter ended December 31, 2003 that have materially affected, or are reasonably likely to materially affect, such controls.
PART III
Item 10. Directors and Executive Officers of the Registrant
Information concerning “Directors and Executive Officers of the Registrant” is set forth under the heading “Directors and Executive Officers” in the Company’s Proxy Statement and is herein incorporated by reference.
Information concerning “Compliance With Section 16(a) of the Securities and Exchange Act of 1934” is set forth under the heading “Compliance With Section 16(a) of the Securities and Exchange Act of 1934 (the “Exchange Act”)” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 11. Executive Compensation
Information concerning “Executive Compensation” is set forth under the heading “Director and Executive Compensation” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” is set forth under the heading “Security Ownership of Principal Shareholders and Management and Related Stockholder Matters” in the Company’s Proxy Statement and is herein incorporated by reference.
Item 13. Certain Relationships and Related Transactions
Information concerning “Certain Relationships and Related Transactions” is set forth under the heading “Certain Relationships and Related Transactions” in the Company’s Proxy Statement and is herein incorporated by reference. In addition, see “Notes to Consolidated Financial Statements – Related Party Transactions” included in Part IV, Item 15.
Item 14. Principal Accountant Fees and Services
Information concerning “Principal Accountant Fees and Services” is set forth under the heading “Directors and Executive Officers - Audit Fees” in the Company’s Proxy Statement and is herein incorporated by reference.
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. Following are the Company’s audited consolidated financial statements.
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REPORT OF ERNST & YOUNG LLP INDEPENDENT AUDITORS
To the Board of Directors and ShareholdersFirst Interstate BancSystem, Inc.
We have audited the accompanying consolidated balance sheets of First Interstate BancSystem, Inc. (the “Company”) as of December 31, 2003 and 2002, and the related consolidated statements of income, cash flows and changes in shareholders’ equity for each of the three years in the period ended December 31, 2003. 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 audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Interstate BancSystem, Inc.at December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Salt Lake City, UtahFebruary 6, 2004
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FIRST INTERSTATE BANCSYSTEM, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS(In thousands, except share data)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands, except share and per share data)
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Exhibit Index
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.
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 and on the dates indicated.