UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
FOR THE TRANSITION PERIOD FROM ________ TO ________
Commission File Number: 000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
DELAWARE 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 W. Pine Street, Lodi, California 95240
(Address of principal Executive offices) (Zip Code)
Registrant's telephone number, including area code (209) 367-2300
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 checkmark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act: (Check
one):
Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
Number of shares of common stock of the registrant: Par value $0.01, authorized
2,000,000 shares; issued and outstanding 817,509 as of August 1, 2006.
FARMERS & MERCHANTS BANCORP
FORM 10-Q
TABLE OF CONTENTS
----------------------------
PART I. - FINANCIAL INFORMATION PAGE
--------------------- ----
ITEM 1 - FINANCIAL STATEMENTS
Consolidated Balance Sheets as of June 30, 2006 (Unaudited),
December 31, 2005 and June 30, 2005 (Unaudited). 4
Consolidated Statements of Income (Unaudited) for the Three Months
and Six Months Ended June 30, 2006 and 2005. 5
Consolidated Statements of Comprehensive Income (Unaudited) for the
Three Months and Six Months Ended June 30, 2006 and 2005. 6
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
for the Six Months Ended June 30, 2006 and 2005. 7
Consolidated Statements of Cash Flows (Unaudited) for the Six
Months Ended June 30, 2006 and 2005. 8
Notes to the Unaudited Consolidated Financial Statements 9
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 13
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 27
ITEM 4 - CONTROLS AND PROCEDURES 31
PART II. - OTHER INFORMATION
-----------------
ITEM 1 - LEGAL PROCEEDINGS 31
ITEM 1A - RISK FACTORS 31
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 32
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES 32
2
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 32
ITEM 5 - OTHER INFORMATION 33
ITEM 6 - EXHIBITS 33
SIGNATURES 34
INDEX TO EXHIBITS 34
3
PART I. - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
FARMERS & MERCHANTS BANCORP
CONSOLIDATED BALANCE SHEETS
=========================================================================================
(in thousands) June 30, December 31, June 30,
2006 2005 2005
ASSETS (Unaudited) (Unaudited)
-----------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due From Banks $ 42,438 $ 50,669 $ 39,723
Federal Funds Sold 280 - -
-----------------------------------------------------------------------------------------
Total Cash and Cash Equivalents 42,718 50,669 39,723
Investment Securities:
Available-for-Sale 157,116 158,029 157,716
Held-to-Maturity 108,720 109,911 111,467
-----------------------------------------------------------------------------------------
Total Investment Securities 265,836 267,940 269,183
-----------------------------------------------------------------------------------------
Loans 1,007,105 973,257 903,069
Less: Allowance for Loan Losses 18,531 17,860 17,943
-----------------------------------------------------------------------------------------
Loans, Net 988,574 955,397 885,126
-----------------------------------------------------------------------------------------
Land, Buildings & Equipment 18,872 17,522 15,913
Bank Owned Life Insurance 37,602 36,799 36,001
Interest Receivable and Other Assets 26,326 24,662 20,184
-----------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,379,928 $ 1,352,989 $ 1,266,130
=========================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
-----------------------------------------------------------------------------------------
Deposits:
Demand $ 278,846 $ 325,745 $ 256,219
Interest Bearing Transaction 124,281 138,321 109,565
Savings 266,921 283,226 288,299
Time Deposits 421,467 356,048 352,075
-----------------------------------------------------------------------------------------
Total Deposits 1,091,515 1,103,340 1,006,158
-----------------------------------------------------------------------------------------
Fed Funds Purchased - 650 22,400
FHLB Borrowings 134,635 98,847 90,868
Subordinated Debentures 10,310 10,310 10,310
Interest Payable and Other Liabilities 17,789 16,194 15,666
-----------------------------------------------------------------------------------------
Total Liabilities 1,254,249 1,229,341 1,145,402
-----------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common Stock 8 8 8
Additional Paid-In Capital 92,770 95,862 98,814
Retained Earnings 36,426 29,463 23,762
Accumulated Other Comprehensive Loss (3,525) (1,685) (1,856)
-----------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 125,679 123,648 120,728
-----------------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $ 1,379,928 $ 1,352,989 $ 1,266,130
=========================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
4
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
===================================================================================================
(in thousands except per share data) Three Months Six Months
Ended June 30, Ended June 30,
2006 2005 2006 2005
---------------------------------------------------------------------------------------------------
INTEREST INCOME
Interest & Fees on Loans $ 18,698 $ 15,134 $ 36,580 $ 28,570
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 24 14 37 56
Interest on Investment Securities:
Taxable 2,136 1,834 4,133 3,729
Tax-Exempt 811 835 1,622 1,555
---------------------------------------------------------------------------------------------------
Total Interest Income 21,669 17,817 42,372 33,910
---------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Deposits 4,074 2,302 7,467 4,302
Borrowed Funds 1,493 860 2,665 1,449
Subordinated Debentures 206 157 395 297
---------------------------------------------------------------------------------------------------
Total Interest Expense 5,773 3,319 10,527 6,048
---------------------------------------------------------------------------------------------------
NET INTEREST INCOME 15,896 14,498 31,845 27,862
Provision for Loan Losses - - 275 -
---------------------------------------------------------------------------------------------------
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES 15,896 14,498 31,570 27,862
---------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposit Accounts 1,527 1,111 2,572 2,145
Net (Loss) Gain on Sale of Investment Securities - (17) (419) 144
Credit Card Merchant Fees 556 520 1,074 980
Increase in Cash Surrender Value of Life Insurance 407 395 803 766
ATM Fees 306 233 585 437
Other 703 781 1,488 1,453
---------------------------------------------------------------------------------------------------
Total Non-Interest Income 3,499 3,023 6,103 5,925
---------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries & Employee Benefits 7,322 7,105 14,608 13,410
Occupancy 628 480 1,237 1,010
Equipment 971 486 1,646 961
Credit Card Merchant Expense 409 374 787 693
Marketing 230 313 377 633
Other 1,816 1,599 3,255 2,949
---------------------------------------------------------------------------------------------------
Total Non-Interest Expense 11,376 10,357 21,910 19,656
---------------------------------------------------------------------------------------------------
INCOME BEFORE INCOME TAXES 8,019 7,164 15,763 14,131
Provision for Income Taxes 2,925 2,575 5,732 5,111
---------------------------------------------------------------------------------------------------
NET INCOME $ 5,094 $ 4,589 $ 10,031 $ 9,020
===================================================================================================
EARNINGS PER SHARE $ 6.22 $ 5.52 $ 12.22 $ 10.85
===================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
5
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
===========================================================================================================================
(in thousands) Three Months Six Months
Ended June 30, Ended June 30,
2006 2005 2006 2005
---------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 5,094 $ 4,589 $ 10,031 $ 9,020
OTHER COMPREHENSIVE (LOSS) INCOME -
UNREALIZED (LOSSES) GAINS ON DERIVATIVE INSTRUMENTS:
Unrealized holding gains arising during the period, net
of income tax effects of $0 and $(1) for the quarters ended
June 30, 2006 and 2005, respectively, and $0 and $(1)
for the six months ended June 30, 2006 and 2005, respectively. - 1 - 1
Less: Reclassification adjustment for realized losses included in net
income, net of related income tax effects of $1 and $(3) for the
quarters ended June 30, 2006 and 2005, respectively, and $1 and
$(6) for the six months ended June 30, 2006 and 2005, respectively. 1 (5) 2 (9)
UNREALIZED (LOSSES) GAINS ON SECURITIES:
Unrealized holding (losses) gains arising during the period, net of
income tax (benefit) provision of $(1,242) and $504 for the quarters ended
June 30, 2006 and 2005, respectively, and of $(1,513) and $(533)
for the six months ended June 30, 2006 and 2005, respectively. (1,712) 695 (2,085) (735)
Less: Reclassification adjustment for realized gains (losses) included
in net income, net of related income tax effects of $0 and $7
for the quarters ended June 30, 2006 and 2005, respectively, and of
$176 and $(61) for the six months ended June 30, 2006 and 2005, - 10 243 (83)
respectively.
---------------------------------------------------------------------------------------------------------------------------
TOTAL OTHER COMPREHENSIVE (LOSS) INCOME (1,711) 701 (1,840) (826)
---------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME $ 3,383 $ 5,290 $ 8,191 $ 8,194
===========================================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
6
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
========================================================================================================================
(in thousands except share data) ACCUMULATED
COMMON ADDITIONAL OTHER TOTAL
SHARES COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
OUTSTANDING STOCK CAPITAL EARNINGS LOSS EQUITY
------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2004 792,722 $ 8 $ 82,237 $ 35,332 $ (1,030) $ 116,547
========================================================================================================================
Net Income - - 9,020 - 9,020
Cash Dividends Declared on -
Common Stock - - (2,659) - (2,659)
5% Stock Dividend 38,995 - 17,641 (17,641) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (290) - (290)
Repurchase of Stock (2,130) - (1,064) - - (1,064)
Change in Unrealized Gain (Loss) on
Derivative Instruments (8) (8)
Change in Net Unrealized Loss
on Securities Available for Sale - - - (818) (818)
------------------------------------------------------------------------------------------------------------------------
BALANCE, JUNE 30, 2005 829,587 $ 8 $ 98,814 $ 23,762 $ (1,856) $ 120,728
========================================================================================================================
------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2005 823,651 $ 8 $ 95,862 $ 29,463 $ (1,685) $ 123,648
========================================================================================================================
Net Income - - 10,031 - 10,031
Cash Dividends Declared on -
Common Stock - - (3,068) - (3,068)
Repurchase of Stock (6,142) - (3,092) - - (3,092)
Change in Unrealized Gain (Loss) on
Derivative Instruments 2 2
Change in Net Unrealized Loss
on Securities Available for Sale - - - (1,842) (1,842)
------------------------------------------------------------------------------------------------------------------------
BALANCE, JUNE 30, 2006 817,509 $ 8 $ 92,770 $ 36,426 $ (3,525) $ 125,679
========================================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
7
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Six Months Ended
===================================================================================================
(in thousands) June 30 June 30
2006 2005
---------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net Income $ 10,031 $ 9,020
Adjustments to Reconcile Net Income to Net
Cash Provided by Operating Activities:
Provision for Loan Losses 275 -
Depreciation and Amortization 927 742
Net (Accretion) Amortization of Investment Security Discounts & Premium (15) 326
Net Loss (Gain) on Sale of Investment Securities 419 (144)
Net Loss on Sale of Property & Equipment 2 -
Net Change in Operating Assets & Liabilities:
Net Increase in Interest Receivable and Other Assets (1,128) (1,068)
Net Increase (Decrease) in Interest Payable and Other Liabilities 1,595 (773)
---------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 12,106 8,103
INVESTING ACTIVITIES:
Securities Available-for-Sale:
Purchased (25,944) (11,235)
Sold, Matured or Called 23,302 37,449
Securities Held-to-Maturity:
Purchased (2,186) (26,710)
Matured or Called 3,349 5,161
Net Loans Originated or Acquired (34,126) (36,442)
Principal Collected on Loans Previously Charged Off 674 497
Net Additions to Premises and Equipment (2,279) (1,684)
---------------------------------------------------------------------------------------------------
Net Cash Used by Investing Activities (37,210) (32,964)
FINANCING ACTIVITIES:
Net Decrease in Demand, Interest-Bearing Transaction,
and Savings Accounts (77,244) (29,154)
Increase in Time Deposits 65,419 33,202
Net (Decrease) Increase in Federal Funds Purchased (650) 22,400
Net Increase in Federal Home Loan Bank Advances 35,788 9,979
Cash Dividends (3,068) (2,949)
Stock Repurchases (3,092) (1,064)
---------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 17,153 32,414
(Decrease) Increase in Cash and Cash Equivalents (7,951) 7,553
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 50,669 32,170
---------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AS OF JUNE 30, 2006 AND JUNE 30, 2005 $ 42,718 $ 39,723
===================================================================================================
The accompanying notes are an integral part of these unaudited consolidated financial statements
8
FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. SIGNIFICANT ACCOUNTING POLICIES
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was established
in 1916. The Bank's wholly owned subsidiaries include Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Farmers & Merchants
Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts
as trustee on deeds of trust originated by the Bank.
The Company's other subsidiaries include F & M Bancorp, Inc. and FMCB Statutory
Trust I. F & M Bancorp, Inc. was created in March 2002 to protect the name F & M
Bank. During 2002, the Company completed a fictitious name filing in California
to begin using the streamlined name, "F & M Bank" as part of a larger effort to
enhance the Company's image and build brand name recognition. In December 2003,
the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB
Statutory Trust I is a non-consolidated subsidiary per generally accepted
accounting principles (GAAP), and was formed for the sole purpose of issuing
Trust Preferred Securities. The accounting and reporting policies of the Company
conform with accounting principles generally accepted in the United States of
America and prevailing practice within the banking industry. The following is a
summary of the significant accounting and reporting policies used in preparing
the consolidated financial statements.
BASIS OF PRESENTATION
The accompanying consolidated financial statements of the Company have been
prepared in accordance with accounting principles generally accepted in the
United States of America for financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all
adjustments (which consist solely of normal recurring accruals) considered
necessary for a fair presentation of the results for the interim periods
presented have been included. These interim consolidated financial statements
should be read in conjunction with the financial statements and related notes
contained in the Company's 2005 Annual Report to Shareholders on Form 10-K.
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Significant inter-company
transactions have been eliminated in consolidation. The results of operations
for the six-month period ended June 30, 2006 may not necessarily be indicative
of the operating results for the full year 2006.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
9
CASH AND CASH EQUIVALENTS
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
INVESTMENT SECURITIES
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. These securities are reported at fair value with aggregate unrealized
gains or losses excluded from income and included as a separate component of
shareholders' equity, net of related income taxes. Fair values are based on
quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method.
Losses in the investment portfolio, reflecting a decline in value judged by the
Company to be other than temporary, are recognized in the period in which they
occur.
Amortization of premium and accretion of discount is calculated using a level
yield of interest over the estimated remaining period until maturity or call
date for Mortgage Backed Securities (MBS) and Zero Coupon Bonds. Municipal
securities and Agency securities are amortized or accreted using the Straight
Line method to the maturity date or call date.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio carried at fair value, with unrealized gains and
losses recorded in non-interest income.
LOANS
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income; thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate, or the observable or estimated market price of the loan or on the fair
value of the collateral if the loan is collateral dependent. Impaired
10
loans are placed on non-accrual status with income reported accordingly. Cash
payments are first applied as a reduction of the principal balance until
collection of the remaining principal and interest can be reasonably assured.
Thereafter, interest income is recognized as it is collected in cash.
ALLOWANCE FOR LOAN LOSSES
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is reduced
by charge-offs and increased by provisions charged to operating expense and by
recoveries on loans previously charged-off. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly basis,
management reviews the credit quality of the loan portfolio and considers many
factors in determining the adequacy of the allowance at the balance sheet date.
The factors evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, current levels of problem loans and delinquencies, credit quality
trends, collateral values, loan volumes and concentrations, seasoning of the
loan portfolio, specific industry conditions, recent loss experience, duration
of the current business cycle, bank regulatory examination results and findings
of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures." These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4
to the Consolidated Financial Statements in the Company's 2005 Annual Report to
Shareholders.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become probable.
PREMISES AND EQUIPMENT
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
OTHER REAL ESTATE
Other real estate, which is included in other assets, is comprised of properties
no longer utilized for business operations and property acquired through
foreclosure in satisfaction of indebtedness. These properties are recorded at
fair value less estimated selling costs upon acquisition. Revised estimates to
the fair value less cost to sell are reported as adjustments to the carrying
amount of the asset, provided that such adjusted value is not in excess of the
carrying amount at acquisition. Initial losses on properties acquired through
full or partial satisfaction of debt are treated as credit losses and charged to
the Allowance for Loan Losses at the time of acquisition. Subsequent declines in
value from the recorded
11
amounts, routine holding costs, and gains or losses upon disposition, if any,
are included in non-interest income or expense as incurred.
INCOME TAXES
The Company uses the liability method of accounting for income taxes. This
method results in the recognition of deferred tax assets and liabilities that
are reflected at currently enacted income tax rates applicable to the period in
which the deferred tax assets or liabilities are expected to be realized or
settled. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes. The deferred
provision for income taxes is the result of the net change in the deferred tax
asset and deferred tax liability balances during the year. This amount combined
with the current taxes payable or refundable results in the income tax expense
for the current year.
DIVIDENDS AND EARNINGS PER SHARE
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded.
On May 12, 2006, the Board of Directors of Farmers & Merchants Bancorp declared
a mid-year cash dividend of $3.75 per share, a 17.2% increase over the $3.20 per
share paid in June of 2005. The cash dividend was paid on June 30, 2006, to
shareholders of record on May 22, 2006.
During this same meeting the decision was made not to issue a stock dividend in
2006. The Board began issuing annual 5% stock dividends in 1975 in order to
increase the number of shares available in the marketplace, maintain an
affordable share price, and satisfy market demand for the stock.
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding for the period. The weighted average
number of shares outstanding for the three and six month periods ended June 30,
2006 were 819,077 and 820,667. The weighted average number of shares outstanding
for the three and six month periods ended June 30, 2005 were 831,262 and
831,482. Prior periods have been restated for applicable 5% stock dividends
paid.
SEGMENT REPORTING
Statement of Financial Accounting Standards No. 131, "Disclosures about Segments
of an Enterprise and Related Information" requires that public companies report
certain information about operating segments. It also requires that public
companies report certain information about their products and services, the
geographic areas in which they operate, and their major customers. The Company
is a holding company for a community bank which offers a wide array of products
and services to its customers. Pursuant to its banking strategy, emphasis is
placed on building relationships with its customers, as opposed to building
specific lines of business. As a result, the Company is not organized around
discernable lines of business and prefers to work as an integrated unit to
customize solutions for its customers, with business line emphasis and product
offerings changing over time as needs and demands change. Therefore, we only
report one segment.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative
Instruments and Certain Hedging Activities" as amended by the Statement of
Financial Accounting Standards, No. 138, establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. All derivatives,
whether designated in hedging relationships or not, are required to be recorded
on the balance sheet at fair value. Changes in the fair value of those
derivatives are accounted for depending on the intended use of the derivative
and the
12
resulting designation under specified criteria. If the derivative is designated
as a fair value hedge, the changes in the fair value of the derivative and of
the hedged item attributable to the hedged risk are recognized in earnings. If
the derivative is designated as a cash flow hedge, designed to minimize interest
rate risk, the effective portions of the change in the fair value of the
derivative are recorded in other comprehensive income (loss), net of related
income taxes. Ineffective portions of changes in the fair value of cash flow
hedges are recognized in earnings.
The Company utilizes from time to time derivative financial instruments such as
interest rate caps, floors, swaps and collars. These instruments are purchased
and/or sold to reduce the Company's exposure to changing interest rates. The
Company marks to market the value of its derivative financial instruments and
reflects gain or loss in earnings in the period of change or in other
comprehensive income (loss). The Company was not utilizing any derivative
instruments during the six month period ended June 30, 2006.
COMPREHENSIVE INCOME
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income (loss) includes
net income and changes in fair value of its available-for-sale investment
securities, minimum pension liability adjustments and cash flow hedges.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following is management's discussion and analysis of the major factors that
influenced our financial performance for the three and six months ended June 30,
2006. This analysis should be read in conjunction with our 2005 Annual Report,
filed as exhibit 13 on Form 10-K, and with the unaudited financial statements
and notes as set forth in this report.
FORWARD-LOOKING STATEMENTS
This quarterly report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of further acts or threats of terrorism; and (viii) other factors
discussed in the Company's Form 10-K filing for the year-ended December 31, 2005
with the Securities and Exchange Commission.
13
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
INTRODUCTION
Farmers & Merchants Bancorp, or the Company, is a bank holding company formed
March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California,
or the Bank, is a California state-chartered bank formed in 1916. The Bank
serves the northern Central Valley of California with 19 banking offices. The
service area includes Sacramento, San Joaquin, Stanislaus and Merced Counties
with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto,
Turlock and Hilmar.
Substantially all of the Company's business activities are conducted within its
market area.
As a bank holding company, the Company is subject to regulation and examination
by the Board of Governors of the Federal Reserve System ("FRB"). The Bank is a
California state-chartered non-FED member bank subject to the regulation and
examination of the California Department of Financial Institutions and the
Federal Deposit Insurance Corporation.
OVERVIEW
The Company's primary service area encompasses the northern Central Valley of
California, a region that is impacted by the seasonal needs of the agricultural
industry. Accordingly, discussion of the Company's Financial Condition and
Results of Operations is influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in fall and winter as crops are harvested and
sold).
For the three and six months ended June 30, 2006, Farmers & Merchants Bancorp
reported net income of $5,094,000 and $10,031,000, earnings per share of $6.22
and $12.22 and return on average assets of 1.51% and 1.50%, respectively. Return
on average shareholders' equity was 16.06% and 15.94% for the three and six
months ended June 30, 2006.
For the three and six months ended June 30, 2005, Farmers & Merchants Bancorp
reported net income of $4,589,000 and $9,020,000, earnings per share of $5.52
and $10.85 and return on average assets of 1.47% and 1.46%, respectively. Return
on average shareholders' equity was 15.17% and 15.11% for the three and six
months ended June 30, 2005.
The Company's improved earnings performance in the first six months of 2006 when
compared to the same period last year was due to a combination of (1) growth in
earning assets; and (2) improvement in the net interest margin due to rising
interest rates.
The following is a summary of the financial results for the six-month period
ended June 30, 2006 compared to June 30, 2005.
- Net income increased 11.2% to $10.0 million from $9.0 million.
- Earnings per share increased 12.7% to $12.22 from $10.85.
14
- Net interest income increased 14.3% to $31.8 million from $27.9 million.
- Net interest margin on a tax-equivalent basis increased 24 basis points
from 5.05% to 5.29%.
- Total assets increased 9.0% to $1.4 billion.
- Gross loans increased 11.5% to $1.0 billion.
- Total deposits increased 8.5% to $1.1 billion.
In addition, during the first half of 2006 the Company declared a cash dividend
of $3.75 per share, a 17.2% increase over the $3.20 per share declared in the
first half of 2005. The decision was also made not to issue a stock dividend in
2006 (See Note 1. Dividends and Earnings Per Share).
RESULTS OF OPERATIONS
NET INTEREST INCOME / NET INTEREST MARGIN
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the three and six month periods ending June 30,
2006 and 2005.
The average yields on earning assets and average rates paid on interest-bearing
liabilities have been computed on an annualized basis for purposes of
comparability with full year data. Average balance amounts for assets and
liabilities are the computed average of daily balances.
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" and is noted wherever applicable.
The Volume and Rate Analysis of Net Interest Income summarizes the changes in
interest income and interest expense based on changes in average asset and
liability balances (volume) and changes in average rates (rate). For each
category of interest-earning assets and interest-bearing liabilities,
information is provided with respect to changes attributable to: (1) changes in
volume (change in volume multiplied by initial rate); (2) changes in rate
(change in rate multiplied by initial volume); and (3) changes in rate/volume
(allocated in proportion to the respective volume and rate components).
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix. (See Item 3. "Quantitative
and Qualitative Disclosures about Market Risk: Market Risk - Interest Rate
Risk").
15
FARMERS & MERCHANTS BANCORP
QUARTERLY AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Three Months Ended June 30, Three Months Ended June 30,
2006 2005
ASSETS Balance Interest Rate Balance Interest Rate
------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 1,901 $ 24 5.06% $ 1,851 $ 14 3.03%
Investment Securities Available-for-Sale
U.S. Agencies 30,845 315 4.08% 60,678 571 3.76%
Municipals - Taxable 0 0 0.00% 0 0 0.00%
Municipals - Non-Taxable 16,106 257 6.38% 16,297 259 6.36%
Mortgage Backed Securities 109,965 1,304 4.74% 79,965 780 3.90%
Other 4,905 87 7.09% 4,962 52 4.19%
------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 161,821 1,963 4.85% 161,902 1,662 4.11%
------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 30,607 318 4.16% 30,736 308 4.01%
Municipals - Taxable 0 0 0.00% 0 0 0.00%
Municipals - Non-Taxable 65,990 968 5.87% 68,416 1,061 6.20%
Mortgage Backed Securities 10,071 96 3.81% 12,568 120 3.82%
Other 2,122 16 3.02% 287 2 2.79%
------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 108,790 1,398 5.14% 112,007 1,491 5.32%
------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 550,175 9,611 7.01% 502,006 8,527 6.81%
Home Equity 65,816 1,309 7.98% 63,969 980 6.14%
Agricultural 164,321 3,423 8.36% 135,860 2,281 6.73%
Commercial 182,327 3,905 8.59% 168,707 2,959 7.03%
Consumer 13,761 306 8.92% 12,778 255 8.00%
Credit Card 5,410 134 9.93% 4,981 121 9.74%
Municipal 1,044 10 3.84% 980 11 4.50%
------------------------------------------------------------------------------------------------------------------------------
Total Loans 982,854 18,698 7.63% 889,281 15,134 6.83%
------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,255,366 $ 22,083 7.06% 1,165,041 $ 18,301 6.30%
================= =================
Unrealized Gain/(Loss) on Securities Available-for-Sale (4,586) (1,872)
Allowance for Loan Losses (18,258) (17,916)
Cash and Due From Banks 36,397 33,632
All Other Assets 79,893 70,714
--------------------------------------------------------------------------- -----------
TOTAL ASSETS $1,348,812 $1,249,599
=========================================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 128,099 $ 23 0.07% $ 113,921 $ 19 0.07%
Savings 277,004 492 0.71% 298,309 327 0.44%
Time Deposits 402,292 3,559 3.55% 350,921 1,956 2.24%
------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 807,395 4,074 2.02% 763,151 2,302 1.21%
Other Borrowed Funds 116,576 1,493 5.14% 81,548 860 4.23%
Subordinated Debentures 10,310 206 8.04% 10,310 157 6.11%
------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 934,281 $ 5,773 2.48% 855,009 $ 3,319 1.56%
================= =================
Interest Rate Spread 4.58% 4.74%
Demand Deposits (Non-Interest Bearing) 271,425 258,379
All Other Liabilities 16,218 15,226
--------------------------------------------------------------------------- -----------
TOTAL LIABILITIES 1,221,924 1,128,614
Shareholders' Equity 126,888 120,985
--------------------------------------------------------------------------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,348,812 $1,249,599
=========================================================================== ===========
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.63% 0.41%
Net Interest Income and Margin on Total Earning Assets 16,310 5.21% 14,982 5.16%
Tax Equivalent Adjustment (414) (484)
------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 15,896 5.08% $ 14,498 4.99%
==============================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan interest income
includes fee income and unearned discount in the amount of $645,000 and $1.1 million for the quarters ended June 30, 2006 and
2005, respectively. Yields on securities available-for-sale are based on historical cost.
16
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Six Months Ended June 30, Six Months Ended June 30,
2006 2005
ASSETS Balance Interest Rate Balance Interest Rate
--------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 1,623 $ 37 4.60% $ 4,320 $ 56 2.61%
Investment Securities Available-for-Sale
U.S. Agencies 30,852 624 4.05% 64,805 1,191 3.68%
Municipals - Taxable - - 0.00% 162 5 6.17%
Municipals - Non-Taxable 15,768 494 6.26% 16,415 518 6.31%
Mortgage Backed Securities 107,956 2,488 4.61% 82,082 1,612 3.93%
Other 4,507 157 6.97% 4,982 116 4.66%
--------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 159,083 3,763 4.73% 168,446 3,442 4.09%
--------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 30,620 635 4.15% 25,787 551 4.27%
Municipals - Non-Taxable 66,129 1,956 5.92% 62,444 1,937 6.20%
Mortgage Backed Securities 10,356 198 3.82% 12,873 246 3.82%
Other 2,123 31 2.92% 290 8 5.52%
--------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 109,228 2,820 5.16% 101,394 2,742 5.41%
--------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 550,133 19,353 7.09% 498,188 16,240 6.57%
Home Equity 66,654 2,581 7.81% 63,642 1,861 5.90%
Agricultural 158,463 6,392 8.13% 132,373 4,252 6.48%
Commercial 180,244 7,374 8.25% 162,162 5,429 6.75%
Consumer 13,425 592 8.89% 12,515 521 8.40%
Credit Card 5,375 267 10.02% 4,939 245 10.00%
Municipal 1,030 21 4.11% 981 22 4.52%
--------------------------------------------------------------------------------------------------------------------------------
Total Loans 975,324 36,580 7.56% 874,800 28,570 6.59%
--------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,245,258 $ 43,200 7.00% 1,148,960 $ 34,810 6.11%
================== ==================
Unrealized Gain/(Loss) on Securities Available-for-Sale (3,608) (1,214)
Allowance for Loan Losses (18,238) (17,855)
Cash and Due From Banks 37,372 33,439
All Other Assets 78,607 69,535
--------------------------------------------------------------------------- -----------
TOTAL ASSETS $1,339,391 $1,232,865
=========================================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 129,294 $ 45 0.07% $ 113,304 $ 38 0.07%
Savings 280,051 847 0.61% 303,132 653 0.43%
Time Deposits 391,747 6,575 3.38% 350,335 3,611 2.08%
--------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 801,092 7,467 1.88% 766,771 4,302 1.13%
Other Borrowed Funds 106,410 2,665 5.05% 64,769 1,449 4.51%
Subordinated Debentures 10,310 395 7.75% 10,310 297 5.83%
--------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 917,812 $ 10,527 2.31% 841,850 $ 6,048 1.45%
================== ==================
Interest Rate Spread 4.68% 4.66%
Demand Deposits (Non-Interest Bearing) 280,540 257,520
All Other Liabilities 15,175 14,079
--------------------------------------------------------------------------- -----------
TOTAL LIABILITIES 1,213,527 1,113,449
Shareholders' Equity 125,864 119,416
--------------------------------------------------------------------------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,339,391 $1,232,865
=========================================================================== ===========
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.61% 0.39%
Net Interest Income and Margin on Total Earning Assets 32,673 5.29% 28,762 5.05%
Tax Equivalent Adjustment (828) (900)
--------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 31,845 5.16% $ 27,862 4.89%
================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan interest income includes
fee income and unearned discount in the amount of $1.5 million and $1.8 million for the six months ended June 30, 2006 and 2005,
respectively. Yields on securities available-for-sale are based on historical cost.
17
FARMERS & MERCHANTS BANCORP
VOLUME AND RATE ANALYSIS OF NET INTEREST REVENUE
(Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Six Months Ended
June 30, 2006 compared to June 30, 2006 compared to
June 30, 2005 June 30, 2005
INTEREST EARNING ASSETS Volume Rate Net Chg. Volume Rate Net Chg.
--------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ - $ 10 $ 10 $ (86) $ 67 $ (19)
Investment Securities Available for Sale
U.S. Agencies (555) 299 (256) (883) 316 (567)
Municipals - Taxable 0 0 0 (2) (3) (5)
Municipals - Non-Taxable (7) 5 (2) (20) (4) (24)
Mortgage Backed Securities 333 191 524 565 311 876
Other (4) 39 35 (31) 72 41
--------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available for Sale (233) 534 301 (371) 692 321
--------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Agencies 0 10 10 129 (45) 84
Municipals - Non-Taxable (37) (56) (93) 215 (196) 19
Mortgage Backed Securities 0 (24) (24) (49) 1 (48)
Other 14 0 14 36 (13) 23
--------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held to Maturity (23) (70) (93) 331 (253) 78
--------------------------------------------------------------------------------------------------------------------------------
Loans:
Real Estate 836 248 1,084 1,770 1,343 3,113
Home Equity 29 300 329 92 628 720
Agricultural 532 610 1,142 931 1,209 2,140
Commercial 253 693 946 651 1,294 1,945
Consumer 21 30 51 39 32 71
Credit Card 11 2 13 22 0 22
Other 4 (5) (1) 2 (3) (1)
--------------------------------------------------------------------------------------------------------------------------------
Total Loans 1,686 1,878 3,564 3,507 4,503 8,010
--------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,430 2,352 3,782 3,381 5,009 8,390
--------------------------------------------------------------------------------------------------------------------------------
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Transaction 2 2 4 6 1 7
Savings (151) 316 165 (138) 332 194
Time Deposits 319 1,284 1,603 470 2,494 2,964
--------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 170 1,602 1,772 338 2,827 3,165
Other Borrowed Funds 423 210 633 1,026 190 1,216
Subordinated Debentures 0 49 49 0 98 98
--------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 593 1,861 2,454 1,364 3,115 4,479
--------------------------------------------------------------------------------------------------------------------------------
TOTAL CHANGE $ 837 $ 491 $ 1,328 $ 2,017 $ 1,894 $ 3,911
================================================================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the
total "net change". The above figures have been rounded to the nearest whole number.
18
2ND QUARTER 2006 VS. 2ND QUARTER 2005
Net interest income for the second quarter of 2006 increased 9.6% to $15.9
million, compared to $14.5 million for the second quarter of 2005. On a fully
taxable equivalent basis, net interest income increased 8.9% and totaled $16.3
million for the second quarter of 2006, compared to $15.0 million for the second
quarter of 2005.
One reason for the increase in net interest income during the second quarter of
2006 when compared to the same period last year was an improvement in the volume
and mix of earning assets (as reflected by an increase in loans as a percentage
of average earning assets). Additionally, the Company's net interest income has
also benefited substantially as a result of the Federal Reserve Bank having
increased short-term market interest rates by 225 basis points since July 1,
2005.
For the three months ended June 30, 2006, the Company's net interest margin on a
fully taxable equivalent basis was 5.21% compared to 5.16% for the same period
in 2005. The Company's yield on earning assets has improved over the last twelve
months as a result of increases in short-term market interest rates. For further
discussion see Market Risk - Interest Rate Risk under Item 3. Quantitative and
Qualitative Disclosures About Market Risk.
Although the Company's net interest margin has improved over the same period in
the prior year, recent trends in pricing of both loans and deposits will, in
management's opinion, place pressures on the Company's net interest margin in
future quarters.
Loans, generally the Company's highest earning asset, increased $104 million as
of June 30, 2006 compared to June 30, 2005. On an average balance basis, loans
increased by $93.6 million for the three months ended June 30, 2006 compared to
the three months ended June 30, 2005. The yield on the loan portfolio increased
80 basis points to 7.63% for the three months ended June 30, 2006 compared to
6.83% for the three months ended June 30, 2005. This increase in yield and
volume resulted in interest revenue from loans increasing 23.6% to $18.7 million
for the second quarter of 2006 compared to $15.1 million for the second quarter
of 2005.
The investment portfolio is the other main component of the Company's earning
assets. Management believes the Company's investment policy is conservative. The
Company invests primarily in mortgage-backed securities, U.S. Government
Agencies, and high-grade municipals. Since the risk factor for these types of
investments is significantly lower than that of loans, the yield earned on
investments is generally less than that of loans.
Average investment securities were $270.6 million for the second quarter of 2006
compared to $273.9 million for the second quarter of 2005. The average yield, on
a taxable equivalent basis (TE), in the investment portfolio was 4.97% for the
second quarter of 2006 compared to 4.60% for the second quarter of 2005. The
increase in the yield on investment securities offset the small decrease in
volume and resulted in an increase in interest income of $208,000, or 6.6%, for
the three months ended June 30, 2006. Net interest income on the Schedule of
Year-to-Date Average Balances and Interest Rates is shown on a taxable
equivalent basis (TE), which is higher than net interest income on the
Consolidated Statements of Income because of adjustments that relate to income
on certain securities that are exempt from federal income taxes.
Compared to the second quarter of 2005, the Company has grown average
interest-bearing sources of funds by $79.3 million or 9.3%. Interest bearing
deposits grew $44.3 million while all other interest bearing
19
sources of funds (including FHLB Advances) increased by $35.0 million (see
Deposits and Federal Home Loan Bank Advances and Other Borrowings). Overall, the
average interest rate on interest-bearing sources of funds was 2.48% for the
three months ended June 30, 2006 and 1.56% for the three months ended June 30,
2005. The increase in the volume and rate on interest-bearing sources of funds
resulted in an increase in interest expense of $2.5 million, or 73.9%, for the
three months ended June 30, 2006 over the same period in 2005.
SIX MONTHS ENDING JUNE 30, 2006 VS. SIX MONTHS ENDING JUNE 30, 2005
During the first six months of 2006, net interest income increased 14.3% to
$31.8 million, compared to $27.9 million at June 30, 2005. On a fully taxable
equivalent basis, net interest income increased 13.6% and totaled $32.7 million
at June 30, 2006, compared to $28.8 million at June 30, 2005.
As reported in previous quarters, one of the reasons for the increase in net
interest income during the first six months of 2006 when compared to the same
period last year was an improvement in the volume and mix of earning assets (as
reflected by an increase in loans as a percentage of average earning assets).
Moreover, as a result of the Federal Reserve Bank having increased short-term
market interest rates by 300 basis points since January 2005, the Company's net
interest income has also benefited substantially from an increase in the yield
on earning assets.
For the six months ended June 30, 2006, the Company's net interest margin was
5.29% compared to 5.05% for the same period in 2005. The Company's yield on
earning assets has improved over the last twelve months as a result of increases
in short-term market interest rates. For further discussion see Market Risk -
Interest Rate Risk under Item 3. Quantitative and Qualitative Disclosures About
Market Risk.
Although the Company's net interest margin has improved over the same period in
the prior year, recent trends in pricing of both loans and deposits will, in
management's opinion, place pressures on the Company's net interest margin in
future quarters.
Loans, on an average balance basis, increased by $100.5 million for the six
months ended June 30, 2006 compared to the six months ended June 30, 2005. The
yield on the loan portfolio increased 97 basis points to 7.56% for the six
months ended June 30, 2006 compared to 6.59% for the six months ended June 30,
2005. This increase in yield and volume resulted in interest revenue from loans
increasing 28.0% or $8.0 million for the first six months of 2006.
Average investment securities were $268.3 million for the six months ended June
30, 2006 compared to $269.8 million for the same period in 2005. The average
yield (TE) for the six months ended June 30, 2006 was 4.91% compared to 4.58%
for the six months ended June 30, 2005, partially due to an increase in higher
yielding mortgage backed securities. The increase in the yield on investment
securities offset the small decrease in volume and resulted in an increase in
interest income of $399,000, or 6.5%, for the six months ended June 30, 2006.
Compared to the first six months of 2005, the Company has grown average
interest-bearing sources of funds by $76.0 million or 9.0%. Interest bearing
deposits grew $34.3 million while all other interest bearing sources of funds
(including FHLB Advances) increased by $42 million (see Deposits and Federal
Home Loan Bank Advances and Other Borrowings). Overall, the average interest
rate on interest-bearing sources of funds was 2.31% for the six months ended
June 30, 2006 and 1.45% for the six months ended June 30, 2005. The increase in
the volume and rate on interest-bearing sources of funds resulted in an increase
in interest expense of $4.5 million, or 74.1%, for the six months ended June 30,
2006 compared to the same period in 2005.
20
ALLOWANCE AND PROVISION FOR LOAN LOSSES
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the loan portfolio. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approval standards, dollar limits on loans to one borrower and
by restricting loans made primarily to its principal market area where
management believes it is better able to assess the applicable risk.
Additionally, management has established guidelines to ensure the
diversification of the Company's credit portfolio such that even within key
portfolio sectors such as real estate or agriculture, the portfolio is
diversified across factors such as location, building type, crop type, etc.
Management reports regularly to the Board of Directors regarding trends and
conditions in the loan portfolio and regularly conducts credit reviews of
individual loans. Loans that are performing but have shown some signs of
weakness are subjected to more stringent reporting and oversight.
The provision for loan losses totaled $275,000 for the first half of 2006,
compared to $0 for the first half of 2005. Changes in the provision between the
first half of 2006 and 2005 were the result of management's evaluation of the
adequacy of the allowance for loan losses relative to factors such as the credit
quality of the loan portfolio, loan growth, current loan losses and the
prevailing economic climate and its effect on borrowers' ability to repay loans
in accordance with the terms of the notes (see "Note 1. Critical Accounting
Policies and Estimates - Allowance for Loan Losses" and "Item 3. Quantitative
and Qualitative Disclosures About Market Risk-Credit Risk").
The allowance for loan losses was $18.5 million or 1.8% of the total loan
balance and $17.9 million or 2.0% of the total loan balance at June 30, 2006 and
June 30, 2005, respectively. As of December 31, 2005, the allowance for loan
losses was $17.9 million, which represented 1.8% of the total loan balance.
After reviewing all factors above, management concluded that the allowance for
loan losses as of June 30, 2006 was adequate. See the table below for allowance
for loan loss activity for the periods indicated.
Three Months Ended Six Months Ended
June 30, June 30,
(in thousands) 2006 2005 2006 2005
---------------------------------------------------------------------------------------
Balance at Beginning of Period $ 18,258 $ 17,758 $ 17,860 $ 17,727
Provision Charged to Expense - - 275 -
Recoveries of Loans Previously Charged Off 406 420 664 496
Loans Charged Off (133) (235) (268) (280)
=======================================================================================
Balance at End of Period $ 18,531 $ 17,943 $ 18,531 $ 17,943
=======================================================================================
21
NON-INTEREST INCOME
Non-interest income includes: (1) service charges and fees from deposit
accounts; (2) net gains and losses from the sale of investment securities; (3)
credit card merchant fees; (4) ATM fees; (5) increases in the cash surrender
value of bank owned life insurance; and (6) fees from other miscellaneous
business services. Overall, non-interest income increased $476,000 or 15.7% for
the three months ended June 30, 2006 compared to the same period of 2005.
The primary reason for this increase was fees related to our Overdraft Privilege
Service which was offered to eligible customers with deposit accounts in good
standing beginning May 1, 2006. In addition, ATM fees increased $73,000 or 31.3%
over the three months ended June 30, 2005 as a result of our expanded ATM
network and fee increases implemented beginning May 1, 2006.
Non-interest income increased $178,000 or 3.0% for the six months ended June 30,
2006 compared to the same period of 2005. As discussed in the paragraph above,
the primary reason for this increase was fees related to our Overdraft Privilege
Service and increases in ATM fees. This increase was offset by losses on the
sale of investment securities of $419,000 through the first six months of 2006
as compared to a gain of $144,000 for the first six months of 2005 (See
"Investment Securities").
NON-INTEREST EXPENSE
Non-interest expense for the Company includes expenses for salaries and employee
benefits, occupancy, equipment, supplies, legal fees, professional services,
data processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.
Non-interest expense increased $1.0 million or 9.8% over the second quarter of
2005, primarily as a result of a $633,000 increase in occupancy and equipment
expense related to the remodeling and expansion of the Bank's branch network and
expanded software maintenance contracts. The branch remodeling and expansion
program has resulted in increased maintenance and equipment expense and
increased furniture & equipment depreciation. The other major factor impacting
non-interest expense was an increase of $217,000 in salaries & employee benefits
due to increased contributions to the Company's employee incentive bonus plans.
Non-interest expense for the six months ended June 30, 2006 increased $2.3
million or 11.5% over the same period in 2005, primarily as a result of a $1.2
million increase in salaries and employee benefits. Salaries and employee
benefits increased over the prior year due to officer raises that took place in
November 2005 and increased contributions to the Company's employee incentive
plans. Additionally, as discussed above, the remodeling and expansion of the
Bank's branch network has impacted non-interest expense along with expanded
software maintenance contracts.
PROVISION FOR INCOME TAXES
The provision for income taxes increased 13.6% to $2.9 million for the second
quarter of 2006. The Company's effective tax rate increased for the second
quarter of 2006 and was 36.5% compared to 35.9% for the same period in 2005.
This increase in the effective tax rate was due to a decrease in the mix of
tax-exempt income from municipal securities and cash surrender value of life
insurance policies.
The provision for income taxes increased 12.2% to $5.7 million for the first six
months of 2006. The Company's effective tax rate increased for the first six
months of 2006 and was 36.4% compared to 36.2% for the same period in 2005.
22
BALANCE SHEET ANALYSIS
This section presents a comparison of the Company's balance sheet for the six
month period ending June 30, 2006 and the same period in 2005. As previously
discussed (see "Overview") the seasonality of the Company's business due to its
agricultural customer base makes a comparison of the June 30th balance sheet to
the preceding December 31st not meaningful.
INVESTMENT SECURITIES
The Financial Accounting Standards Board Statement, "Accounting for Certain
Investments in Debt and Equity Securities", requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and are carried at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. Securities classified as available-for-sale include securities, which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demand and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes.
Losses in the investment portfolio, reflecting a decline in value judged by the
Company to be other than temporary, are recognized in the period in which they
occur.
The investment portfolio provides the Company with an income alternative to
loans as well as a tool to better manage its liquidity and interest rate risk.
As of June 30, 2006 the investment portfolio represented 19.3% of the Company's
total assets. Total investment securities decreased $3.3 million from a year ago
and now total $265.8 million. Reductions in the securities portfolio were used
to fund higher yielding loans. During the first half of 2006, the Company sold
$10.1 million in investment securities at a loss of $419,000. Funds not invested
in loans were reinvested in higher yielding securities which should serve to
strengthen the Company's future net interest margin and better align the
portfolio with the Company's evolving asset/liability management objectives.
Not included in the investment portfolio are overnight investments in Federal
Funds Sold. For the six months ended June 30, 2006, average Federal Funds Sold
was $1.6 million compared to $4.3 million at June 30, 2005.
LOANS
The Company's loan portfolio at June 30, 2006 increased $104.0 million from June
30, 2005. The increase was due to strong loan demand in the Company's market
area, along with an aggressive calling program on selected loan prospects.
Additionally, on an average balance basis loans have increased $100.5 million or
11.5% from prior year. The following table sets forth the distribution of the
loan portfolio by type as of the dates indicated.
23
Loan Portfolio As Of:
------------------------
(in thousands) June 30, 2006 Dec. 31, 2005 June 30, 2005
----------------------------------------------------------------------------
Real Estate $ 473,542 $ 432,378 $ 450,491
Real Estate Construction 92,618 110,235 59,903
Home Equity 66,402 69,013 64,571
Agricultural 176,621 170,657 147,243
Commercial 179,808 174,530 164,368
Consumer 20,514 18,958 18,836
----------------------------------------------------------------------------
Gross Loans 1,009,505 975,771 905,412
Less:
Unearned Income 2,400 2,514 2,343
Allowance for Loan Losses 18,531 17,860 17,943
----------------------------------------------------------------------------
Net Loans $ 988,574 $ 955,397 $ 885,126
============================================================================
NON-PERFORMING ASSETS
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of June
30, 2006 were $127,000 compared to $64,000 at June 30, 2005. Accrued interest
reversed from income on loans placed on a non-accrual status totaled $15,000 at
June 30, 2006 compared to $3,000 at June 30, 2005. The Company has reported no
other real estate owned from June 30, 2005 through June 30, 2006.
Non-Performing Assets
---------------------
(in thousands) June 30, 2006 Dec. 31, 2005 June 30, 2005
----------------------------------------------------------------------------------
Non-Performing Loans $ 127 $ 694 $ 64
Other Real Estate Owned - - -
==================================================================================
Total $ 127 $ 694 $ 64
==================================================================================
----------------------------------------------------------------------------------
Non-Performing Assets
as a % of Total Loans 0.01% 0.07% 0.01%
----------------------------------------------------------------------------------
Allowance for Loan Losses as a
% of Non-Performing Loans
14,591.3% 2,573.5% 28,035.9%
----------------------------------------------------------------------------------
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of June 30, 2006 for which known credit problems of
the borrower would cause serious doubts as to the ability of these borrowers to
comply with their present loan repayment terms, or any known events that would
result in the loan being designated as non-performing at some future date. The
Company's management cannot, however, predict the extent to which the following
or other factors may affect a borrower's ability to pay: (1) deterioration in
general economic conditions, real estate values or agricultural commodity
prices; (2) increases in interest rates; or (3) changes in the overall financial
condition or business of a borrower.
24
DEPOSITS
One of the key sources of funds to support earning assets (loans and
investments) is the generation of deposits from the Company's customer base. The
ability to grow the customer base and subsequently deposits is a significant
element in the performance of the Company.
At June 30, 2006, deposits totaled $1.1 billion. This represents an increase of
8.5% or $85.4 million from June 30, 2005. Core deposits (exclusive of Public
Time Deposits) increased 8.2% over the same period. Public Time Deposits have
increased $7.9 million since June 30, 2005.
Demand, interest bearing transaction and time deposit accounts increased $106.7
million or 14.9% from June 30, 2005. The Company's calling efforts for
prospective customers includes acquiring both loan and deposit relationships
which result in new demand, interest bearing transaction accounts and time
deposits. Savings deposits (which include money market accounts) decreased $21.4
million or 7.4% from June 30, 2005. Savings deposits have declined as customers
have transferred their funds to higher yielding time deposit accounts with the
Bank.
FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS
Advances from the Federal Home Loan Bank are another key source of funds to
support earning assets (see "Item 3. Quantitative and Qualitative Disclosures
about Market Risk and Liquidity Risk"). These advances are also used to manage
the Company's interest rate risk exposure, and as opportunities exist, to borrow
and invest the proceeds at a positive spread through the investment portfolio.
FHLB Advances as of June 30, 2006 were $134.6 million compared to $90.9 million
of FHLB Advances as of June 30, 2005. This increase of $43.7 million in
borrowings occurred as a result of the Company's growth in average earning
assets exceeding its growth in average deposits by $20.3 million over the last
twelve months.
LONG-TERM SUBORDINATED DEBENTURES
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. Although this amount is reflected as subordinated debt on
the Company's balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital (see "Capital"). These
securities accrue interest at a variable rate based upon 3-month Libor plus
2.85%. Interest rates reset quarterly and were 8.25% as of June 30, 2006, 7.35%
at December 31, 2005 and 6.27% at June 30, 2005.
CAPITAL
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders' Equity totaled $125.7 million at June
30, 2006 and $120.7 million at June 30, 2005.
The Company and the Bank are subject to capital adequacy requirements
administered by the federal banking agencies. Under these requirements and the
regulatory framework for prompt corrective action, the Company and the Bank must
meet specific capital guidelines that involve quantitative measures of the
Company's and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company's and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors. Failure to meet minimum capital requirements can initiate certain
mandatory, and possibly discretionary, actions by regulators that, if
undertaken, could have a direct material effect on the Company's and the Bank's
financial statements. Management believes, as of June 30, 2006, that the Company
and the Bank meet all capital adequacy requirements to which they are subject.
25
In its most recent notification from the Federal Deposit Insurance Corporation
the Bank was categorized as "well capitalized" under the regulatory framework
for prompt corrective action. To be categorized as "well capitalized", the Bank
must maintain minimum Total risk-based, Tier 1 risk-based, Tier 1 leverage
ratios as set forth in the table below. There are no conditions or events since
that notification that management believes have changed the institution's
categories.
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
---------------------------------------------------------------------------------------------------------------
THE COMPANY: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
---------------------------------------------------------------------------------------------------------------
As of June 30, 2006
Total Capital to Risk Weighted Assets $ 154,909 12.36% $ 100,279 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $ 139,203 11.11% $ 50,139 4.0% N/A N/A
Tier I Capital to Average Assets $ 139,203 10.40% $ 53,553 4.0% N/A N/A
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
--------------------------------------------------------------------------------------------------------------------
THE BANK: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
--------------------------------------------------------------------------------------------------------------------
As of June 30, 2006
Total Capital to Risk Weighted Assets $ 151,741 12.14% $ 99,967 8.0% $ 124,959 10.0%
Tier I Capital to Risk Weighted Assets $ 136,083 10.89% $ 49,984 4.0% $ 74,975 6.0%
Tier I Capital to Average Assets $ 136,083 10.18% $ 53,450 4.0% $ 66,812 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December 2003 the Company issued
$10 million of trust preferred securities. On March 1, 2005 the Federal Reserve
Board issued its final rule effective April 11, 2005, concerning the regulatory
capital treatment of trust preferred securities ("TPS") by bank holding
companies ("BHCs"). Under the final rule BHCs may include TPS in Tier 1 capital
in an amount equal to 25% of the sum of core capital net of goodwill. The
quantitative limitation concerning goodwill will not be effective until March
31, 2009. Any portion of trust preferred securities not qualifying as Tier 1
capital would qualify as Tier 2 capital subject to certain limitations. The
Company has received notification from the Federal Reserve Bank of San Francisco
that all of the Company's trust preferred securities currently qualify as Tier 1
capital.
In accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board approved a
second stock repurchase program because it concluded that the Company continued
to have more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as "well capitalized." On April 4,
2006, the Board unanimously approved expanding the Repurchase Program to allow
the repurchase of up to $15 million of stock between May 1, 2006 and April 30,
2009.
26
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain "well-capitalized" after the
repurchase. All shares repurchased under the repurchase program will be retired
(see the Company's 2005 Form 10-K, Part II, Item 5. Market for Registrant's
Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Securities).
During the second quarter of 2006, the Company repurchased 4,041 shares at an
average share price of $508 per share. During the second quarter of 2005, the
Company repurchased 2,117 shares at an average share price of $500. Since the
second share repurchase program was approved in 2004, the Company has
repurchased over 19,000 shares for total consideration of $9.2 million.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This "Management's Discussion and Analysis of Financial Condition and Results of
Operations," is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company's financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. These judgments govern areas such as
the allowance for loan losses, the fair value of financial instruments,
accounting for income taxes and pension accounting.
For a full discussion of the Company's critical accounting policies and
estimates see "Management's Discussion and Analysis" in the Company's Annual
Report to Shareholders for the year ended December 31, 2005.
OFF BALANCE SHEET ARRANGEMENTS
Off-balance sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a material variable interest held by the Company in an
unconsolidated entity that provides financing, liquidity, market risk or credit
risk support to the Company, or engages in leasing, hedging or research and
development services with the Company.
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. As of June 30, 2006, the Company had entered
into commitments with certain customers amounting to $319.9 million compared to
$447.7 million at December 31, 2005 and $421.2 million at June 30, 2005. Letters
of credit at June 30, 2006, December 31, 2005 and June 30, 2005, were $9.1
million, $11.5 million and $15.4 million, respectively. These commitments are
not reflected in the accompanying consolidated financial statements and do not
significantly impact operating results.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company. Specifically, credit risk, interest rate risk, liquidity risk,
compliance risk, strategic risk, reputation risk and price risk can all affect
the market risk of the Company. These specific risk factors are not mutually
exclusive. It is recognized that any product or service offered by the Company
may expose the Company to one or more of these risk factors.
27
CREDIT RISK
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Company's policy statements. In
addition, certain securities carry insurance to enhance credit quality of the
bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Company.
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan - Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectible in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system, specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies." In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio
28
segments. The conditions evaluated in connection with the second element of the
analysis of the allowance include, but are not limited to the following
conditions that existed as of the balance sheet date:
- then-existing general economic and business conditions affecting the key
lending areas of the Company;
- credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
- collateral values;
- loan volumes and concentrations;
- seasoning of the loan portfolio;
- specific industry conditions within portfolio segments;
- recent loss experience within portfolio segments;
- duration of the current business cycle;
- bank regulatory examination results; and
- findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio.
Management believes that the allowance for loan losses at June 30, 2006 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan charge-offs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
MARKET RISK - INTEREST RATE RISK
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company does not attempt to predict
interest rates and positions the balance sheet in a manner which seeks to
minimize, to the extent possible, the effects of changing interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products which reduces the market volatility of those
instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a
29
greater net interest margin during periods of rising interest rates and a lower
net interest margin during periods of declining interest rates. Conversely, a
negative Gap will generally produce a lower net interest margin during periods
of rising interest rates and a greater net interest margin during periods of
decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 200 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At June
30, 2006, the Company's estimated net interest income sensitivity to changes in
interest rates, as a percent of net interest income was an increase in net
interest income of 0.50% if rates increase by 200 basis points and a decrease in
net interest income of 1.63% if rates decline 200 basis points. Comparatively,
at December 31, 2005, the Company's estimated net interest income sensitivity
was an increase in net interest income of 0.54% if rates increase by 200 basis
points and a decrease in net interest income of 3.11% if rates decrease 200
basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape; prepayments on loans and securities; pricing strategies on loans and
deposits; replacement of asset and liability cashflows; and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change.
LIQUIDITY RISK
Liquidity risk is the risk to earnings or capital resulting from the Company's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Company's ability to liquidate assets or acquire
funds quickly and with minimum loss of value. The Company endeavors to maintain
a cash flow adequate to fund operations, handle fluctuations in deposit levels,
respond to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
30
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. At June 30, 2006, the Company maintained
Federal Funds credit lines of $75 million with banks subject to the customary
terms and conditions for such arrangements and $150 million in repurchase lines
with major brokers. In addition, the Company has additional borrowing capacity
of $119 million from the Federal Home Loan Bank.
At June 30, 2006, the Company had available sources of liquidity, which included
cash and cash equivalents and unpledged investment securities of approximately
$106.6 million, which represents 7.7% of total assets.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures designed to ensure that
information is recorded and reported in all filings of financial reports. Such
information is reported to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer to allow timely and accurate
disclosure based on the definition of "disclosure controls and procedures" in
Rule 13a-15(e). In designing these controls and procedures, management
recognizes that they can only provide reasonable assurance of achieving the
desired control objectives. Management also evaluates the cost-benefit
relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company carried out an
evaluation of the effectiveness of Company's disclosure controls and procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. The
evaluation was based, in part, upon reports and affidavits provided by a number
of executives. Based on the foregoing, the Company's Chief Executive Officer and
the Chief Financial Officer concluded that the Company's disclosure controls and
procedures were effective.
There have been no significant changes in the Company's internal controls over
financial reporting or in other factors that could significantly affect the
internal controls over financial reporting during the second quarter of 2006.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
-------------------------
Certain lawsuits and claims arising in the ordinary course of business have been
filed or are pending against the Company or its subsidiaries. Based upon
information available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.
There are no material proceedings adverse to the Company to which any director,
officer or affiliate of the Company is a party.
ITEM 1A. RISK FACTORS
See Item 1A. Risk Factors in the Company's 2005 Form 10-K. In management's
opinion there have been no material changes in risk factors since the filing of
the 2005 Form 10-K.
31
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
-------------------------------------------------------------------
The following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the second quarter of 2006.
The Board of Directors approved a $10 million Repurchase Program in May 2004. As
of April 30, 2006 the Company had repurchased $7.87 million of stock under the
Repurchase Program. On April 4, 2006 the Board unanimously approved expanding
the Repurchase Program to allow for the repurchase of up to $15 million of stock
between May 1, 2006 and April 30, 2009. The table below reflects the dollar
value of shares that may be repurchased restarting at $15 million on May 1,
2006.
NUMBER OF SHARES APPROXIMATE DOLLAR
PURCHASED AS PART VALUE OF SHARES THAT
AVERAGE OF A PUBLICLY MAY YET BE
NUMBER OF PRICE PER ANNOUNCED PLAN OR PURCHASED UNDER THE
SECOND QUARTER 2006 SHARES SHARE PROGRAM PLAN OR PROGRAM
-----------------------------------------------------------------------------------------
04/01/2006 - 04/30/2006 1,397 $ 510 1,397 $ 2,131,000
05/01/2006 - 05/31/2006* 2,112 505 2,112 13,932,900*
06/01/2006 - 06/30/2006 532 510 532 13,661,580
-----------------------------------------------------------------------------------------
Total 4,041 $ 508 4,041 $ 13,661,580
*Reflects changes to stock repurchase program approved by Board on April 4, 2006. See
paragraph above.
The common stock of Farmers & Merchants Bancorp is not widely held, is not
listed on any exchange, nor is it included on the NASDAQ National Market or the
NASDAQ Small Cap Market. However, trades may be reported on the OTC Bulletin
Board under the symbol "FMCB.OB." Additionally, management is aware that there
are private transactions in the Company's common stock.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
---------------------------------------
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
-----------------------------------------------------------
The Annual Meeting of Shareholders of Farmers & Merchants Bancorp was held on
May 15, 2006. The business conducted at the meeting included election of
directors. Following is the voting results from the 2006 annual meeting of
shareholders. As of May 15, 2006 there were 619,849 shares represented in person
-------
and by proxy that participated in this election and shares were voted on the
measure before the shareholders as follows:
32
1. ELECTION OF DIRECTORS
Directors % For % Withheld
--------------------- ------ ------- ----- --------
Stewart C. Adams, Jr. 94.99 588,787 5.01 31,062
------ ------- ----- --------
Ralph Burlington 99.03 613,822 0.97 6,027
------ ------- ----- --------
Edward Corum, Jr. 99.03 613,822 0.97 6,027
------ ------- ----- --------
Robert F. Hunnell 99.03 613,822 0.97 6,027
------ ------- ----- --------
Ole R. Mettler 99.00 613,622 1.00 6,227
------ ------- ----- --------
James E. Podesta 99.02 613,793 0.98 6,056
------ ------- ----- --------
Kevin Sanguinetti 99.03 613,822 0.97 6,027
------ ------- ----- --------
H. C. Schumacher 99.02 613,793 0.98 6,056
------ ------- ----- --------
Kent A. Steinwert 98.99 613,593 1.01 6,256
------ ------- ----- --------
Calvin (Kelly) Suess 99.03 613,822 0.97 6,027
------ ------- ----- --------
Carl A. Wishek, Jr. 98.44 610,203 1.56 9,646
------ ------- ----- --------
ITEM 5. OTHER INFORMATION
-------------------------
None
ITEM 6. EXHIBITS
----------------
See Exhibit Index on Page 34.
33
SIGNATURES
Pursuant to the requirement 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.
FARMERS & MERCHANTS BANCORP
Date: August 4, 2006 /s/ Kent A. Steinwert
_________________________
Kent A. Steinwert
President and
Chief Executive Officer
(Principal Executive Officer)
Date: August 4, 2006 /s/ Stephen W. Haley
_________________________
Stephen W. Haley
Executive Vice President and
Chief Financial Officer
(Principal Accounting Officer)
INDEX TO EXHIBITS
-----------------
Exhibit No. Description
----------- -----------
31(a) Certification of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31(b) Certification of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32 Certifications of the Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
34