United States Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the transition period from __________to
Commission File Number:333-203449
(Exact name of small business issuer as specified in its charter)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
As of November 1, 2015, there were 5,735,393 shares of common stock, $1.00 par value per share, issued and outstanding.
TABLE OF CONTENTS
FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q of SmartFinancial, Inc. (“we”, “our” or “us” on a consolidated basis) contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Such statements include projections, predictions, expectations or statements as to beliefs or future events or results or refer to other matters that are not historical facts. Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking statements contained in this quarterly report are based on various factors and were derived using numerous assumptions. In some cases, you can identify these forward-looking statements by words like “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “intend”, “believe”, “estimate”, “predict”, “potential”, or “continue” or the negative of those words and other comparable words. You should be aware that those statements reflect only our predictions. If known or unknown risks or uncertainties should materialize, or if any one or more of our material underlying assumptions should prove inaccurate, actual results could differ materially from past results and those anticipated, estimated or projected. You should bear this in mind when reading this quarterly report and not place undue reliance on these forward-looking statements. Factors that might cause such differences include, but are not limited to:
The forward-looking statements speak only as of the date on which they are made, and, except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
SmartFinancial, Inc. and Subsidiaries
Consolidated Balance Sheets
The Notes to Consolidated Financial Statements are an integral part of these statements.
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
SmartFinancial, Inc. and subsidiaries
Consolidated Statement of Changes in Stockholders' Equity - Unaudited
For the Nine Months Ended September 30, 2015
Consolidated Statements of Cash Flows
SMARTFINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Note 1. Presentation of Financial Information
Nature of Business-SmartFinancial, Inc. (the “Company”) is a bank holding company whose primary business is performed by its wholly owned subsidiaries, SmartBank and Cornerstone Community Bank (collectively referred to herein as the “Banks”). As discussed more fully in Note 7 below, the Company acquired Cornerstone Bancshares, Inc., the one bank holding company of Cornerstone Community Bank, in a merger that became effective August 31, 2015. The Banks provide a full range of banking services to the Sevierville, Knoxville and Chattanooga, Tennessee markets. SmartBank also provides a full range of banking services to the Florida panhandle. Additionally, Cornerstone Community Bank has established a loan production office in Dalton, Georgia and SmartBank has established a loan production in Panama City, Florida.
Interim Financial Information (Unaudited)-The financial information in this report for September 30, 2015 and September 30, 2014 has not been audited. The information included herein should be read in conjunction with the Company’s 2014 annual consolidated financial statements and footnotes included elsewhere herein and in our Form 8-K/A filed on November 12, 2015. The consolidated financial statements presented herein conform to U.S. generally accepted accounting principles and to general industry practices. In the opinion of SmartFinancial’s management, the accompanying interim financial statements contain all material adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.
Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses, foreclosed assets and deferred tax assets.
Consolidation-The accompanying consolidated financial statements include the accounts of SmartFinancial and the Banks. Substantially all intercompany transactions, profits and balances have been eliminated.
Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation. The reclassifications had no effect on net income, total assets or stockholders’ equity as previously reported.
Accounting Policies-During interim periods, SmartFinancial follows the accounting policies set forth in its annual audited financial statements for the year ended December 31, 2014 as filed with the Securities and Exchange Commission. Since December 31, 2014, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.
In May 2014, the FASB issued Accounting Standards Update 2014-09, "Revenue from Contracts with Customers." This update is a joint project with the International Accounting Standards Board initiated to clarify the principles for recognizing revenue and to develop a common revenue standard that is meant to remove inconsistencies and weaknesses in revenue requirements, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices, provide more useful information to users of financial statements and simplify the preparation of financial statements. The guidance in this update supersedes the revenue recognition requirements in ASC Topic 605, "Revenue Recognition" and most industry-specific guidance throughout the Industry Topics of Codification. This update is effective for annual and interim periods beginning after December 15, 2016. SmartFinancial does not believe this update will have a significant impact on the consolidated financial statements.
Earnings per Common Share- Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.
The following is a summary of the basic and diluted earnings per share for the three and nine month periods ended September 30, 2015 and September 30, 2014.
For the three and nine months ended September 30, 2015 and 2014, the effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings per common share because the exercise price of such options is higher than the market price. There are 22,309 antidilutive stock options as of September 30, 2015. There were no antidilutive stock options as of September 30, 2014.
Note 2. Stock Based Compensation
The Company has one equity incentive plan administered by the Board of Directors, and four plans or programs, pursuant to which the Company has outstanding prior grants. These plans are described below:
Legacy Cornerstone Bancshares, Inc. 2002 Long Term Incentive Plan – The plan provided Cornerstone Bancshares, Inc. officers and employees incentive stock options or non-qualified stock options to purchase shares of common stock. The exercise price for incentive stock options was not less than 100 percent of the fair market value of the common stock on the date of the grant. The exercise price of the non-qualified stock options was equal to or more or less than the fair market value of the common stock on the date of the grant.
Legacy Cornerstone Non-Qualified Plan Options — During 2013 and 2014, Cornerstone issued non-qualified options to employees and directors. The options were originally documented in 2013 as being issued out of the Cornerstone Bancshares, Inc. 2002 Long Term Incentive Plan but that plan expired in 2012. The non-qualified options are governed by the grant document issued to the holders which incorporate the terms of the plan by reference.
Legacy SmartBank Stock Option Plan – This plan was assumed by the Company on August 31, 2015. The plan provides for incentive stock options and nonqualified stock options. The maximum number of common shares that can be sold or optioned under the plan is 500,000 shares. Under the plan, the exercise price of each option shall not be less than 100 percent of the fair market value of the common stock on the date of grant.
Legacy SmartFinancial, Inc. 2010 Incentive Plan - This plan was assumed by the Company on August 31, 2015. This plan provides for incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, performance awards, dividend equivalents and stock or other stock-based awards. The maximum number of common shares that can be sold or optioned under the plan is 500,000 shares. Under the plan, the exercise price of each option shall not be less than 100 percent of the fair market value of the common stock on the date of grant.
2015 Stock Incentive Plan – This plan provides for incentive stock options, nonqualified stock options, and restricted stock. The maximum number of shares of common stock that can be sold or optioned under the plan is 2,000,000 shares. The term of each option shall be no more than ten years from the date of grant. In the case of an incentive stock option granted to a participant who, at the time the option is granted, owns stock representing more than ten percent of the voting power of all classes of stock of the Company or any parent or subsidiary thereof, the term of the option shall be five years from the date of grant or such shorter term as may be provided in the award agreement
The per share exercise price for the shares to be issued upon exercise of an option shall be such price as is determined by the plan administrator, subject to the following: In the case of an incentive stock option: (1) granted to an employee who, at the time of grant of such option, owns stock representing more than ten percent of the voting power of all classes of stock of the company or any parent or subsidiary thereof, the exercise price shall be no less than one hundred and ten percent of the fair market value per share on the date of grant; or (2) granted to any other employee, the per share exercise price shall be no less than one hundred percent of the fair market value per share on the date of grant. In the case of a nonstatutory stock option, the per share exercise price shall be no less than one hundred percent of the fair market value per share on the date of grant, unless otherwise determined by the Administrator.
The incentive stock options vest 30 percent on the second anniversary of the grant date, 60 percent on the third anniversary of the grant date and 100 percent on the fourth anniversary of the grant date, and the non-qualified stock options vest 50 percent on the first anniversary of the grant date and 100 percent on the second anniversary of the grant date.
A summary of the status of these stock option plans is presented in the following table:
Information pertaining to options outstanding at September 30, 2015, is as follows:
The Company recognized stock-based compensation expense of $ 111,184 and $10,270 for the periods ended September 30, 2015 and September 30, 2014, respectively. The total fair value of shares underlying the options which vested during the periods ended September 30, 2015 and September 30, 2014, was $96,907 and $95,370, respectively. There were no income tax benefits recognized for the exercise of options for the periods ended September 30, 2015 and December 31, 2014.
The intrinsic value of options exercised during the period ended September 30, 2015 was $78,968. The aggregate intrinsic value of total options outstanding and exercisable options at September 30, 2015 was $4,281,557 and $4,278,005, respectively. Cash received from options exercised under all share-based payment arrangements for the period ended September 30, 2015, was approximately $133,900.
Information related to non-vested options for the period ended September 30, 2015, is as follows:
As of September 30, 2015, there was approximately $647,000 of total unrecognized compensation cost related to nonvested stock-based compensation arrangements granted under the Plans. The cost is expected to be recognized over a weighted-average period of 4.0 years.
The weighted average grant date fair value of all stock options granted during the nine months ended September 30, 2015 was $12.31. This was determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:
There were no stock options granted during the nine months period ended September 30, 2014.
Note 3. Securities
The amortized cost and fair value of securities available-for-sale at September 30, 2015 and December 31, 2014 are summarized as follows:
At September 30, 2015, securities with a fair value totaling approximately $124.5 million were pledged to secure public funds, securities sold under agreements to repurchase, as collateral for federal funds purchased from other financial institutions and serve as collateral for borrowings at the Federal Home Loan Bank.
For the nine months ended September 30, 2015 and 2014, there were available-for-sale securities sold with proceeds totaling $10,968,362 and $9,003,601, respectively, which resulted in gross gains realized of $52,255 and $91,925, respectively and gross losses of $0 and $96,099, respectively. For the three months ended September 30, 2015 and September 30, 2014, there were no securities sold.
The amortized cost and estimated market value of securities at September 30, 2015, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following tables present the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available-for-sale have been in a continuous unrealized loss position, as of September 30, 2015 and December 31, 2014:
Upon acquisition of a security, the Banks determine the appropriate impairment model that is applicable. If the security is a beneficial interest in securitized financial assets, the Banks use the beneficial interests in securitized financial assets impairment model. If the security is not a beneficial interest in securitized financial assets, the Banks use the debt and equity securities impairment model. The Banks conduct periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred. The Banks do not have any securities that have been classified as other-than-temporarily-impaired at September 30, 2015 or December 31, 2014.
At September 30, 2015, the categories of temporarily impaired securities, and management’s evaluation of those securities, are as follows:
U.S. Government-sponsored enterprises:At September 30, 2015, two investments in U.S. GSE securities had unrealized losses. These unrealized losses related principally to changes in market interest rates. The contractual terms of the investments does not permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Banks do not intend to sell the investments and it is more likely than not that the Banks will not be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Banks do not consider these investments to be other-than temporarily impaired at September 30, 2015.
Municipal securities: At September 30, 2015, eight investments in obligations of municipal securities had unrealized losses. The Banks believes the unrealized losses on those investments were caused by the interest rate environment and do not relate to the underlying credit quality of the issuers. Because the Banks do not intend to sell the investments and it is not more likely than not that the Banks will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Banks do not consider these investments to be other-than-temporarily impaired at September 30, 2015.
Mortgage-backed securities: At September 30, 2015, thirty-one investments in residential mortgage-backed securities had unrealized losses. This impairment is believed to be caused by the current interest rate environment. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because the Banks do not intend to sell the investments and it is not more likely than not that the Banks will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Banks do not deem those investments to be other-than-temporarily impaired at September 30, 2015.
Note 4. Loans and Allowance for Loan Losses
At September 30, 2015 and December 31, 2014, loans are summarized as follows (in thousands):
The following describe risk characteristics relevant to each of the portfolio segments:
Commercial Real Estate: Commercial real estate loans include owner-occupied commercial real estate loans and loans secured by income-producing properties. Owner-occupied commercial real estate loans to operating businesses are long-term financing of land and buildings. These loans are repaid by cash flow generated from the business operation. Real estate loans for income-producing properties such as apartment buildings, office and industrial buildings, and retail shopping centers are repaid from rent income derived from the properties. Loans within this portfolio segment are particularly sensitive to the valuation of real estate.
Consumer Real Estate: Consumer real estate loans include real estate loans secured by first liens, second liens, or open end real estate loans, such as home equity lines. These are repaid by various means such as a borrower's income, sale of the property, or rental income derived from the property. One to four family first mortgage loans are repaid by various means such as a borrower's income, sale of the property, or rental income derived from the property. Loans within this portfolio segment are particularly sensitive to the valuation of real estate.
Construction and Land Development:Loans for real estate construction and development are repaid through cash flow related to the operations, sale or refinance of the underlying property. This portfolio segment includes extensions of credit to real estate developers or investors where repayment is dependent on the sale of the real estate or income generated from the real estate collateral. Loans within this portfolio segment are particularly sensitive to the valuation of real estate.
Commercial and Industrial: The commercial and industrial loan portfolio segment includes commercial, financial, and agricultural loans. These loans include those loans to commercial customers for use in normal business operations to finance working capital needs, equipment purchases, or expansion projects. Loans are repaid by business cash flows. Collection risk in this portfolio is driven by the creditworthiness of the underlying borrower, particularly cash flows from the customers' business operations.
Consumer and Other: The consumer loan portfolio segment includes direct consumer installment loans, overdrafts and other revolving credit loans, and educational loans. Loans in this portfolio are sensitive to unemployment and other key consumer economic measures.
Credit Risk Management:
The Company employs a credit risk management process with defined policies, accountability and routine reporting to manage credit risk in the loan portfolio segments. Credit risk management is guided by credit policies that provide for a consistent and prudent approach to underwriting and approvals of credits. Within the Credit Policy, procedures exist that elevate the approval requirements as credits become larger and more complex. All loans are individually underwritten, risk-rated, approved, and monitored.
Responsibility and accountability for adherence to underwriting policies and accurate risk ratings lies in each portfolio segment. For the consumer real estate and consumer and other portfolio segments, the risk management process focuses on managing customers who become delinquent in their payments. For the other portfolio segments, the risk management process focuses on underwriting new business and, on an ongoing basis, monitoring the credit of the portfolios, including a third party review of the largest credits on an annual basis or more frequently as needed. To ensure problem credits are identified on a timely basis, several specific portfolio reviews occur periodically to assess the larger adversely rated credits for proper risk rating and accrual status.
Credit quality and trends in the loan portfolio segments are measured and monitored regularly. Detailed reports, by product, collateral, accrual status, etc., are reviewed by the Senior Credit Officer and the Directors Loan Committee.
The allowance for loan losses is a valuation reserve allowance established through provisions for loan losses charged against income. The allowance for loan losses, which is evaluated quarterly, is maintained at a level that management deems sufficient to absorb probable losses inherent in the loan portfolio. Loans deemed to be uncollectible are charged against the allowance for loan losses, while recoveries of previously charged-off amounts are credited to the allowance for loan losses. The allowance for loan losses is comprised of specific valuation allowances for loans evaluated individually for impairment, general allocations for pools of homogeneous loans with similar risk characteristics and trends, and an unallocated component that reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The allowance for loan losses related to specific loans is based on management's estimate of potential losses on impaired loans as determined by ( 1) the present value of expected future cash flows; (2) the fair value of collateral if the loan is determined to be collateral dependent or (3) the loan's observable market price. The Company's homogeneous loan pools include commercial real estate loans, consumer real estate loans, construction and land development loans, commercial and industrial loans, and consumer and other loans. The general allocations to these loan pools are based on the historical loss rates for specific loan types and the internal risk grade, if applicable, adjusted for both internal and external qualitative risk factors.
The qualitative factors considered by management include, among other factors, (1) changes in local and national economic conditions; (2) changes in asset quality; (3) changes in loan portfolio volume; (4) the composition and concentrations of credit; (5) the impact of competition on loan structuring and pricing; (6) the impact of interest rate changes on portfolio risk and (7) effectiveness of the Company's loan policies, procedures and internal controls. The total allowance established for each homogeneous loan pool represents the product of the historical loss ratio and the total dollar amount of the loans in the pool.
SmartFinancial follows the loan impairment accounting guidance in ASC Topic 310. A loan is considered impaired when, based on current information and events, it is probable that SmartFinancial will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming loans and loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in interest rates, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collections.
The composition of loans by loan classification for impaired and performing loan status at September 30, 2015 and December 31, 2014, is summarized in the tables below (amounts in thousands):
The following tables show the allowance for loan losses allocation by loan classification for impaired and performing loans as of September 30, 2015 and December 31, 2014 (amounts in thousands):
There was no allowance for PCI loans at September 30, 2015 or December 31, 2014.
The following tables detail the changes in the allowance for loan losses for the nine month period ending September 30, 2015 and year ending December 31, 2014, by loan classification (amounts in thousands):
The following is an analysis of the impaired loan portfolio detailing the related allowance recorded as of September 30, 2015 and December 31, 2014 (amounts in thousands):
PCI loans: None in 2015
A description of the general characteristics of the risk grades used by the Company is as follows:
Pass:Loans in this risk category involve borrowers of acceptable-to-strong credit quality and risk who have the apparent ability to satisfy their loan obligations. Loans in this risk grade would possess sufficient mitigating factors, such as adequate collateral or strong guarantors possessing the capacity to repay the debt if required, for any weakness that may exist.
Special Mention: Loans in this risk grade are the equivalent of the regulatory definition of "Other Assets Especially Mentioned" classification. Loans in this category possess some credit deficiency or potential weakness, which requires a high level of management attention. Potential weaknesses include declining trends in operating earnings and cash flows and /or reliance on the secondary source of repayment. If left uncorrected, these potential weaknesses may result in noticeable deterioration of the repayment prospects for the asset or in the Company's credit position.
Substandard: Loans in this risk grade are inadequately protected by the borrower's current financial condition and payment capability or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful:Loans in this risk grade have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or orderly repayment in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimated loss is deferred until its more exact status may be determined.
Uncollectible: Loans in this risk grade are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Charge-offs against the allowance for loan losses are taken in the period in which the loan becomes uncollectible. Consequently, the Company typically does not maintain a recorded investment in loans within this category.
The following tables outline the amount of each loan classification and the amount categorized into each risk rating as of September 30, 2015 and December 31, 2014 (amounts in thousands):
Non PCI Loans
PCI Loans
A loan is considered past due if any required principal and interest payments have not been received as of the date such payments were required to be made under the terms of the loan agreement. Generally, management places a loan on nonaccrual when there is a clear indicator that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is generally when a loan is 90 days past due.
The following tables present the aging of the recorded investment in loans and leases as of September 30, 2015 and December 31, 2014 (amounts in thousands):
Impaired loans also include loans that the Company has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that the Banks may have to otherwise incur. At September 30, 2015 and December 31, 2014, the Company has loans of approximately $5,015,000 and $5,563,000, respectively, that were modified in troubled debt restructurings. Troubled commercial loans are restructured by specialists within our Special Asset department and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce the Company’s overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral terms, additional collateral or other similar strategies.
There were no troubled debt restructurings during the nine month period ended September 30,2015.
The following table presents a summary of loans that were modified as troubled debt restructurings during the nine month period ended September 30, 2014 (amounts in thousands):
There were no loans that were modified as troubled debt restructurings during the past twelve months and for which there was a subsequent payment default.
The Company has acquired loans which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. The carrying amount of those loans is as follows:
Activity related to the accretable portion of the purchase discount on loans acquired with deteriorated credit quality is as follows for the three and nine months period ended September 30, 2015:
The Company did not increase the allowance for loan losses on purchase credit impaired loans during the three or nine month periods ended September 30, 2015.
Purchased credit impaired loans acquired during the nine month period ended September 30, 2015 for which it was probable at acquisition that all contractually required payments would not be collected are as follows:
Note 5. Commitments and Contingent Liabilities
Off Balance Sheet Arrangements - In the normal course of business, the Banks have entered into off-balance sheet financial instruments which include commitments to extend credit (i.e., including unfunded lines of credit) and standby letters of credit. Commitments to extend credit are usually the result of lines of credit granted to existing borrowers under agreements that the total outstanding indebtedness will not exceed a specific amount during the term of the indebtedness. Typical borrowers are commercial concerns that use lines of credit to supplement their treasury management functions; thus their total outstanding indebtedness may fluctuate during any time period based on the seasonality of their business and the resultant timing of their cash flows. Other typical lines of credit are related to home equity loans granted to consumers. Commitments to extend credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.
Standby letters of credit are generally issued on behalf of an applicant (our client) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the Banks under certain prescribed circumstances. Subsequently, the Banks would seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.
The Banks follow the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each client’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment and personal property.
The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should customers default on their resulting obligation to the Banks the maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.
A summary of the Banks’ total contractual amount for all off-balance sheet commitments at September 30, 2015 is as follows:
Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at September 30, 2015 will not have a material effect on SmartFinancial’s consolidated financial statements.
Note 6. Fair Value Disclosures
Fair Value Measurements:
SmartFinancial uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurements and Disclosures” ASC Topic 820, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
ASC Topic 820 provides a consistent definition of fair value, which focuses on exit price in an orderly transaction between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
ASC Topic 820 also establishes a three-tier fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value, as follows:
Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that SmartFinancial has the ability to access.
Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.
Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.
The following methods and assumptions were used by SmartFinancial in estimating fair value disclosures for financial instruments.
Cash and cash equivalents:
The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets. Cash and cash equivalents are classified as Level 1 of the fair value hierarchy.
Securities:
Fair values are estimated using pricing models and discounted cash flows that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, and credit spreads. Securities classified as available-for-sale are reported at fair value utilizing Level 2 inputs.
The carrying value of restricted investments approximates fair value based on the redemption provisions of the restrictive entities. Restricted investments are classified as Level 3 of the fair value hierarchy.
Loans:
For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed-rate loans are estimated using discounted cash flow analysis, using market interest rates for comparable loans. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Accounting by Creditors for Impairment of a Loan.”
Deposits:
The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date. The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits. Generally, Level 3 inputs are utilized in this estimate.
Federal funds purchased and securities sold under agreements to repurchase:
The carrying amount of these liabilities approximates their estimated fair value. These liabilities are included in Level 3 of the fair value hierarchy.
Federal Home Loan Bank advances and other borrowings:
The fair value of these fixed rate advances is estimated based on discounted contractual cash flows using current incremental borrowing rates for similar type borrowing arrangements. These liabilities are included in Level 3 of the fair value hierarchy.
Accrued interest:
The carrying amounts of accrued interest approximate fair value. Accrued interest is included in Level 3 of the fair value hierarchy.
Commitments to extend credit, letters of credit and lines of credit:
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.
Assets and liabilities recorded at fair value on a recurring basis are as follows.
SmartFinancial has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs. Additionally, there were no transfers between Level 1 and Level 2 in the fair value hierarchy.
Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The tables below present information about assets and liabilities on the balance sheet at September 30, 2015 and December 31, 2014 which are measured at fair value on a nonrecurring basis.
Loans considered impaired under ASC 310-10-35, “Receivables”, are loans for which, based on current information and events, it is probable that SmartFinancial will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent.
The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above.
Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at fair value less estimated costs to sell upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, a loss is recognized.
For Level 3 assets measured at fair value on a non-recurring basis as of September 30, 2015, the significant unobservable inputs used in the fair value measurements are presented below.
The carrying amount and estimated fair value of SmartFinancial’s financial instruments at September 30, 2015 and December 31, 2014 are as follows (in thousands):
Note 7. Business Combination
On June 18, 2015, the shareholders of the Company approved a merger with Cornerstone Bancshares, Inc. (Cornerstone) ticker symbol CSBQ, the one bank holding company of Cornerstone Community Bank, which became effective August 31, 2015. The Company’s shareholders received 1.05 shares of Cornerstone common stock in exchange for each share of the Company’s common stock. After the merger, shareholders of the Company owned approximately 56% of the outstanding common stock of the combined entity on a fully diluted basis, after taking into account the exchange ratio and new shares issued as part of a capital raise through a private placement.
While Cornerstone was the acquiring entity for legal purposes, the merger is being accounted for as a reverse merger using the acquisition method of accounting, in accordance with the provisions of FASB ASC 805-10 Business Combinations. Under this guidance, for accounting purposes, the Company is considered the acquirer in the merger, and as a result the historical financial statements of the combined entity will be the historical financial statements of the Company.
The merger was effected by the issuance of shares of Cornerstone stock to shareholders of the Company. The assets and liabilities of Cornerstone as of the effective date of the merger were recorded at their respective estimated fair values and combined with those of the Company. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill.
In periods following the merger, the financial statements of the combined entity will include the results attributable to Cornerstone Community Bank beginning on the date the merger was completed.
The following table details the preliminary estimated financial impact of the merger, including the calculation of the purchase price, the allocation of the purchase price to the fair values of net assets assumed, and goodwill recognized:
Pro forma data for the nine months ended September 30, 2015 and 2014 in the table below presents information as if the merger occurred at the beginning of each period.
Net interest income (in thousands)
Net income available to common shareholders (in thousands)
Supplemental pro forma earnings in the above table for the nine months ended 2015 and 2014 include $1,027 and $0 of nonrecurring costs, respectively
Net Interest Margin Analysis
Taxable Equivalent Basis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SmartFinancial is a bank holding company and the parent company of the Banks, Tennessee banking corporations which operate primarily in East Tennesse and the Florida Panhandle. The Banks have ten full-service banking offices located in Eastern Tennessee, two full-service banking offices in the Florida Panhandle, and loan production offices located in Dalton, Georgia and Panama City, Florida. The Banks’ business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Banks are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Banks are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.
The following is a discussion of SmartFinancial’s financial condition at September 30, 2015 and December 31, 2014 and our results of operations for the three months and nine months ended September 30, 2015 and 2014. The purpose of this discussion is to focus on information about SmartFinancial’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with SmartFinancial’s consolidated financial statements and the related notes included elsewhere herein along with our Form 8-K/A filed November 12, 2015. Amounts in the narrative are shown in thousands, except for numbers of shares and stock options, per share amounts and as otherwise noted.
Critical Accounting Policies
SmartFinancial’s accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our critical accounting policies are integral to understanding the results reported. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that SmartFinancial reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.
Purchased Loans
The fair values of purchased loans with evidence of credit deterioration, purchased credit impaired loans (“PCI loans”), are recorded net of accretable discount. Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized in interest income over the remaining life of the loan when there is reasonable expectation about the amount and timing of such cash flows. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is the nonaccretable difference. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior changes or a reclassification of the difference from nonaccretable to accretable with a positive impact on the accretable discount. Purchased loans are initially recorded at fair value at acquisition date. Accretable discounts related to certain fair value adjustments are accreted into income over the estimated lives of the loans.
SmartFinancial accounts for performing loans acquired in the acquisition using the expected cash flows method of recognizing discount accretion based on the acquired loans' expected cash flows. Purchased performing loans are recorded at fair value, including a credit discount. Credit losses on acquired performing loans are estimated based on analysis of the performing portfolio. Such estimated credit losses are recorded as nonaccretable discounts in a manner similar to purchased impaired loans. The fair value discount other than for credit loss is accreted as an adjustment to yield over the estimated lives of the loans. A provision for loan losses is recorded for any deterioration in these loans subsequent to the acquisition.
Allowance for Loan Losses
The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan losses and reduced through loan charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance.
Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact SmartFinancial’s net income as a result of the change in the provision for loan losses. Refer to Note 4 in the notes to SmartFinancials’ consolidated financial statements for a discussion of methodology of establishing the allowance.
Estimates of Fair Value
Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. SmartFinancial’s available-for-sale securities are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. SmartFinancial uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.
Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that SmartFinancial make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate SmartFinancial’s assessments regarding assumptions that market participants would use in pricing the asset or the liability.
Changes in fair value could materially impact our financial results. Refer to Note 6, “Fair Value Disclosures,” in the notes to SmartFinancial’s consolidated financial statements for a discussion of the methodology in calculating fair value.
Income Taxes
SmartFinancial is subject to various taxing jurisdictions where the Company conducts business. Management estimates income tax expense based on amounts expected to be owed to these jurisdictions. SmartFinancial evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.
The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and is reported in other liabilities or other assets, respectively, in SmartFinancial’s consolidated balance sheets. SmartFinancial assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management’s evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.
SmartFinancial periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, management evaluates the deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 9, “Income Taxes,” to SmartFinancial’s consolidated financial statements for the year ended December 31, 2014 set forth in Form S-4 filed April 16, 2015 for more information.
Merger Between SmartFinancial, Inc. and Cornerstone Bancshares, Inc.
On June 18, 2015, the shareholders of legacy SmartFinancial, Inc. (“legacy SmartFinancial”) approved a merger with Cornerstone Bancshares, Inc. (“Cornerstone”), which was renamed SmartFinancial, Inc. (“SmartFinancial”) following the merger which became effective August 31, 2015. Each outstanding share and option to purchase a share of legacy SmartFinancial converted into the right to receive 1.05 shares of Cornerstone common stock. After the merger, legacy SmartFinancial’s shareholders owned approximately 56.4% of the outstanding common stock of SmartFinancial, Cornerstone’s shareholders owned approximately 30.1% of the outstanding common stock of SmartFinancial, and shareholders taking place in the private placment owned approximately 13.5% of the outstanding common stock of SmartFinancial.
The merger was a reverse merger using the acquisition method of accounting, in accordance with the provisions of ASC 805-10, “Business Combinations”. As a result, the historical financial statements of SmartFinancial will be the historical financial statements of legacy SmartFinancial. The assets and liabilities of Cornerstone as of the effective date of the merger were recorded at their respective estimated fair values and added to those of legacy SmartFinancial. Any excess of purchase price over the net estimated fair values of the acquired assets and assumed liabilities of Cornerstone were allocated to all identifiable intangibles assets. Any remaining excess was then allocated to goodwill.
The merger increased SmartFinancial’s total revenue by approximately $1,937 and increased net income before taxes by approximately $697 for both the three and nine months ended September 30, 2015. The earnings growth was offset somewhat by an increase in non-interest expenses related to the merger. Salaries expense totaled approximately $3,187 and $7,724 for the three and nine months ended September 30, 2015 compared to approximately $2,495 and $6,828 for the same periods in 2014, an increase of approximately $692 and $895 between the respective periods, most of which is attributed to the addition of Cornerstone personnel. Expenses related to the merger totaled approximately $748 and $1,003 for the three and nine months ended September 30, 2015, respectively. These expenses were related to various professional fees for legal, accounting and other consultants. These and other factors that contributed to SmartFinancial’s earnings results for the periods indicated are discussed in more detail below.
As of June 30, 2015, Cornerstone, including its wholly-owned subsidiary Cornerstone Community Bank, had total assets of approximately $436 million, total loans of approximately $310 million and total deposits of approximately $332 million.
As a result of the merger, SmartFinancial:
Review of Financial Performance
As of September 30, 2015, SmartFinancial had total consolidated assets of approximately $1,007 million, total loans of approximately $710 million, total securities of approximately $152 million, total deposits of approximately $847 million and stockholders’ equity of approximately $98 million. Net loss for the three month period ended September 30, 2015 totaled approximately $77 thousand and net income for the nine month period ended September 30, 2015 totaled approximately $328 thousand.
Results of Operations
Net loss for the three months ended September 30, 2015 was approximately $77 thousand or ($0.03) basic earnings (loss) per common share, compared to a net income of approximately $705 thousand or $0.22 basic earnings per common share for the same period in 2014. Net income for the nine months ended September 30, 2015 was approximately $328 thousand or $0.07 basic earnings per common share, compared to a net income of approximately $1,476 thousand or $0.45 basic earnings per common share for the same period in 2014.
The following table presents our results for the three and nine months ended September 30, 2015 compared to the three and nine months ended September 30, 2014 (amounts in thousands).
Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended September 30, 2015, net interest income before provision for loan loss increased approximately $1.5 million or 30.68 percent over the same period of 2014. For the nine months ended September 30, 2015, net interest income before provision for loan loss increased approximately $1.5 million or 10.67 percent.
The interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities) was 3.94 percent compared to 4.16 percent for the three month periods ended September 30, 2015 and 2014, respectively. The interest rate spread on a tax equivalent basis was 3.86 percent compared to 4.10 percent for the nine month periods ended September 30, 2015 and 2014, respectively.
The net interest margin on a tax equivalent basis was 4.02 percent and 4.22 percent for the three month periods ended September 30, 2015 and 2014, respectively. The net interest margin on a tax equivalent basis was 3.92 percent and 4.17 percent for the nine month periods ended September 30, 2015 and 2014, respectively.
Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:
Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. There was approximately $32 thousand in provision for loan losses recorded in the three months ended September 30, 2015 due to increases in outstanding loan balances. For the nine months ended September 30, 2015, the Banks recorded approximately $356 thousand of provision compared to approximately $299 for the same period in 2014.
Noninterest Income-Items reported as noninterest income include service charges on checking accounts, insufficient funds charges, automated clearing house (“ACH”) processing fees and the Banks’ secondary mortgage department earnings. Increases in income derived from service charges and ACH fees are primarily a function of the Banks’ growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.
The following table presents the components of noninterest income for the three and nine months ended September 30, 2015 and 2014 (dollars in thousands):
The most significant reason for the increases in noninterest income during the three and nine months ended September 30, 2015 and 2014 relate to the merger between legacy SmartFinancial and Cornerstone that was effective August 31, 2015. However, following is a description of certain components of noninterest income and other reasons for fluctuations.
Noninterest Expense-Items reported as noninterest expense include salaries and associated benefits, occupancy and equipment expense, net foreclosed assets expense, depository insurance and other operating expense.
The following table presents the components of noninterest expense for the three and nine months ended September 30, 2015 and 2014 (dollars in thousands).
The most significant reason for the increases in noninterest expense during the three and nine months ended September 30, 2015 and 2014 relate to the merger between legacy SmartFinancial and Cornerstone that was effective August 31, 2015.
Financial Condition
Overview- Consolidated assets totaled approximately $1,007 million at September 30, 2015 and $534 million as of December 31, 2014. The increase in assets from December 31, 2014 to September 30, 2015 was primarily due to the merger effective August 31, 2015. The increase in cash and cash equivalents was approximately $43.2 million, securities was approximately $53.3 million, and loans, net of allowance, was approximately $347.1 million. As a result of the merger, goodwill and core deposit intangibles increased approximately $4.2 million and $2.8 million, respectively.
Liabilities as of September 30, 2015 and December 31, 2014 totaled approximately $909 million and $478 million, respectively. The increase in liabilities from December 31, 2014 to September 30, 2015 was primarily due to the merger effective August 31, 2015. The increase in deposits was approximately $392.1 million and the increase in Federal Home Loan Bank advances and other borrowings was approximately $39.3 million.
Stockholders’ equity as of September 30, 2015 and December 31, 2014 totaled approximately $98 million and $56 million, respectively. The increase in equity from December 31, 2014 to September 30, 2015 was primarily due to the merger effective August 31, 2015.
Securities-The primary purposes of the investment portfolio is to provide earnings and liquidity, satisfy pledging requirements, collateralize the repurchase accounts and secure FHLB borrowings. The investment portfolio, primarily consisting of government sponsored-enterprise securities, collateralized mortgage obligations, mortgage backed securities and municipal securities, amounted to approximately $152.2 million as of September 30, 2015 compared to approximately $98.9 million as of December 31, 2014. The primary reason for the increase in securities from December 31, 2014 to September 30, 2015 was due to the merger effective August 31, 2015.
Loans-The composition of loans at September 30, 2015 and at December 31, 2014 and the percentage of each classification to total loans are summarized in the following table (dollars in thousands):
The table below provides a summary of PCI loans as of September 30, 2015:
Allowance for Loan Losses-The allowance for loan losses represents SmartFinancial’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio quarterly to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Banks use a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Banks perform prudent credit underwriting, no assurances can be given that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.
The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2015 and for the year ended December 31, 2014 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):
Non-Performing Assets-The specific economic and credit risks associated with the loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.
The Banks attempt to reduce these economic and credit risks by adherence to a lending policy approved by the board of directors. The lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards. The Banks classify loans that are ninety (90) days past due and still accruing interest, renegotiated loans, nonaccrual loans, foreclosures and repossessed property as non-performing assets. At the time the loan is categorized as nonaccrual the interest previously accrued but not collected may be reversed and charged against current earnings.
The following table summarizes SmartFinancial’s non-performing assets at each quarter end from December 31, 2014 to September 30, 2015 (amounts in thousands):
Deposits and Borrowings-The Banks’ deposits consist of non-interest bearing demand deposits, interest- bearing demand accounts, savings and money market accounts, and time deposits. The Banks have agreements with some customers to sell certain of its securities under agreements to repurchase the securities the following day. The Banks have also obtained advances from the FHLB and a line of credit with a correspondent bank.
Capital Resources-At September 30, 2015 and December 31, 2014, SmartFinancial’s stockholders’ equity amounted to approximately $98.4 million and $55.9 million, respectively.
The following is a summary of the Company’s and the Banks’ capital ratios as of September 30, 2015:
Market and Liquidity Risk Management
Interest Rate Sensitivity
The Asset Liability Management Committee (“ALCO”) for each bank is responsible for making decisions regarding liquidity and funding solutions based upon approved liquidity, loan, capital and investment policies. The ALCO must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. To assist in this process the Banks have contracted with an independent third party to prepare quarterly reports that summarize several key asset-liability measurements. In addition, the third party will provide recommendations to the Banks’ ALCO regarding future balance sheet structure, earnings and liquidity strategies. The following is a brief discussion of the primary tools used by the ALCO to perform its responsibilities:
Earnings at Risk Model
The Banks use an earnings at risk model to analyze interest rate risk. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of interest rates for the next 12 months and are combined with other factors in order to produce various earnings simulations.
Economic Value of Equity
The economic value of equity model measures the extent that estimated economic values of assets and liabilities will change as a result of interest rate changes. Economic values are determined by discounting expected cash flows from assets and liabilities, which establishes a base case economic value of equity.
Liquidity Analysis
The Banks use a liquidity analysis model to examine the current liquidity position and analyze the potential sources of coverage in the event of a liquidity crisis. The following is a brief description of the key measurements contained in the analysis:
Regular Liquidity Position-This is a measurement used to capture the ability of an institution to cover its current debt obligations.
Basic Surplus-The basic surplus ratio is used to determine the number of times non-obligated assets could be used to meet immediate liquidity needs.
Dependency Ratio-The dependency ratio determines the reliance on short-term liabilities.
Leverage Analysis
The leverage analysis examines the potential of the institution to absorb additional debt. The key measurements included in this analysis are the Banks’ tier 1 capital, leverage and total capital ratios.
Balance Sheet Analytics
Balance sheet analytics involve an in depth examination of the balance sheet structure, including diversification of structure and most recent pricing practices. This review uses trend analysis to compare previous balance sheet positions. The analysis enables the ALCO to review significant changes in the Banks’ loan and security portfolios as well as deposit composition.
Liquidity Risk Management
Liquidity is measured by the Banks’ ability to raise cash at a reasonable cost or with a minimum of loss. These funds are used primarily to fund loans and satisfy deposit withdrawals. Several factors must be considered by management when attempting to minimize liquidity risk. Examples include changes in interest rates, competition, loan demand, and general economic conditions. Minimizing liquidity risk is a responsibility of the ALCO and is reviewed by the Banks’ regulatory agencies on a regular basis.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
This item is not applicable to smaller reporting companies.
Item 4. Controls and Procedures
Under the supervision and with the participation of management, including SmartFinancial’s Chief Executive Officer and Chief Financial Officer, SmartFinancial has evaluated the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of September 30, 2015 (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, SmartFinancial’s disclosure controls and procedures were effective in alerting them on a timely basis to material information relating to SmartFinancial (including its consolidated subsidiaries) required to be included in SmartFinancial’s periodic filings under the Exchange Act.
There were no changes in SmartFinancial’s internal control over financial reporting during SmartFinancial’s fiscal quarter ended September 30, 2015 that have materially affected, or are reasonably likely to materially affect, SmartFinancial’s internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
There are various claims and lawsuits in which SmartFinancial is periodically involved incidental to the Banks’ business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.
Item 1A. Risk Factors
SmartFinancial, as a smaller reporting company, is not required to provide the information required by this Item.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Unregistered Sales of Equity Securities
As previously disclosed on a Current Report on Form 8-K filed on August 20, 2015, in connection with the merger with legacy SmartFinancial, we conducted a private offering of our common stock at a purchase price of $15.00 per share (such purchase price being adjusted to reflect the one-for-four reverse split of our common stock effectuated on August 31, 2015). The offering was conducted in multiple tranches, with the first tranche closing on August 28, 2015, and a second closing occurring on September 30, 2015. The first tranche of 600,000 shares was issued on August 28, 2015. A second tranche of 363,166.5 shares was issued on September 30, 2015. The gross proceeds from the offering will total $15 million. The shares were offered to accredited investors in accordance with exemptions from registration under Regulation D and Regulation S of the Securities Act of 1933, as amended.
On September 30, 2015, we issued an aggregate of 6,659 shares of common stock to the directors of our wholly owned subsidiary, Cornerstone Community Bank, as compensation for their services as members of the board of the bank. The shares were issued pursuant to the exemption from registration provided by Rule 506(b) promulgated under the Securities Act of 1933, as amended, The Company made this determination as each of the persons who received shares was an “accredited investor” as defined in Rule 501(a) of Regulation D promulgated under the Securities Act.
Issuer Purchases of Equity Securities
On August 31, 2015, we redeemed all 600,000 shares of our Series A Convertible Preferred Stock at a redemption price of $26.042 per share. The total redemption price was $15,625,200.
Item 3. Defaults Upon Senior Securities
None
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
William Y. Carroll, Jr.