UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2005
For the transition period from to
Commission file number 000-23423
C&F Financial Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(804) 843-2360
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
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. x Yes ¨ No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). x Yes ¨ No
At May 3, 2005, the latest practicable date for determination, 3,556,354 shares of common stock, $1.00 par value, of the registrant were outstanding.
TABLE OF CONTENTS
Financial Statements
Consolidated Balance Sheets -March 31, 2005 and December 31, 2004
Consolidated Statements of Income -Three months ended March 31, 2005 and 2004
Consolidated Statements of Shareholders’ Equity -Three months ended March 31, 2005 and 2004
Consolidated Statements of Cash Flows -Three months ended March 31, 2005 and 2004
Notes to Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
Exhibits
PART I - FINANCIAL INFORMATION
ITEM 1. - FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share and per share amounts)
ASSETS
Cash and due from banks
Interest-bearing deposits in other banks
Total cash and cash equivalents
Securities-available for sale at fair value, amortized cost of $67,933 and $69,776, respectively
Loans held for sale, net
Loans, net
Federal Home Loan Bank stock
Corporate premises and equipment, net of accumulated depreciation
Accrued interest receivable
Goodwill
Other assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
Noninterest bearing demand deposits
Savings and interest-bearing demand deposits
Time deposits
Total deposits
Borrowings
Accrued interest payable
Other liabilities
Total liabilities
Commitments and contingent liabilities
Shareholders’ Equity
Preferred stock ($1.00 par value, 3,000,000 shares authorized)
Common stock ($1.00 par value, 8,000,000 shares authorized, 3,556,354 and 3,538,554 shares issued and outstanding, respectively)
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income, net
Total shareholders’ equity
Total liabilities and shareholders’ equity
The accompanying notes are an integral part of the consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Interest income
Interest and fees on loans
Interest on other market investments
Interest on securities
U.S. government agencies and corporations
Tax-exempt obligations of states and political subdivisions
Corporate bonds and other
Total interest income
Interest expense
Savings and interest-bearing deposits
Certificates of deposit, $100,000 or more
Other time deposits
Short-term borrowings and other
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income
Gains on sales of loans
Service charges on deposit accounts
Other service charges and fees
Gain on calls of available for sale securities
Other income
Total noninterest income
Noninterest expenses
Salaries and employee benefits
Occupancy expenses
Other expenses
Total noninterest expenses
Income before income taxes
Income tax expense
Net income
Per share data
Net income – basic
Net income – assuming dilution
Cash dividends paid and declared
Weighted average number of shares – basic
Weighted average number of shares – assuming dilution
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands)
Common
Stock
Additional
Paid-In
Capital
Comprehensive
Income
Retained
Earnings
Accumulated
Other
December 31, 2004
Comprehensive income
Other comprehensive loss, net of tax
Unrealized loss on securities
Stock options exercised
Cash dividends
March 31, 2005
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December 31, 2003
Other comprehensive income, net of tax
Unrealized gain on securities, net of reclassification adjustment
Repurchase of common stock
March 31, 2004
Unrealized net holding gains arising during period
Less: reclassification adjustment for gains included in net income
Net unrealized gains on securities
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation
Amortization of intangible assets
Accretion of discounts and amortization of premiums on investment securities, net
Net realized gain on securities
Proceeds from sale of loans
Origination of loans held for sale
Change in other assets and liabilities:
Net cash provided by (used in) operating activities
Cash flows from investing activities:
Proceeds from maturities and calls of securities available for sale
Purchase of securities available for sale
Net increase in customer loans
Purchase of corporate premises and equipment
Sale of corporate premises and equipment
(Purchase) redemption of Federal Home Loan Bank stock
Net cash (used in) provided by investing activities
Cash flows from financing activities:
Net (decrease) increase in demand, interest bearing demand and savings deposits
Net increase (decrease) in time deposits
Net increase in other borrowings
Proceeds from exercise of stock options
Net cash provided by financing activities
Net (decrease) increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosure
Interest paid
Income taxes paid
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with applicable quarterly reporting regulations of the Securities and Exchange Commission. They do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the C&F Financial Corporation Annual Report on Form 10-K for the year ended December 31, 2004.
In the opinion of C&F Financial Corporation’s management, all adjustments, consisting only of normal recurring accruals, necessary to present fairly the financial position as of March 31, 2005 and the results of operations and cash flows for the three months ended March 31, 2005 and 2004 have been made. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.
The consolidated financial statements include the accounts of C&F Financial Corporation (the “Corporation”) and its subsidiary, Citizens and Farmers Bank (the “Bank”), with all significant intercompany transactions and accounts being eliminated in consolidation.
Stock Compensation Plans: The Corporation has three stock-based compensation plans that are accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.
(in 000’s, except per share amounts)
Net income, as reported
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net income
Earnings per share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
On December 16, 2004, the Financial Accounting Standards Board issued SFAS No. 123R, Share-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or
6
liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic method and requires that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of income. The effective date of SFAS No. 123R (as amended by the SEC) is for annual periods beginning after June 15, 2005. The provisions of SFAS No. 123R do not have an impact on the Corporation’s results of operations at the present time. The Corporation will begin recognizing compensation expense in 2006 for options that have been issued but not yet vested prior to January 1, 2006. Projected compensation expense associated with adopting SFAS No. 123R will approximate $321,000 in 2006. This estimate applies only to options issued through March 31, 2005 but not yet vested prior to January 1, 2006. Options issued after March 31, 2005 will increase compensation expense above this estimate for 2006.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107. SAB 107 expresses the views of the SEC staff regarding the interaction of SFAS No. 123R and certain SEC rules and regulations and provides the SEC staff’s view regarding the valuation of share-based payment arrangements for public companies. SAB 107 does not impact the Corporation’s results of operations at the present time.
Options approved by the Compensation Committee of the Board of Directors and issued in December 2004 were granted with a six-month vesting period. The effect of the six-month vesting is included in the pro forma earnings per share calculations for the three months ended March 31, 2005. This vesting period was determined as part of a broad review of long-term incentive compensation in light of changes in market practice and changes in accounting rules. The issuance of SFAS No. 123R allowed only a very limited period for evaluating the Corporation’s compensation plans and the Board believes the decision for a six-month vesting period on options granted in December 2004 was in the best interest of the Corporation and the shareholders. The Board will continue reviewing the effects of SFAS 123R and its impact on compensation plans throughout the Corporation.
Note 2
Diluted net income per share has been calculated on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding for the applicable periods. Potentially-dilutive common stock had no effect on income available to common shareholders.
Note 3
During the first three months of 2004, the Corporation repurchased 26,200 shares of its common stock in privately-negotiated transactions and 1,500 shares in open-market transactions at prices from $38.50 to $41.50. There were no stock repurchases in the first three months of 2005.
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Note 4
Securities in an unrealized loss position at March 31, 2005, by duration of the period of unrealized loss, are shown below. No impairment has been recognized on any securities in a loss position because of management’s intent and demonstrated ability to hold securities to scheduled maturity or call dates.
(in 000’s)
Fair
Value
Unrealized
Loss
Mortgage-backed securities
Obligations of states and political subdivisions
Subtotal-debt securities
Preferred stock
Total temporarily impaired securities
Note 5
The Bank has a noncontributory defined benefit plan for which the components of net periodic benefit cost are as follows:
Service cost
Interest cost
Expected return on plan assets
Amortization of net obligation at transition
Amortization of prior service cost
Amortization of net loss
Net periodic benefit cost
In December 2004, the Bank made a $462,419 cash payment to the plan. This payment was the maximum tax-deductible contribution for 2004 allowable under the Internal Revenue Code.
Note 6
The Corporation operates in a decentralized fashion in three principal business segments: Retail Banking, Mortgage Banking and Consumer Finance. Revenues from Retail Banking operations consist primarily of interest earned on loans and investment securities and service charges on deposit accounts. Mortgage Banking operating revenues consist principally of gains on sales of loans in the secondary market, loan origination fee income and interest earned on mortgage loans held for sale. Revenues from Consumer Finance consist primarily of interest earned on automobile loans.
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The Corporation’s other subsidiaries include:
The results of these other subsidiaries are not significant to the Corporation as a whole and have been included in “Other.”
Three Months Ended March 31, 2005
Retail
Banking
Mortgage
Consumer
Finance
Revenues:
Total operating income
Expenses:
Personnel expenses
Total operating expenses
Provision for income taxes
Capital expenditures
Three Months Ended March 31, 2004
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The Retail Banking segment extends a warehouse line of credit to the Mortgage Banking segment, providing the funds needed to originate mortgage loans. The Retail Banking segment charges the Mortgage Banking segment interest at the daily FHLB advance rate plus 50 basis points. The Retail Banking segment also provides the Consumer Finance segment with a portion of the funds needed to originate loans and charges the Consumer Finance segment interest at LIBOR plus 250 basis points. The Retail Banking segment acquires certain lot and permanent loans and home equity lines of credit from the Mortgage Banking segment at prices similar to those paid by third-party investors. These transactions are eliminated to reach consolidated totals. Certain corporate overhead costs incurred by the Retail Banking segment are not allocated to the Mortgage Banking, Consumer Finance and Other segments.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains statements concerning the Corporation’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management and risks and uncertainties. Actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, changes in:
These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.
The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Corporation. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies that require our most difficult, subjective or complex judgments and uncertainties affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.
Allowance for Loan Losses: We establish the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the adequacy of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as changes in the nature and
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volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay, overall portfolio quality and specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available.
Impairment of Loans: We measure impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan (or, as a practical expedient, at the loan’s observable market price) or the fair value of the collateral if the loan is collateral dependent. We consider a loan impaired when it is probable that the Corporation will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment. The loans currently designated as impaired are being valued based on collateral. The reserves that we have established are based on appraisals of the collateral and have been adjusted for items such as selling costs and current conditions. We believe these adjustments are reasonable.
Impairment of Securities: Impairment of investment securities results in a write-down that must be included in net income when a market decline below cost is other-than-temporary. We regularly review each investment security for impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer and our ability and intention with regard to holding the security to maturity.
Valuation of Derivatives: The Corporation enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (i.e., rate lock commitments). The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 15 to 90 days. The Corporation protects itself from changes in interest rates by entering into loan purchase agreements with third party investors that provide for the investor to purchase loans at the same terms (including interest rate) as committed to the borrower. Under the contractual relationship with the purchaser of the loan, the Corporation is obligated to sell the loan to the purchaser only if the loan closes. No other obligation exists. As a result of these contractual terms with purchasers of loans, the Corporation is not exposed to losses nor will it realize gains related to its rate lock commitments due to changes in interest rates.
Goodwill: On January 1, 2002, the Corporation adopted SFAS No. 142, Goodwill and Other Intangible Assets. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment using a two-step process that begins with an estimation of the fair value of the reporting unit. In assessing the recoverability of the Corporation’s goodwill, all of which was recognized in connection with the Bank’s acquisition of C&F Finance in September 2002, we must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in determining impairment were increases in future income, sales multiples in determining terminal value and the discount rate applied to future cash flows. We completed the annual test for impairment during the fourth quarter of 2004 and determined there was no impairment to be recognized in 2004. As part of the impairment test, we performed a sensitivity analysis by increasing the discount rate, lowering sales multiples and reducing increases in future income. Based on the analysis performed, no charge for impairment was determined to be necessary. If the underlying estimates and related assumptions change in the future, we may be required to record impairment charges.
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Defined Benefit Pension Plan: The Bank maintains a noncontributory, defined benefit pension plan for eligible full-time employees as specified by the plan. Plan assets, which consist primarily of marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Bank’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions include the discount rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, may impact pension expense as measured in accordance with SFAS No. 87, Employers’ Accounting for Pensions.
Accounting for Income Taxes: Determining the Corporation’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Corporation’s tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.
For further information concerning accounting policies, refer to Note 1 of the Corporation’s Consolidated Financial Statements in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004.
OVERVIEW
Our primary financial goals are to maximize the Corporation’s earnings and to deploy capital in profitable growth initiatives that will enhance shareholder value. We track three primary performance measures in order to assess the level of success in achieving these goals: (i) return on average assets, (ii) return on average equity and (iii) growth in earnings. In addition to these financial performance measures, we track the performance of the Corporation’s three principal business activities: retail banking, mortgage banking and consumer finance. We also actively manage our capital through: growth, stock repurchases and dividends.
Financial Performance Measures. For the Corporation, net income increased 11.1 percent to $2.6 million for the first quarter ended March 31, 2005. Diluted net income per share increased 14.5 percent to $.71 per share. The Corporation’s ROA was 1.72 percent for the first quarter of 2005 compared with 1.66 percent for the first quarter of 2004, and its ROE was 14.70 percent for the first quarter of 2005 compared with 14.38 percent for the first quarter of 2004. Net income for the first quarter of 2005 included earnings improvement in each of the Corporation’s primary business segments. Factors influencing first quarter earnings included rising interest rates, higher commercial and consumer loan demand, strong seasonal mortgage loan production, maintenance of asset quality and higher operating expenses to support growth.
Principal Business Activities. An overview of the financial results for each of the Corporation’s principal segments is presented below. A more detailed discussion is included in “Results of Operations.”
Retail Banking: Net income for the Retail Banking segment increased approximately $116,000 to $1.5 million for the quarter ended March 31, 2005. The improvement in the performance of the Retail Banking segment resulted from a higher level of and a higher-yielding composition of earning assets. These improvements were offset in part by an increase in the provision for loan losses, the costs associated with the expansion of the Retail Banking segment into the Hanover County and Peninsula markets of Virginia and an increase in operational and administrative expenses to support growth.
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During the first quarter of 2005, the Bank installed a new mainframe computer, upgraded its primary operating system and enhanced the operating platform in all branches, which will help us be more efficient and offer better customer service. In addition, progress continues on the Bank’s new operations center, which we expect to occupy during the third quarter of 2005. The Bank has also started construction of two new retail branches in the Virginia Peninsula region, which we expect to open in the fourth quarter of 2005.
Mortgage Banking: Net income for the Mortgage Banking segment increased 50.4 percent to approximately $567,000 for the quarter ended March 31, 2005. This increase resulted from a higher volume of loans sold in 2005, offset in part by lower profit margins resulting from a proportionately higher volume of variable-rate loans sold versus fixed rate loans. The gain on sales of variable-rate loans is less than that of fixed-rate loans. For the first quarter of 2005, the amount of loan originations at C&F Mortgage resulting from refinancings was $79.2 million compared to $56.2 million for the first quarter of 2004. Loans originated for new and resale home purchases for these two time periods were $123.8 million and $114.2 million, respectively. Future earnings of the Mortgage Banking segment will be negatively affected if the upward trend in interest rates continues and there are fewer new and resale home sales and loan refinancings.
Consumer Finance: Net income for the Consumer Finance segment increased 7.7 percent to approximately $617,000 for the quarter ended March 31, 2005. The increase in 2005 resulted from a 17.6 percent increase in average loans outstanding, which more than offset the increases in the cost of borrowings attributable to rising interest rates, the provision for loan losses and operating expenses to support growth and technology investments. During the second quarter of 2005, the Consumer Finance segment will complete its conversion to a new loan system, which will create efficiencies and expand capacity for new business, and will move its operations center to a new location in Richmond, Virginia. Future earnings of the Consumer Finance segment in the short-term will be affected by the continuing investments in technology to enhance operations and the initial start-up costs associated with the expansion of the Consumer Finance segment into new markets in Northern Virginia and in portions of Tennessee and Maryland.
Capital Management. Total assets grew by $7.4 million to $616.5 million during the first quarter of 2005. A detailed discussion of the changes in our financial position is included in the section “Financial Condition.” Dividends for the first quarter of 2005 were 24 cents per share versus 22 cents per share in the first quarter of 2004. The weighted average number of shares outstanding in the first quarter of 2005 was 3,551,093 compared to 3,594,204 in the first quarter of 2004. This decrease resulted from the repurchase of 89,050 shares throughout 2004. No share repurchases have been made in 2005.
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RESULTS OF OPERATIONS
Net Interest Income
Selected Average Balance Sheet Data and Net Interest Margin
Average
Balance
Yield/
Cost
Securities
Loans held for sale
Loans
Interest bearing deposits in other banks
Total earning assets
Time and savings deposits
Total interest bearing liabilities
Net interest margin
Interest income and expense are affected by fluctuations in interest rates, by changes in the volume of earning assets and interest-bearing liabilities, and by the interaction of rate and volume factors. The following table shows the direct causes of the changes from the first quarter of 2004 to the first quarter of 2005 in the components of net interest income on a taxable-equivalent basis. Rate/volume variances, the third element in the calculation, are not shown separately in the table, but are allocated to the rate and volume variances in proportion to the relationship of the absolute dollar amounts of the change in each. Loans include both nonaccrual loans and loans held for sale.
Increase(Decrease)
Due to Changes in
Total
Increase
(Decrease)
Interest income:
Interest expense:
Change in net interest income
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Net interest income, on a taxable equivalent basis, for the three months ended March 31, 2005 was $9.2 million. Net interest income, on a taxable equivalent basis, for the first quarter of 2004 was $7.9 million. The increase was a result of a 6.8% increase in the average balance of interest-earning assets and an increase in the net interest margin to 6.66% for the quarter ended March 31, 2005 from 6.08% for the quarter ended March 31, 2004.
Average loans outstanding increased $42.7 million at the Retail Banking segment and $14.2 million at the Consumer Finance segment. Average loans held for sale at the Mortgage Banking segment increased $9.0 million. The increase in loans at the Retail Banking segment was mainly attributable to loan production in the Virginia Peninsula market and residential construction loan growth. The increase in loans held for sale at the Mortgage Banking segment resulted from higher production volume. The increase in loans at the Consumer Finance segment was mainly attributable to the new markets this segment serves, in addition to overall growth at existing locations. The yield on loans held for investment at the Retail Banking segment and the Consumer Finance segment increased 27 basis points and the yield on loans held for sale at the Mortgage Banking segment increased 29 basis points. These increases resulted from a general increase in interest rates, including a 175 basis point increase in the prime rate since March 31, 2004.
Average securities available for sale decreased $1.2 million; however, their average yield increased 28 basis points. The decline in the average balance resulted from the utilization of proceeds from maturities and calls to fund the increase in loan demand. The yield increase was a result of the mix of investments. The percentage of shorter-term, lower-yielding investments decreased in the first quarter of 2005 as compared to 2004.
Average interest earning deposits at other banks, primarily the FHLB, decreased $29.5 million; however, their average yield increased 145 basis points. The decline in the average balance resulted from the utilization of these low-yielding deposits to fund the increase in loan demand. The yield increase reflected the increase in short-term interest rates as measured by the 175 basis point increase in prime rate since the first quarter of 2004.
A 12 basis point increase in the cost of deposits during 2005 resulted from an increase in interest rates. Generally, deposit interest rate increases lag the increase in loan interest rates. Although interest rates have increased in 2005, deposits will reprice more gradually as existing certificates of deposit mature in future periods.
The $10.1 million increase in average borrowings and the 102 basis point increase in the average rate resulted from the increase in loans at the Consumer Finance segment, which was funded by a LIBOR-based line of credit with an unrelated third party.
The net interest margin has benefited in the short term as prime-based loans have repriced as the prime rate has changed. However, we expect that the favorable impact of the deposit repricing lag will neutralize in the longer term and the cost of borrowings will continue to increase as short-term interest rates rise. As a result, the increase in the net interest margin experienced in the first three months of 2005 should decline throughout the year if rates continue to rise.
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Noninterest Income
Other and
Eliminations
Total noninterest income increased 18.6 percent, to $5.7 million for the first quarter of 2005 from $4.9 million for the first quarter of 2004. This increase was attributable to (1) higher service charges and fees on deposit accounts at the Retail Banking segment resulting from deposit account growth, (2) higher gains on sales of loans and other service charges at the Mortgage Banking segment resulting from an increase in the volume of loans closed and sold and (3) higher other income at the Consumer Finance segment resulting from fees generated from loan origination.
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Noninterest Expense
Occupancy expense
Total noninterest expense
Total noninterest expense increased 15.7 percent, to $9.7 million for the first quarter of 2005 from $8.4 million for the first quarter of 2004. The Retail Banking and the Consumer Finance segments reported increases in total noninterest expenses that were primarily attributable to higher personnel and operating expenses to support growth at both segments and technology enhancements at the Consumer Finance segment. Start-up costs associated with the Bank’s expansion efforts will continue throughout 2005 as construction has started on two new retail branches on the Virginia Peninsula. We will also incur additional costs as the Retail Banking segment relocates its operations departments to a new facility in 2005. The Consumer Finance segment continues to invest in both technology and people to create efficiencies and serve new markets in Northern Virginia and in portions of Tennessee and Maryland. An increase in noninterest expenses for the Mortgage Banking segment reflected higher production-based compensation and operating expenses due to an increase in production.
Income Taxes
Income tax expense for the three months ended March 31, 2005 amounted to $1.2 million, resulting in an effective tax rate of 30.7 percent, compared to $966,000, or 29.2 percent, for the three months ended March 31, 2004. The increase in the effective tax rate for the quarter resulted from a lower proportion of earnings from tax-exempt assets, such as obligations of states and political subdivisions. The change in the composition of earnings mainly reflected the higher earnings at the Mortgage Banking and the Consumer Finance segments.
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ASSET QUALITY
Allowance for Loan Losses
The allowance for loan losses represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. The provision for loan losses increases the allowance, and loans charged off, net of recoveries, reduce the allowance. The following tables summarize the allowance activity for periods indicated:
Retail and
Allowance, beginning of period
Loans charged off
Recoveries of loans previously charged off
Net loans charged off
Allowance, end of period
During the first quarter of 2005, the provision for loan losses was $100,000 at the combined Retail Banking and Mortgage Banking segments. This provision resulted primarily from the impact of construction and commercial loan growth, rather than any deterioration in asset quality. We believe that the current level of the allowance for loan losses is adequate to absorb any losses on existing loans that may become uncollectible.
The Consumer Finance segment, consisting solely of C&F Finance, accounted for the majority of the activity in the allowance for loans losses during the first quarter of 2005. In addition to maintaining the allowance for loan losses, C&F Finance has retained dealer bad debt reserves that were established at the time loans were made and are specific to each individual dealer. Loans charged off at C&F Finance have first been charged to the dealer bad debt reserves, to the extent that an individual dealer had reserves, and the remainder has been charged to the allowance for loan
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losses. Dealer bad debt reserves are a liability of C&F Finance and payable to individual dealers upon the termination of the relationship with C&F Finance and the payment of outstanding loans associated with a specific dealer. C&F Finance ceased originating loans with a dealer bad debt reserve as of January 1, 2004. However, existing dealer bad debt reserves at December 31, 2003 were retained to absorb future losses for each specific dealer. The provision for loan losses and the corresponding allowance for loan losses at the Consumer Finance segment will increase in future periods as dealer bad debt reserves are reduced by virtue of loan charge-offs or balance pay-offs to dealers. The following table summarizes the dealer bad debt reserves activity:
Dealer bad debt reserves, beginning of period
Dealer bad debt reserves, end of period
Nonperforming Assets
Retail and Mortgage Banking
March 31,
2005
December 31,
2004
Nonperforming assets*
Accruing loans past due for 90 days or more
Allowance for loan losses
Nonperforming assets to total loans**
Allowance for loan losses to total loans**
Allowance for loan losses to nonperforming assets
Consumer Finance
Nonaccrual loans
Dealer bad debt reserves
Nonaccrual consumer finance loans to total consumer finance loans
Allowance for loan losses to total consumer finance loans
Dealer bad debt reserves to total consumer finance loans
Allowance for loan losses and dealer bad debt reserves to total consumer finance loans
Nonperforming assets of the combined Retail and Mortgage Banking segment decreased slightly from $4.3 million at December 31, 2004 to $4.2 million at March 31, 2005. The most significant component of nonperforming assets continued to be one commercial real estate loan relationship. We are closely monitoring this relationship. The nonaccrual principal balance outstanding of this relationship was $2.9 million for which management had allocated a reserve of $767,000 at March 31, 2005. We believe this is an adequate reserve to cover potential losses.
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Nonaccrual loans of the Consumer Finance segment as a percentage of total consumer finance loans declined 7 basis points, and was accompanied by a 6 basis point decline in the ratio of the allowance for loan losses and dealer bad debt reserves to total consumer finance loans. As previously mentioned, C&F Finance no longer originates loans with a dealer bad debt reserve provision. Therefore, the ratio of dealer bad debt reserves to total consumer finance loans declined from 1.15 percent at December 31, 2004 to .91 percent at March 31, 2005. The decline in the dealer bad debt reserves is offset in part by a higher provision for loan losses that resulted in an increase in the ratio of the allowance for loan losses to total consumer finance loans from 7.15% at December 31, 2004 to 7.33% at March 31, 2005.
FINANCIAL CONDITION
At March 31, 2005, the Corporation had total assets of $616.5 million compared to $609.1 million at December 31, 2004. The increase was principally a result of an increase in loans held for investment, which was offset in part by a decline in interest-bearing deposits in other banks. Growth in loan demand was funded by the decline in lower-yielding overnight funds and proceeds from the maturities and calls of securities available for sale and borrowings.
Loan Portfolio
The following table sets forth the composition of the Corporation’s loans held for investment in dollar amounts and as a percentage of the Corporation’s total gross loans held for investment at the dates indicated:
Real estate - mortgage
Real estate - construction
Commercial, financial and agricultural
Equity lines
Consumer- C&F Finance
Total loans
Less unearned loan fees
Less allowance for loan losses
Total loans, net
The increase in loans held for investment occurred predominantly in (1) the variable-rate categories of real estate construction and commercial loans and (2) the fixed-rate category of consumer loans at C&F Finance. Typically, growth in the variable-rate categories will favorably impact net interest margin in a rising interest rate environment. There was also growth in fixed-rate consumer loans at C&F Finance. These loans are funded by variable-rate borrowings; therefore, net interest margin will be negatively impacted in a rising interest rate environment.
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Investment Securities
The following table sets forth the composition of the Corporation’s securities available for sale in dollar amounts at fair value and as a percentage of the Corporation’s total securities available for sale at the dates indicated:
Total debt securities
Total available for sale securities
The decline in securities resulted from maturities and calls during the first quarter of 2005.
Other Borrowings
Borrowings totaled $81.5 million at March 31, 2005 compared to $78.3 million at December 31, 2004. This increase occurred in the Consumer Finance segment’s line of credit and was used to fund loan growth.
Off-Balance Sheet Arrangements
As of March 31, 2005, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004.
Contractual Obligations
As of March 31, 2005, there have been no material changes outside the ordinary course of business to the contractual obligations disclosed in “Management’s Discussion and Analysis” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004.
Liquidity
Liquid assets, which include cash and due from banks, interest-bearing deposits at other banks and nonpledged securities available-for-sale, at March 31, 2005 totaled $59.3 million. The Corporation’s funding sources consist of an established federal funds line with a regional correspondent bank of $14.0 million that had no outstanding balance as of March 31, 2005, an established line with the FHLB that had $20.0 million outstanding under a total line of $116.1 million as of March 31, 2005 and a revolving line of credit with a third party bank that had $52.4 million outstanding under a total line of $60 million as of March 31, 2005. We have no reason to believe these arrangements will not be renewed at maturity.
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As a result of the Corporation’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Corporation maintains overall liquidity sufficient to satisfy its operational requirements and contractual obligations.
Capital Resources
The Corporation’s and the Bank’s actual capital amounts and ratios are presented in the following table.
Minimum Capital
Requirements
Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions
Total Capital (to Risk-Weighted Assets)
Corporation
Bank
Tier I Capital (to Risk-Weighted Assets)
Tier I Capital (to Average Assets)
Effects of Inflation
The effect of changing prices on financial institutions is typically different from other industries as the Corporation’s assets and liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price level indices. Impacts of inflation on interest rates, loan demand and deposits are reflected in the consolidated financial statements.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no significant changes from the quantitative and qualitative disclosures made in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004.
ITEM 4. CONTROLS AND PROCEDURES
The Corporation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Corporation’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Corporation’s disclosure controls and procedures were effective as of March 31, 2005 to ensure that information required to be disclosed by the Corporation in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and regulations and that such information is accumulated and communicated to the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that the Corporation’s disclosure controls and procedures will detect or uncover every situation involving the failure of persons within the Corporation or its subsidiary to disclose material information otherwise required to be set forth in the Corporation’s periodic reports.
Management of the Corporation is also responsible for establishing and maintaining adequate internal control over financial reporting and control of the Corporation’s assets to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. There were no changes in the Corporation’s internal control over financial reporting during the Corporation’s first quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 6. - EXHIBITS
2.1 Stock Purchase Agreement by and between Citizens and Farmers Bank, C&F Financial Corporation, Moore Loans, Inc., Abby W. Moore, Joanne Moore and John D. Moore dated as of August 30, 2002 (incorporated by reference to Exhibit 2.1 to Form 8-K filed on September 3, 2002)
3.1 Articles of Incorporation of C&F Financial Corporation (incorporated by reference to Exhibit 3.1 to Form 10-KSB filed March 29, 1996)
3.2 Bylaws of C&F Financial Corporation (incorporated by reference to Exhibit 3.2 to Form 10-KSB filed March 29, 1996)
31.1 Certification of CEO pursuant to Rule 13a-14(a)
31.2 Certification of CFO pursuant to Rule 13a-14(a)
32 Certification of CEO/CFO pursuant to 18 U.S.C. Section 1350
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Larry G. Dillon
Chairman, President and Chief Executive Officer
(Principal Executive Officer)
/s/ Thomas F. Cherry
Executive Vice President,
Chief Financial Officer and Secretary
(Principal Financial and Accounting Officer)
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