UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 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.)
Eighth and Main Streets
West Point, VA
(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
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
At October 31, 2005, the latest practicable date for determination, 3,135,668 shares of common stock, $1.00 par value, of the registrant were outstanding.
TABLE OF CONTENTS
Part I -Financial Information
Item 1.
Item 2.
Item 3.
Item 4.
Part II -Other Information
Item 6.
Signatures
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 $65,929 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, 3,135,668 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 and dividend income
Interest and fees on loans
Interest on other market investments
Interest on investment securities
U.S. government agencies and corporations
Tax-exempt obligations of states and political subdivisions
Corporate bonds and other
Total interest and dividend income
Interest expense
Savings and interest bearing deposits
Certificates of deposit, $100 or more
Other time deposits
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
Gains 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 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)
December 31, 2004
Comprehensive income
Other comprehensive loss, net of tax Net change in unrealized net holding gains on securities, net of reclassification adjustment
Share repurchase-tender offer
Stock options exercised
Cash dividends
September 30, 2005
Change in unrealized net holding gains on securities during period
Less: reclassification adjustment for gains included in net income
Net change in unrealized net holding gains on securities
3
December 31, 2003
Repurchase of common stock
September 30, 2004
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net income to net cash from operating activities:
Depreciation
Amortization of intangible assets
Accretion of discounts and amortization of premiums on investment securities, net
Net realized gains on calls of 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
Net redemption of Federal Home Loan Bank stock
Net cash used in investing activities
Cash flows from financing activities:
Net increase in demand, interest-bearing demand and savings deposits
Net increase (decrease) in time deposits
Net increase in 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 September 30, 2005, the results of operations for the three months and nine months ended September 30, 2005 and 2004, and cash flows for the nine months ended September 30, 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.
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
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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 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 $345,000 in 2006. This estimate applies only to options issued through September 30, 2005 but not yet vested prior to January 1, 2006. Any options issued after September 30, 2005 will increase compensation expense above this estimate for 2006.
In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 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 nine months ended September 30, 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 No. 123R and its impact on compensation plans throughout the Corporation.
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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
On June 1, 2005, the Corporation made an offer to its shareholders to repurchase up to 180,000 shares of its common stock at a price of $41.00 per share net to sellers in cash. The initial expiration date of the offer was June 30, 2005. The number of shares tendered by the expiration date far exceeded the 180,000 shares initially authorized. Therefore, the Corporation’s Board of Directors extended the expiration date of its offer until July 22, 2005 and increased the number of shares subject to the offer to up to 450,000 shares. The tender offer expired on July 22, 2005 and 427,186 tendered shares of the Corporation’s common stock were accepted on July 27, 2005. The total cost of the share repurchase, including transaction costs, approximated $17.6 million. Refer to Note 7 for a discussion of the Corporation’s issuance of trust preferred securities to partially fund this repurchase.
During the first nine months of 2004, the Corporation repurchased 26,200 shares of its common stock in privately-negotiated transactions and 46,350 shares in open-market transactions at prices from $35.00 to $41.50.
Note 4
Securities in an unrealized loss position at September 30, 2005 are shown below by duration of the period of unrealized loss. 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.
Fair
Value
Unrealized
Loss
Mortgage-backed securities
Obligations of states and political subdivisions
Subtotal-debt securities
Preferred stock
Total temporarily impaired securities
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Securities in an unrealized loss position at December 31, 2004 are shown below by duration of the period of unrealized loss.
U.S government agencies and corporations
Note 5
The Bank has a noncontributory defined benefit plan for which the components of net periodic benefit cost are as follows:
(in 000’s)
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 $462,000 cash payment to the plan. This payment was the maximum tax-deductible contribution for 2004 allowable under the Internal Revenue Code.
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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 operations consist primarily of interest earned on automobile loans.
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.”
Revenues:
Interest income
Other
Total operating income
Expenses:
Personnel expenses
Total operating expenses
Provision for income taxes
Capital expenditures
10
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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 the 30-day LIBOR rate plus 175 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.
Note 7
On July 21, 2005, the Corporation issued $10.0 million of trust preferred securities through a statutory business trust subsidiary. The proceeds of the trust preferred securities were used to fund a portion of the repurchase of 427,186 of common stock at a price of $41 per share net to sellers in cash pursuant to the Corporation’s tender offer to repurchase up to 450,000 of its common stock, which expired on July 22, 2005. The 427,186 tendered shares were accepted by the Corporation on July 27, 2005. The total cost of the repurchase, including transaction costs, approximated $17.6 million.
Trust preferred securities are hybrid securities that are treated as Tier 1 capital for regulatory purposes and debt for income tax purposes. The trust preferred securities mature in September 2035, are redeemable at the Corporation’s option beginning after five years and require quarterly distributions to the holders of the trust preferred securities at a fixed rate of 6.07 percent as to $5.0 million of the securities and at a rate equal to the three-month LIBOR rate plus 1.57 percent as to the remaining $5.0 million, which rate is initially 5.21 percent. The fixed rate portion of the securities converts to the three-month LIBOR rate plus 1.57 percent in September 2010.
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Note 8
On August 1, 2005, the Consumer Finance segment, consisting solely of C&F Finance Company, entered into an agreement with a third-party lender to obtain financing in the form of a secured revolving line of credit of up to $100.0 million and maturing four years from the date of closing. The interest rate on the line is the 30-day LIBOR rate plus from 175 basis points to 180 basis points, depending on the average loan outstanding. This rate represents a reduction of from 70 to 75 basis points from previous financing terms. The outstanding loan balance with the current third-party lender as of September 30, 2005 approximated $63.9 million. The proceeds of the new line were initially used to fund the pay-off of the previous third-party lender and will be used in the future to provide working capital for loan growth and for other operational needs.
Note 9
In May 2005, the Financial Accounting Standards Board issued SFAS No. 154, Accounting Changes and Error Corrections – A Replacement of APB Opinion No. 20 and FASB Statement No. 3. The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Corporation does not anticipate that SFAS No. 154 will have a material effect on its financial statements.
In November 2004, the Emerging Issues Task Force (“EITF”) published Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. generally accepted accounting principles when developing its views. The Task Force also requested that the scope of the impairment issue be expanded to include equity investments and investments subject to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and that the issue be addressed by the Task Force as a separate EITF issue. At the EITF meeting, the Task Force reached a consensus on one issue that certain quantitative and qualitative disclosures should be required for securities accounted for under SFAS No. 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Board ratified the consensus on that one issue at its November 25, 2004 meeting. In September 2004, the Financial Accounting Standards Board directed the FASB staff to issue two proposed FASB Staff Positions: Proposed FSP EITF Issue 03-1-a, which provides guidance for the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays the effective date of Issue 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. In June 2005, the FASB reached a decision whereby they declined to provide additional guidance on the meaning of other-than-temporary impairment. The Board directed the FASB staff to issue EITF 03-1-a as final and to draft a new FSP that will replace EITF 03-1. The final FSP (retitled SFAS 115-1, The Meaning of Other-Than-Temporary Impairment and it Application to Certain Investments) would be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. The Corporation does not anticipate this amendment of SFAS No. 115 will have a material effect on its financial statements
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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 and notes.
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 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.
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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 Company 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 making judgments. 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 our 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 (ROA), (ii) return on average equity (ROE) 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 for the third quarter ended September 30, 2005 increased 10.0 percent to $3.4 million compared to the third quarter of 2004 and net income for the first nine months of 2005 increased 8.3 percent to $9.0 million compared to the first nine months of 2004. Diluted net income per share increased 20.2 percent to $1.01 per share and 13.0 percent to $2.52 per share for the three and nine months ended September 30, 2005, respectively, compared to the same periods in 2004. The Corporation’s ROA was 2.01 percent for the third quarter of 2005 compared with 2.09 percent for the third quarter of 2004 and 1.88 percent for the first nine months of 2005 compared with 1.91 percent for the first nine months of 2004. The Corporation’s ROE was 21.49 percent for the third quarter of 2005 compared with 18.48 percent for the third quarter of 2004 and 17.41 percent for the first nine months of 2005 compared with 16.83 percent for the first nine months of 2004.
Factors influencing 2005 earnings included rising interest rates, utilization of the Corporation’s liquidity to fund loan demand, strong seasonal mortgage loan production and higher operating expenses to support growth. The improvement in earnings per share relative to the increase in net income for 2005, as well as the increase in the Corporation’s ROE, reflected the accretive effect of the tender offer that concluded in the third quarter of 2005 with the Corporation’s repurchase of 427,186 shares of its outstanding shares.
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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 for the quarter ended September 30, 2005 increased 6.6 percent to approximately $1.7 million compared to the third quarter of 2004 and net income for the nine months ended September 30, 2005 increased 11.1 percent to approximately $4.7 million compared to the first nine months of 2004. The improvement in the performance of the Retail Banking segment during these periods resulted from an increase in both the amount and yield of earning assets. These improvements were offset in part by an increase in the provision for loan losses and an increase in operational and administrative expenses to support growth.
During the first nine months of 2005, the Bank installed a new mainframe computer, upgraded its primary operating system and enhanced the operating platform in all branches, which will increase our efficiency and help us offer better customer service. In addition, progress continues on the Bank’s new operations center, which we expect to occupy by the end 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 first quarter of 2006.
Mortgage Banking: Net income for the Mortgage Banking segment for the quarter ended September 30, 2005 increased 35.0 percent to approximately $1.1 million compared to the third quarter of 2004 and net income for the nine months ended September 30, 2005 increased 17.6 percent to approximately $2.5 million compared to the first nine months of 2004. The volume of the mortgage loan applications and the level of the mortgage loan pipeline have followed a typical seasonal pattern in 2005, as reflected in earnings growth in the third quarter. The volume of loans sold in the third quarter and the first nine months of 2005 increased by 40.4 percent and 22.8 percent, respectively, compared to the same periods in 2004, which more than offset the lower profit margins on loans sold caused by product mix and more competitive pricing. For the third quarter of 2005, the amount of loan originations at C&F Mortgage resulting from refinancings was $121.5 million compared to $123.9 million for the third quarter of 2004. Loans originated for new and resale home purchases for these two quarters were $198.2 million and $119.8 million, respectively. For the first nine months of 2005, the amount of loan originations at C&F Mortgage resulting from refinancings was $288.1 million compared to $276.7 million for the first nine months of 2004. Loans originated for new and resale home purchases for these two nine-month periods were $536.3 million and $403.7 million, respectively. Future earnings of the Mortgage Banking segment may 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 for the quarter ended September 30, 2005 decreased 9.2 percent to approximately $555,000 compared to the third quarter of 2004 and net income for the nine months ended September 30, 2005 decreased 1.6 percent to approximately $1.8 million compared to the first nine months of 2004. These declines were attributable to net interest margin compression resulting from increased variable-rate borrowings in a rising rate environment, a higher provision for loans losses attributable to loan growth, and higher operating expenses to support growth and technology investments, offset in part by loan growth in excess of 19 percent.
Earlier in 2005, the Consumer Finance segment completed its conversion to a new loan system, which will create efficiencies and expand capacity for new business. The Consumer Finance segment completed the consolidation and relocation of its operations center to a new location in Richmond, Virginia during the third quarter of 2005. Also, during the third quarter of 2005, the Consumer Finance segment changed third-party lenders for its secured revolving line of credit with financing terms that
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substantially increase the line of credit over time and provide for a rate reduction from the prior terms, as well as lower administration fees. Future earnings of the Consumer Finance segment in the short-term will also 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.
Capital Management. Total assets grew by $63.0 million to $672.1 million during the first nine months of 2005. A detailed discussion of the changes in our financial position is included below in “Financial Condition.” Dividends for the first nine months of 2005 were 73 cents per share versus 66 cents per share in the first nine months of 2004. The weighted average number of shares outstanding in the first nine months of 2005 was 3,454,683 compared to 3,575,794 in the first nine months of 2004. This decrease resulted from the repurchase of 427,186 shares in 2005 versus 89,050 shares throughout 2004. The repurchase of shares in 2005 resulted from a tender offer that concluded in the third quarter of 2005.
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RESULTS OF OPERATIONS
Net Interest Income
Selected Average Balance Sheet Data and Net Interest Margin
Securities
Loans held for sale
Loans held for investment
Fed funds sold / interest bearing deposits at 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 tables show the direct causes of the changes in the components of net interest income on a taxable-equivalent basis from the third quarter of 2004 to the third quarter of 2005 and from the first nine months of 2004 to the first nine months of 2005. 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.
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Total
Increase
Interest income:
Loans
Total interest income
Interest expense:
Change in net interest income
Nine Months EndedSeptember 30, 2005
Net interest income, on a taxable equivalent basis, for the third quarter of 2005 was $9.8 million compared to $8.9 million for the third quarter of 2004. Net interest income, on a taxable equivalent basis, for the first nine months of 2005 was $28.4 million compared to $25.3 million for the first nine months of 2004. The net interest margin for the third quarter of 2005 decreased 25 basis points to 6.31 percent and increased 10 basis points to 6.43 percent for the first nine months of 2005. Average interest-earning assets increased 14.6 percent for the third quarter of 2005 and 10.3 percent for the first nine months of 2005. However, the ratio of interest-earning assets to interest-bearing liabilities declined to 120.8 percent for the third quarter of 2005 compared to 123.7 percent for the third quarter of 2004, contributing to the decline in net interest margin in the third quarter of 2005. There was a minimal change in the ratio of interest-earning assets to interest-bearing liabilities for the first nine months of 2005.
All of the Corporation’s principal business segments experienced loan growth for the three and nine months ended September 30, 2005 compared to the same periods in 2004. Average loans increased $58.4 million for the third quarter of 2005 and $52.6 million for the first nine months of 2005 in the Retail Banking segment. Average loans in the Consumer Finance segment increased $19.9 million for the third quarter of 2005 and $16.9 million for the first nine months of 2005. Average loans held for sale in the Mortgage Banking segment increased $32.2 million for the third quarter of 2005 and $16.9 million for the first nine months of 2005. The increase in loans in the Retail Banking segment was mainly attributable to loan production in the Virginia Peninsula market and residential construction
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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 growth in our newer markets of Tennessee and Northern Virginia, as well as growth in loan volume at our other locations. The increased yields on both loans held for sale and loans held for investment for the three and nine months ended September 30, 2005 resulted from a general increase in interest rates since mid-2004.
Average securities available for sale decreased slightly for the third quarter and the first nine months of 2005; however, their average yield increased slightly for the same periods. 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 2005 as compared to 2004.
Average interest earning deposits at other banks, primarily the FHLB, decreased $29.1 million and $30.6 million for the third quarter and first nine months of 2005, respectively, compared to the same periods in 2004; however, their average yield increased 201 basis points and 166 basis points for the third quarter and first nine months of 2005, respectively, compared to the same periods in 2004. The decline in the average balance resulted from the liquidation of these low-yielding deposits to fund the increase in loan demand. The yield increase reflected the increase in short-term interest rates beginning in mid-2004.
Although average interest-bearing deposits have increased $29.4 million and $18.3 million for the third quarter and the first nine months of 2005, respectively, the increase in interest on deposits has been influenced to a greater extent by the increase in deposit rates. The average cost of deposits increased 68 basis points for the third quarter of 2005 and 39 basis points for the first nine months of 2005. Generally, deposit interest rate increases lag behind the increase in loan interest rates. Although short-term interest rates have increased in 2005, deposits will reprice more gradually as existing certificates of deposit mature in future periods.
The increases in average borrowings of $46.9 million for the third quarter of 2005 compared to the third quarter of 2004 and $27.3 million for the first nine months of 2005 compared to the first nine months of 2004 were attributable to loan growth at the Mortgage Banking and the Consumer Finance segments, as well as the issuance of trust preferred securities to partially fund the Corporation’s repurchase of 427,186 shares of its common stock in the third quarter of 2005. The trust preferred securities have fixed and variable rate components. Loan growth at the Mortgage Banking segment is funded by short-term advances from the FHLB. Loan growth at the Consumer Finance segment is funded by a LIBOR-based line of credit with an unrelated third-party lender. The 126 basis point and 119 basis point increases in the cost of borrowings for the three months and nine months ended September 30, 2005, respectively, were primarily attributable to the rising cost of funds at the Consumer Finance segment.
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. Given these factors, we anticipate a continuation of the declining trend in the net interest margin.
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Noninterest Income
Gain on calls of available for sale securities
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Total noninterest income increased 24.1 percent to $8.2 million for the third quarter of 2005 and 15.0 percent to $20.8 million for the first nine months of 2005 from the comparable periods in 2004. These increases were attributable to (1) higher service charges and fees on deposit accounts at the Retail Banking segment resulting from deposit account growth and higher gains on call of securities, (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 originations.
Noninterest Expenses
Occupancy expense
Total noninterest expense
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Total noninterest expense increased 17.1 percent to $11.3 million for the third quarter of 2005 and 12.2 percent to $31.3 million for the first nine months of 2005 from the comparable periods in 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 in 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 the fourth quarter of 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 third quarter of 2005 totaled $1.5 million, an effective tax rate of 30.4 percent, compared with $1.5 million, or 32.1 percent, for the third quarter of 2004. Income tax expense for the first nine months of 2005 totaled $4.0 million, an effective tax rate of 30.8 percent, compared with $3.7 million, or 30.9 percent, for the first nine months of 2004. There was minimal change in the effective tax rate for the first nine months of 2005 compared to the prior year. The decrease in the effective tax rate for the third quarter of 2005 resulted from tax credits associated with the Bank’s investment in a low-income housing equity fund, the benefit of which was offset in part by higher earnings at the Mortgage Banking segment.
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, reduces the allowance. The following tables summarize the allowance activity for the periods indicated:
Allowance, beginning of period
Loans charged off
Recoveries of loans previously charged off
Net loans charged off
Allowance, end of period
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During the third quarter and first nine months of 2005, the provision for loan losses was $125,000 and $325,000, respectively, at the combined Retail Banking and Mortgage Banking segments. This provision resulted primarily from the impact of loan growth, rather than any deterioration in asset quality. We believe that the current level of the allowance for loan losses at the combined Retail and Mortgage Banking segments is adequate to absorb any losses on existing loans that may become uncollectible.
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The Consumer Finance segment, consisting solely of C&F Finance Company, accounted for the majority of the activity in the allowance for loans losses during the third quarter and first nine months 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 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 phased out by virtue of loan charge-offs or balance pay-offs to dealers. The following table summarizes the dealer bad debt reserves activity:
Dealer reserves, beginning of period
Dealer reserves, end of period
The increases in net charge-offs to the allowance for loan losses for the third quarter and the first nine months of 2005 resulted from loan growth and a decrease in loan losses charged to the dealer bad debt reserves because C&F Finance no longer originates loans with dealer bad debt reserves. We believe that the current level of the allowance for loan losses at the Consumer Finance segment is adequate to absorb any losses on existing loans that may become uncollectible.
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Nonperforming Assets
Retail and Mortgage Banking
September 30,
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
Total nonaccrual and accruing loans past due for 90 days or more 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 $4.1 million at September 30, 2005. Accruing loans past due 90 days or more increased from $1.6 million at December 31, 2004 to $2.8 million at September 30, 2005. The most significant component of nonperforming and 90-day delinquent accruing assets was one commercial relationship. The loans to this borrower are in the process of collection and we believe allocated reserves are adequate to cover potential losses.
Total nonaccrual loans and accruing loans past due for 90 days or more of the Consumer Finance segment as a percentage of total consumer finance loans decreased slightly from 1.94 percent at December 31 2004 to 1.92 percent at September 30, 2005. The ratio of the allowance for loan losses and dealer bad debt reserves to total consumer finance loans declined 28 basis points since December 31, 2004. 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 .62 percent at September 30, 2005. The decline in the dealer bad debt reserves was 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 percent at December 31, 2004 to 7.40 percent at September 30, 2005.
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FINANCIAL CONDITION
At September 30, 2005, the Corporation had total assets of $672.1 million compared with $609.1 million at December 31, 2004. The increase was principally a result of increases in loans held for sale, loans held for investment and corporate premises, which were offset in part by declines in securities available for sale and interest-bearing deposits in other banks. Growth in loan demand was funded by lowering the amount the Corporation placed in lower-yielding overnight funds, utilizing proceeds from calls and maturities of investment securities, deposit growth and additional borrowings. The increase in corporate premises resulted from construction in process on the Bank’s new operations center and its two new Virginia Peninsula branches, as well as the acquisition of a new operations center for the Consumer Finance segment.
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
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 loans, commercial loans and equity lines of credit 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, which 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 available for sale occurred primarily in securities of U.S. government agencies and corporations and resulted from maturities and calls during the first nine months of 2005.
Deposits totaled $489.8 million at September 30, 2005 compared with $447.1 million at December 31, 2004. This increase was primarily attributable to (i) the increase in noninterest-bearing deposits, which totaled $85.4 million at September 30, 2005 compared with $78.7 million at December 31, 2004 and (ii) the increase in time deposits, which totaled $214.1 million at September 30, 2005 compared with $182.5 million at December 31, 2004. These increases occurred most significantly in the the Bank’s Central and Richmond regions.
Other Borrowings
Borrowings totaled $106.6 million at September 30, 2005 compared with $78.3 million at December 31, 2004. This increase occurred in (i) the Consumer Finance segment’s line of credit to fund this segment’s loan growth, (ii) short-term borrowings from a third-party lender for general corporate purposes and (iii) the issuance of trust preferred securities to partially fund the Corporation’s tender offer in the third quarter of 2005.
Off-Balance Sheet Arrangements
As of September 30, 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 September 30, 2005, other than as described below, 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.
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On July 21, 2005, the Corporation issued $10.0 million of trust preferred securities through a statutory business trust subsidiary. The proceeds of the trust preferred securities were used to fund a portion of the Corporation’s tender offer. In addition, on August 1, 2005, the Consumer Finance segment entered into an agreement with a third-party lender to obtain financing in the form of a secured revolving line of credit with a current credit limit of $85.0 million. These obligations are described in Notes 7 and 8 to the financial statements contained herein.
Liquidity
Liquid assets, which include cash and due from banks, interest-bearing deposits at other banks and nonpledged securities available-for-sale, at September 30, 2005 totaled $58.0 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 September 30, 2005, an established line with the FHLB that had $15.0 million outstanding under a total line of $117.4 million as of September 30, 2005, an unsecured revolving line of credit with a third-party lender that had $7.0 million outstanding under a total line of $7.0 million as of September 30, 2005 and a revolving line of credit with a third-party bank that had $63.9 million outstanding under a total line of $85.0 million as of September 30, 2005. Management has no reason to believe these arrangements will not be renewed at maturity.
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.
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Capital Resources
The Corporation’s and the Bank’s actual capital amounts and ratios are presented in the following table.
Minimum To Be
Well Capitalized
Under Prompt
Corrective Action
Provisions
As of September 30, 2005:
Total Capital (to Risk-Weighted Assets)
Corporation*
Bank
Tier I Capital (to Risk-Weighted Assets)
Tier I Capital (to Average Assets)
As of December 31, 2004:
Corporation
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 September 30, 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 third quarter ended September 30, 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 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer Purchases of Equity Securities
Maximum Numberof Shares that
May Yet BePurchased Underthe Program1
July 1-31, 2005
August 1-31, 2005
September 1-30, 2005
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ITEM 6. EXHIBITS
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)
Certain instruments relating to trust preferred securities not being registered have been omitted in accordance with Item 601(b)(4)(iii) of Regulation S-K. The registrant will furnish a copy of any such instrument to the Securities and Exchange Commission upon its request.
10.19 Loan and Security Agreement by and between Wells Fargo Financial Preferred Capital, Inc. and C&F Finance Company dated as of August 1, 2005 (incorporated by reference to Exhibit 10.19 to Form 10-Q filed August 5, 2005)
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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
/s/ Thomas F. Cherry
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