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 MARCH 31, 2004
[ ] 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: 0-15624
SECOND BANCORP INCORPORATED
(Exact Name of Registrant as Specified in Charter)
OHIO 34-1547453
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
108 MAIN AVENUE SW, WARREN, OHIO 44481
(Address of Principal Executive Offices) (Zip Code)
330.841.0123
(Registrant's telephone number, including area code)
NOT APPLICABLE
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: As of April 30, 2004, the
registrant had 9,485,626 outstanding shares of common stock.
1
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
INDEX
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated balance sheets -
March 31, 2004 and 2003 (unaudited) and December 31, 2003 3
Consolidated statements of income (unaudited) -
Three months ended March 31, 2004 and 2003 .............. 4
Consolidated statements of comprehensive income (unaudited) -
Three months ended March 31, 2004 and 2003 .............. 5
Consolidated statements of shareholders' equity (unaudited) -
Three months ended March 31, 2004 and 2003 .............. 6
Consolidated statements of cash flows (unaudited) -
Three months ended March 31, 2004 and 2003 .............. 7
Notes to consolidated financial statements ........................... 8-17
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations ........... 18-22
Item 3. Quantitative and Qualitative Disclosures about Market Risk ........... 23
Item 4. Controls and Procedures .............................................. 24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings .................................................... 25
Item 2. Changes in Securities and Use of Proceeds ............................ 25
Item 3. Defaults upon Senior Securities ...................................... 25
Item 4. Submission of Matters to a Vote of Security Holders .................. 25
Item 5. Other Information .................................................... 25
Item 6. Exhibits and Reports on Form 8-K ..................................... 25
SIGNATURES .................................................................... 26
Exhibit 10.1 Form of Amended Management Severance Agreement
Exhibit 10.2 Form of Noncompetition, Nonsolicitation and Confidentiality
Agreement
Exhibit 11.1 Statement Re: Computation of Earnings Per Share
Exhibit 31.1 Certification of Chief Executive Officer pursuant to Exchange
Act Rule 13a-14(a)/ 15d-14(a) as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2 Certification of Chief Financial Officer pursuant to Exchange
Act Rule 13a-14(a)/ 15d-14(a) as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
2
PART 1. FINANCIAL INFORMATION
Item 1. Financial Statements
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31 December 31 March 31
---------------- ------------- ----------------
(Dollars in thousands) 2004 (Unaudited) 2003 (Note 1) 2003 (Unaudited)
---------------------- ---------------- ------------- ----------------
ASSETS
Cash and due from banks $ 40,046 $ 40,773 $ 43,334
Federal funds sold and temporary investments 18,065 6,529 29,523
Securities available-for-sale (at market value) 620,091 620,696 539,309
Loans 1,339,838 1,349,820 1,215,481
Less allowance for loan losses 19,137 18,874 17,756
----------- ----------- -----------
Net loans 1,320,701 1,330,946 1,197,725
Premises and equipment 19,257 19,013 16,125
Accrued interest receivable 8,214 8,501 9,414
Goodwill 16,700 16,700 16,647
Other intangible assets 3,235 3,347 3,696
Servicing assets 18,808 20,936 13,743
Other assets 51,830 49,320 39,511
----------- ----------- -----------
Total assets $ 2,116,947 $ 2,116,761 $ 1,909,027
=========== =========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Demand - non-interest bearing $ 156,302 $ 170,176 $ 155,892
Demand - interest bearing 133,592 142,709 147,747
Savings 350,702 346,851 363,443
Time deposits 646,696 555,606 454,784
----------- ----------- -----------
Total deposits 1,287,292 1,215,342 1,121,866
Federal funds purchased and securities sold under
agreements to repurchase 179,327 216,761 206,069
Note payable 13,000 7,750 14,000
Other borrowed funds 661 1,301 155
Federal Home Loan Bank advances 446,391 492,299 379,971
Accrued expenses and other liabilities 15,587 14,755 20,089
Debentures 31,550 31,537 0
Corporation-obligated mandatorily redeemable capital
securities of subsidiary trust 0 0 30,508
----------- ----------- -----------
Total liabilities 1,973,808 1,979,745 1,772,658
Shareholders' equity:
Common stock, no par value; 30,000,000 shares
authorized; 10,999,230, 10,991,460 and 11,041,083
shares issued, respectively 43,160 42,973 41,745
Treasury stock; 1,520,089, 1,520,089 and 1,542,784
shares, respectively (36,173) (36,173) (33,740)
Accumulated other comprehensive income 4,136 (834) 6,410
Retained earnings 132,016 131,050 121,954
----------- ----------- -----------
Total shareholders' equity 143,139 137,016 136,369
----------- ----------- -----------
Total liabilities and shareholders' equity $ 2,116,947 $ 2,116,761 $ 1,909,027
=========== =========== ===========
See notes to consolidated financial statements.
3
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Three Months
Ended March 31
--------------------
(Dollars in thousands, except per share data) 2004 2003
---------- ----------
INTEREST INCOME
Loans (including fees):
Taxable $ 19,001 $ 18,605
Exempt from federal income taxes 211 211
Securities:
Taxable 5,587 6,234
Exempt from federal income taxes 643 728
Federal funds sold and other 34 123
---------- ----------
Total interest income 25,476 25,901
INTEREST EXPENSE
Deposits 5,660 5,779
Federal funds purchased and securities
sold under agreements to repurchase 539 581
Note payable 49 63
Other borrowed funds 2 3
Federal Home Loan Bank advances 4,912 4,659
Debentures and capital securities 756 733
---------- ----------
Total interest expense 11,918 11,818
---------- ----------
Net interest income 13,558 14,083
Provision for loan losses 1,350 2,173
---------- ----------
Net interest income after provision for loan losses 12,208 11,910
NON-INTEREST INCOME
Mortgage banking revenue 1,928 4,358
Service charges on deposit accounts 1,620 1,527
Trust fees 687 609
Security gains 498 51
Gain on sale of banking centers 0 5,619
Other operating income 1,826 2,098
---------- ----------
Total non-interest income 6,559 14,262
NON-INTEREST EXPENSE
Salaries and employee benefits 7,729 7,604
Net occupancy 1,252 1,199
Equipment 1,015 1,039
Professional services 795 767
Assessment on deposits and other taxes 430 392
Amortization of intangible assets 113 118
Merger costs 1,138 0
Other operating expenses 2,377 2,554
---------- ----------
Total non-interest expense 14,849 13,673
---------- ----------
Income before federal income taxes 3,918 12,499
Income tax expense 1,151 3,838
---------- ----------
Net income $ 2,767 $ 8,661
========== ==========
NET INCOME PER COMMON SHARE:
Basic $ 0.29 $ 0.90
Diluted $ 0.29 $ 0.89
Weighted average common shares outstanding:
Basic 9,477,710 9,620,401
Diluted 9,702,224 9,714,253
See notes to consolidated financial statements.
4
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Three Months
Ended March 31
--------------------
(Dollars in thousands) 2004 2003
------- -------
Net income $ 2,767 $ 8,661
Other comprehensive income, net of tax:
Change in unrealized market value adjustment on securities
available-for-sale 4,126 (246)
Change in other comprehensive income - derivatives 844 0
------- -------
Total other comprehensive income 4,970 (246)
------- -------
Comprehensive income $ 7,737 $ 8,415
======= =======
See notes to consolidated financial statements.
5
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
Other
Common Treasury Comprehensive Retained
(Dollars in thousands, except per share data) Stock Stock Income Earnings Total
--------------------------------------------- ----- ----- ------ -------- -----
Balance, January 1, 2003 $ 41,763 $ (27,180) $ 6,656 $ 115,095 $ 136,334
Net income 8,661 8,661
Change in unrealized gain on securities of $(327),
net of reclassification adjustment for gains
included in net income of $51 and net of tax of $(132) (246) (246)
Cash dividends declared: common ($.19 per share) (1,802) (1,802)
Purchase of treasury shares (6,560) (6,560)
Common stock issued-dividend reinvestment plan-net (18) (18)
--------- --------- --------- --------- ---------
Balance, March 31, 2003 $ 41,745 $ (33,740) $ 6,410 $ 121,954 $ 136,369
========= ========= ========= ========= =========
Balance, January 1, 2004 $ 42,973 $ (36,173) $ (834) $ 131,050 $ 137,016
Net income 2,767 2,767
Change in unrealized gain on securities of $6,846,
net of reclassification adjustment for gains
included in net income of $498 and net of tax of $2,222 4,126 4,126
Change in other comprehensive income - unrealized
gain on derivatives, net of tax of $454 844 844
Cash dividends declared: common ($.19 per share) (1,801) (1,801)
Common stock issued - dividend reinvestment plan-net 187 187
--------- --------- --------- --------- ---------
Balance, March 31, 2004 $ 43,160 $ (36,173) $ 4,136 $ 132,016 $ 143,139
========= ========= ========= ========= =========
See notes to consolidated financial statements.
6
SECOND BANCORP INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Months Ended
--------------------------
(Dollars in thousands) March 31 March 31
2004 2003
--------- ---------
OPERATING ACTIVITIES
Net income $ 2,767 $ 8,661
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for loan losses 1,350 2,173
Depreciation 755 771
Amortization of intangible assets 113 118
Amortization of servicing assets 1,088 1,579
Amortization of investment discount and premium 702 203
Increase in allowance for servicing assets 2,909 989
Deferred income taxes (benefit) (979) 0
Net securities gains (498) (51)
Gain on the sale of banking centers 0 (5,619)
Other gains, net (1,294) (4,336)
Decrease (increase) in interest receivable 287 (652)
Increase (decrease) in interest payable 77 (59)
Originations of loans held-for-sale (147,817) (297,001)
Proceeds from sale of loans held-for-sale 149,111 301,343
Net change in other assets and other liabilities (2,138) 3,873
--------- ---------
Net cash provided by operating activities 6,433 11,992
INVESTING ACTIVITIES
Proceeds from maturities of securities - available-for-sale 25,872 77,715
Proceeds from sales of securities - available-for-sale 66,816 10,578
Purchases of securities - available-for-sale (85,942) (104,465)
Net decrease (increase) in loans 7,025 (53,611)
Net increase in premises and equipment (999) (270)
--------- ---------
Net cash provided by (used by) investing activities 12,772 (70,053)
FINANCING ACTIVITIES
Net (decrease) increase demand deposits, interest bearing demand and
savings deposits (19,140) 69,797
Net deposits sold 0 (85,868)
Net increase (decrease) in time deposits 91,090 (51,594)
Net (decrease) increase in federal funds purchased and securities sold
under agreements to repurchase (37,434) 67,273
Increase in note payable 5,250 7,000
Net decrease in borrowings (640) (3,708)
Net (decrease) increase in advances from Federal Home Loan Bank (45,908) 14,127
Cash dividends (1,801) (1,802)
Purchase of treasury stock 0 (6,560)
Net issuance of common stock 187 (18)
--------- ---------
Net cash (used by) provided by financing activities (8,396) 8,647
--------- ---------
Increase (decrease) in cash and cash equivalents 10,809 (49,414)
--------- ---------
Cash and cash equivalents at beginning of year 47,302 122,271
--------- ---------
Cash and cash equivalents at end of period $ 58,111 $ 72,857
========= =========
Supplementary Cash Flow Information:
Cash paid for 1) Federal income taxes - $1,900 and $3,838 for the three months
ended March 31, 2004 and 2003, respectively and 2) Interest - $11,841 and
$11,759 for the three months ended March 31, 2004 and 2003, respectively.
See notes to consolidated financial statements.
7
Second Bancorp Incorporated and Subsidiaries
Notes to Consolidated Financial Statements (unaudited)
(Dollars in thousands, except per share data)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. The consolidated balance
sheet as of December 31, 2003 has been extracted from the audited financial
statements included in the Company's 2003 Annual Report to Shareholders on Form
10-K. Operating results for the three-month period ended March 31, 2004 are not
necessarily indicative of the results that may be expected for the year ended
December 31, 2004. (See Note 2). Certain reclassifications have been made to
amounts previously reported in order to conform to current period presentations.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Corporation's Annual Report on Form 10-K for
the year ended December 31, 2003.
NOTE 2 - PENDING MERGER
On January 8, 2004, the Corporation and Sky Financial Group. Inc., based in
Bowling Green, Ohio, announced an agreement whereby Sky Financial Group will
acquire the Corporation and its wholly-owned subsidiaries including the Bank.
The transaction is expected to close during the second quarter of 2004. Under
the terms of the agreement, shareholders of the Corporation will receive 1.26
shares of Sky Financial Group common stock for each share of the Corporation.
The agreement provides for the merger of the Corporation into Sky Financial
Group, and the subsequent merger of the Bank into Sky Bank, Sky Financial
Group's commercial banking affiliate. The Corporation's insurance affiliate
Stouffer-Herzog will be integrated into Sky Insurance some time after the merger
is complete.
The merger is subject to receipt of applicable regulatory approvals and to the
approval of the shareholders of the Corporation.
NOTE 3 - STOCK OPTIONS
At March 31, 2004, the Corporation had three stock-based compensations plans.
The Corporation accounts for those plans under recognition and measurement
principles of Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock Issued to Employees" and related Interpretations. Under APB No. 25,
because the exercise price of the Corporation's employee stock options equals
the market price of the underlying stock on the date of the grant, no
compensation expense is recognized.
8
(Dollars in thousands, except per share data)
Pro-forma information regarding net income and earnings per share is required by
SFAS No. 123, "Accounting for Stock-Based Compensation" and has been determined
as if the Corporation had accounted for its employee stock options under the
fair value method of that Statement. Under the fair-value based method,
compensation cost is measured at the grant date based upon the value of the
award and recognized over the service period. For purposes of the pro-forma
disclosures, the estimated fair value of the option is amortized to expense over
the options' vesting period. The Corporation's pro-forma information follows:
Three Months Ended March 31
---------------------------
2004 2003
--------- ---------
Net income, as reported $ 2,767 $ 8,661
Deduct: Total stock-based compensation expense determined under fair-value
based method for all awards, net of related tax effects 21 156
--------- ---------
Pro-forma net income $ 2,746 $ 8,505
========= =========
Earnings per share:
Basic-as reported $ .29 $ .90
Basic-pro-forma $ .29 $ .88
Diluted-as reported $ .29 $ .89
Diluted-pro-forma $ .28 $ .88
NOTE 4 - COMPREHENSIVE INCOME
Accumulated other comprehensive income, net of related tax, at March 31, 2004,
December 31, 2003 and March 31, 2003 totaled $4,136, $(834) and $6,410,
respectively and was comprised of accumulated changes in unrealized market value
adjustments on securities available-for-sale, net of tax, minimum pension
liability, net of tax and deferred supplemental income, net of tax and
derivatives, net of tax. Disclosure of reclassification amounts, net of tax for
the three-month periods ended March 31, 2004 and 2003 are as follows:
2004 2003
------- -------
Unrealized holding gains (losses) arising during the period $ 6,846 $ (327)
Less: reclassification of gains included in net income (498) (51)
------- -------
Net unrealized gains (losses) on available-for-sale securities 6,348 (378)
Income tax (effect) benefit (2,222) 132
------- -------
Net unrealized gains (losses) on available-for-sale securities,
net of tax $ 4,126 $ (246)
======= =======
9
(Dollars in thousands, except per share data)
NOTE 5 - RECENT ACCOUNTING PRONOUNCEMENTS
Consolidation of Variable Interest Entities
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities" ("VIEs"), an interpretation of
Accounting Research Bulletin No. 51, "Consolidated Financial Statements", to
improve financial reporting of special purpose and other entities. In accordance
with FIN 46, business enterprises that represent the primary beneficiary of
another entity by retaining a controlling financial interest in that entity's
assets, liabilities and results of operating activities must consolidate the
entity in its financial statements. Prior to the issuance of FIN 46,
consolidation generally occurred when an enterprise controlled another entity
through voting interests. Certain VIEs that are qualifying special purpose
entities subject to the reporting requirements of FASB 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities"
will not be required to be consolidated under the provisions of FIN 46. The
consolidation provisions of FIN 46 apply to VIEs entered into after January 31,
2003. For preexisting VIEs, the FASB deferred the consolidation provisions on
October 8, 2003, to periods ending after December 15, 2003. In December 2003,
the FASB reissued FIN 46 with certain modifications and clarifications.
Application of this guidance was effective for interests in certain VIEs
commonly referred to as special-purpose entities (SPEs) as of December 31, 2003.
Application for all other types of entities is required for periods ending after
March 15, 2004, unless previously applied.
The Corporation makes investments directly in low income housing projects
through the Retail Banking line of business. As a limited partner in these
unconsolidated projects, the Corporation is allocated tax credits and deductions
associated with the underlying properties. The Corporation has determined these
projects to be VIEs in which it has an interest, but for which it is not the
primary beneficiary. At March 31, 2004, estimated assets of the projects totaled
approximately $265,280. The Corporation's maximum exposure to loss from its
involvement with these projects is the unamortized investment balance of $442 at
March 31, 2004. During the quarter ended March 31, 2004, the Corporation
obtained no significant interests in low income housing projects created after
January 31, 2003.
The Corporation applied the provisions of FIN 46 to a wholly-owned subsidiary
grantor trust that had issued mandatorily redeemable preferred securities of the
grantor trust to third party investors. The application of FIN 46 to this
pre-existing VIE was effective December 31, 2003 and resulted in the
deconsolidation of the trust. The assets and liabilities of the subsidiary trust
that was deconsolidated totaled $33.0 million and $32.0 million, respectively.
The capital securities held by the trust continue to qualify as Tier 1 capital
of the Corporation for regulatory capital purposes. The Federal Reserve Board
has not issued any guidance which would change the capital treatment for trust
preferred securities based on the impact of the adoption of FIN 46.
The adoption of FIN 46 did not have a material impact on the Corporation's
financial condition, results of operations or liquidity.
Accounting for Certain Loans or Debt Securities Acquired in a Transfer
In December 2003, the FASB cleared Statement of Position No. 03-3, "Accounting
for Certain Loans or Debt Securities Acquired in a Transfer" (SOP 03-3) which
had been issued by the Accounting Standards Executive Committee of the AICPA.
SOP 03-3 addresses accounting for differences between contractual cash flows and
cash flows expected to be collected from an investor's initial investment in
loans or debt securities acquired in a transfer if those differences are
attributable, at least in part, to credit quality. The provisions of SOP 03-3
are effective for the Corporation for loans acquired beginning January 1, 2005,
with early adoption encouraged. The Corporation is currently assessing the
potential impact this statement will have on results of operation, financial
position or liquidity.
10
(Dollars in thousands, except per share data)
Loan Commitments
On March 9, 2004, the SEC released Staff Accounting Bulletin No. 105,
"Application of Accounting Principles to Loan Commitments" that requires all
registrants to account for mortgage loan interest rate lock commitments related
to loans held for sale as written options, effective no later than for
commitments entered into after March 31, 2004. The Corporation enters into such
commitments with customers in connection with residential mortgage loan
applications and at March 31, 2004 had approximately $49 million in notional
amount of these commitments outstanding. This guidance requires the Corporation
to recognize a liability on its balance sheet equal to the fair value of the
commitment at the time the loan commitment is issued. As a result, this guidance
delays the recognition of any revenue related to these commitments until such
time as the loan is sold, however, it would have no effect on the ultimate
amount of revenue or cash flows recognized over time. The Corporation is
currently assessing the impact on this pending guidance on its results of
operations and financial position. In the quarter of adoption, there would
likely be a one-time negative impact to mortgage banking revenue yet to be
determined.
Revised Statement 132 about Pensions and Other Postretirement Benefits
In December 2003, the FASB revised Statement No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits". The revised statement retains
disclosures required by the original Statement No. 132 and requires additional
disclosures about the assets, obligations, cash flows and net periodic benefit
cost of defined benefit pension and other postretirement plans. In addition, the
revised Statement No. 132 requires interim period disclosure of the components
of net periodic benefit costs and contributions if significantly different from
previously reported amounts. See Note 11 to the consolidated financial
statements as of March 31, 2004 for the additional pension disclosures.
NOTE 6 - SECURITIES
Debt and equity securities are classified as available-for-sale and are carried
at their estimated fair value. Adjustments to fair value of the securities
available-for-sale, in the form of unrealized holding gains and losses, are
excluded from earnings and reported net of tax as a separate component of
shareholders' equity. Available-for-sale securities offer Management flexibility
to sell securities to fund liquidity and manage the Corporation's interest rate
risk.
The amortized cost of the debt securities is adjusted for amortization of
premiums and accretion of discounts to maturity, probable call date, or, in the
case of mortgage-backed securities, over the estimated life of the security.
Such amortization is included in interest income from securities. Interest and
dividends are included in interest income from securities. Realized gains and
losses, and declines in value judged to be other than temporary are included in
net securities gains (losses). The cost of securities sold is based on the
specific identification method.
11
(Dollars in thousands, except per share data)
The following is a summary of securities as of March 31, 2004 and 2003:
March 31, 2004
------------------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---- ----- ------ -----
Available for Sale:
U.S. Treasury securities and obligations of
other U.S. government agencies and
corporations $ 3,014 $ 18 $ 0 $ 3,032
Obligations of states and political subdivisions 45,691 2,763 (10) 48,444
Corporate securities 9,412 46 0 9,458
Mortgage-backed securities 535,456 4,532 (1,917) 538,071
-------- -------- -------- --------
Total debt securities 593,573 7,359 (1,927) 599,005
Equity securities 21,086 0 0 21,086
-------- -------- -------- --------
Total available-for-sale securities $614,659 $ 7,359 $ (1,927) $620,091
======== ======== ======== ========
March 31, 2003
------------------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
---- ----- ------ -----
Available for Sale:
U.S. Treasury securities and obligations of
other U.S. government agencies and
corporations $ 26,317 $ 1,075 $ 0 $ 27,392
Obligations of states and political subdivisions 62,163 3,454 (56) 65,561
Corporate securities 64,045 3,309 (2,312) 65,042
Mortgage-backed securities 344,234 6,284 (206) 350,312
-------- -------- -------- --------
Total debt securities 496,759 14,122 (2,574) 508,307
Equity securities 30,903 99 0 31,002
-------- -------- -------- --------
Total available-for-sale securities $527,662 $ 14,221 $ (2,574) $539,309
======== ======== ======== ========
Accumulated unrealized gain in other comprehensive income, net of tax is $4,130
and $7,592 for the three months ended March 31, 2004 and 2003, respectively.
12
(Dollars in thousands, except per share data)
There were no holdings of trading securities at March 31, 2004 and 2003. The
amortized cost and estimated market value of securities at March 31, 2004 by
contractual maturity are shown below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without prepayment penalties.
Estimated
Amortized Market
Cost Value
---- -----
Under 1 year $ 5,903 $ 5,998
1 to 5 years 12,869 13,719
5 to 10 years 23,574 25,162
Over 10 years 15,771 16,055
-------- --------
58,117 60,934
Mortgage-backed securities 535,456 538,071
Equity securities 21,086 21,086
-------- --------
Total available-for-sale securities $614,659 $620,091
======== ========
Information relating to sales of available-for-sale securities for the three
months ended March 31 is as follows:
2004 2003
-------- --------
Proceeds from sales of available-for-sale securities $ 66,816 $ 10,578
-------- --------
Gross realized gains $ 667 $ 245
Gross realized losses (169) (194)
-------- --------
Net gains on sales $ 498 $ 51
======== ========
At March 31, 2004 and 2003, securities with a carrying value of $554,079 and
$363,270, respectively, were pledged to secure repurchase agreements, deposits
of public funds and for other purposes.
NOTE 7 - LOANS
Loans consist of the following as of March 31, 2004 and 2003:
2004 2003
---------- ----------
Commercial $ 649,767 $ 558,499
Consumer 420,031 325,819
Real estate 270,040 331,163
---------- ----------
Total loans $1,339,838 $1,215,481
========== ==========
NOTE 8 - ASSET QUALITY
Allowance for Loan Losses
The allowance for loan losses is that amount believed adequate to absorb credit
losses in the loan portfolio based on management's evaluation of various factors
including overall growth in the loan portfolio, an analysis of individual loans,
prior and current loss experience, and current economic conditions. A provision
for loan losses is charged to operations based on management's periodic
evaluation of these and other pertinent factors.
13
(Dollars in thousands, except per share data)
Changes in the allowance for loan losses for the three months ended March 31
were as follows:
2004 2003
-------- --------
Balance at January 1 $ 18,874 $ 17,595
Charge-offs (1,534) (2,213)
Recoveries 447 201
-------- --------
Net charge-offs (1,087) (2,012)
Provision for loan losses 1,350 2,173
-------- --------
Balance at March 31 $ 19,137 $ 17,756
======== ========
Allowance for loan losses as a percent of total loans 1.43% 1.46%
Non-accrual, past-due and restructured loans (non-performing loans) as of March
31, 2004 and 2003:
2004 2003
------- -------
Non-accrual loans $14,135 $12,709
Past-due loans 8,784 6,623
Restructured loans 497 374
------- -------
Total $23,416 $19,706
======= =======
Percent of total loans at year end 1.75% 1.62%
Other real estate owned (net of reserve) $ 921 $ 1,270
NOTE 9 - GOODWILL AND INTANGIBLE ASSETS
Goodwill represents the excess of the cost of an acquisition over the fair value
of the net assets acquired. On January 1, 2002, the Corporation adopted SFAS No.
142, "Goodwill and Other Intangible Assets". Under the provisions of SFAS No.
142, goodwill is no longer ratably amortized into the income statement over an
estimated life but rather is tested at least annually for impairment. The
Corporation performed the annual testing for impairment as of July 1, 2003 and
concluded that no impairment had occurred.
Other intangible assets represent purchased assets that also lack physical
substance but can be distinguished from goodwill because of contractual or other
legal rights or because the asset is capable of being sold or exchanged either
on its own or in combination with a related contract, asset or liability.
Intangible assets resulting from the excess of the purchase price over net
identifiable tangible assets acquired through acquisitions are specifically
identified when determinable. The resulting core deposit and customer list
intangibles are amortized both on an accelerated basis and on a straight-line
basis over the estimated useful life. Original estimated useful lives for the
intangibles range from 10 to 18 years.
The Corporation is not anticipating any impairment, any reclassifications
between goodwill and intangible assets or any changes in the useful lives of
intangible assets.
NOTE 10 - SERVICING ASSETS
Servicing assets consisted of the following as of March 31, 2004 and 2003:
2004 2003
------- -------
Mortgage servicing assets $18,369 $13,299
Other servicing assets 439 444
------- -------
Total $18,808 $13,743
======= =======
14
(Dollars in thousands, except per share data)
At March 31, 2004 and 2003, the Corporation serviced mortgage loans for others
totaling $1,807,020 and $1,463,015, respectively. Following is an analysis of
the activity for capitalized servicing assets during the three months ended
March 31:
2004 2003
-------- --------
Balance at January 1 $ 20,936 $ 12,403
Additions 1,869 3,900
Amortizations (1,088) (1,571)
Change in valuation allowance (2,909) (989)
-------- --------
Balance at March 31 $ 18,808 $ 13,743
======== ========
The amortization of mortgage servicing rights and the change in valuation
allowance are offset by entries to mortgage banking revenue in the Statement of
Income.
The fair value of mortgage servicing assets is estimated by calculating the
present value of estimated future cash flows, taking into consideration several
different variables including discount rate, investor type, product type,
interest rate, escrow balances, delinquencies, servicing fees and costs and
prepayment speeds. The expected and actual rate of mortgage loan prepayments is
the most significant factor affecting the value of mortgage servicing assets.
The risk characteristics used to stratify the recognized servicing assets
include method of origination and interest rate. The fair value of the servicing
assets was $18,980 and $13,892 as of March 31, 2004 and 2003, respectively.
Following is an analysis of the aggregate changes in the valuation allowances
for mortgage servicing assets for the three months ended March 31:
2004 2003
------ ------
Balance at January 1 $2,393 $3,794
Additions 2,909 989
------ ------
Balance at March 31 $5,302 $4,783
====== ======
The Corporation utilized interest rate derivatives to mitigate the risk of
changes in the valuation of mortgage servicing assets. The fair value of the
derivatives was $2,530 and $(667) as of March 31, 2004 and 2003, respectively.
Changes in market value of derivatives included in mortgage banking revenue were
$3,738 and $1,805 for the three months ended March 31, 2004 and 2003,
respectively.
NOTE 11 - EMPLOYEE BENEFIT PLANS
The Corporation has a non-contributory, defined-benefit pension plan covering
substantially all of its employees. In addition, the Corporation has
supplemental retirement deferred benefit plans for certain employees, which
provide benefits in excess of the defined benefit plan. The components of net
periodic benefit cost associated with these plans for the three months ended
March 31 were as follows:
2004 2003
----- -----
Service cost $ 404 $ 345
Interest cost 292 249
Expected return on plan assets (375) (263)
Amortization of prior service cost 25 0
Amortization of initial net asset 0 (1)
Recognized net actuarial loss 53 19
----- -----
Net periodic benefit cost $ 399 $ 349
===== =====
15
(Dollars in thousands, except per share data)
NOTE 12 - LINE OF BUSINESS REPORTING
The Corporation operates three major lines of business: Retail, Commercial and
Mortgage.
Retail includes deposit gathering, direct and indirect consumer lending along
with a minor amount of small business banking services. Commercial includes
credit and related financial services to small- to large- sized corporations and
businesses. Mortgage includes mortgage banking activities, including the
ownership, origination, sale and servicing of mortgages.
The business units are identified by the product or services offered and the
channel through which the product or service is delivered. The accounting
policies of the individual business units are the same as those for the
Corporation.
The reported results reflect the underlying economics of the businesses.
Expenses for centrally provided services are allocated based upon estimated
usage of those services. The business units' assets and liabilities are
matched-funded and interest rate risk is centrally managed. Transactions between
business units are primarily conducted at fair value, resulting in gains or
losses that are eliminated for reporting consolidated results of operations.
Parent and other are primarily comprised of the results of the investment
funding activities, inter-segment revenue (expense) eliminations and unallocated
corporate income and expense. Operating results of the business units are
discussed in the Results of Operations section of Management's Discussion and
Analysis of Financial Condition and Results of Operations. Selected financial
information by line of business is included in the table below:
Three Months Ended March 31, 2004
Parent
Mortgage Commercial Retail And Other Consolidated
-------- ---------- ------ --------- ------------
Interest income $ 4,115 $ 7,628 $ 6,800 $ 6,741 $ 25,284
Interest expense -- -- (4,399) (7,519) (11,918)
Transfer pricing (2,463) (3,093) 5,428 128 --
Loan fees 80 185 (74) 1 192
----------- ----------- ----------- ----------- -----------
Net interest margin 1,732 4,720 7,755 (649) 13,558
Provision for loan losses (333) (437) (579) (1) (1,350)
Non-interest (loss) income (1,705) 565 1,921 5,778 6,559
Non-interest expense-direct (1,441) (1,563) (4,524) (7,321) (14,849)
----------- ----------- ----------- ----------- -----------
Direct contribution (1,747) 3,285 4,573 (2,193) 3,918
Allocations (680) (189) (3,413) 4,282 --
----------- ----------- ----------- ----------- -----------
(Loss) income before taxes (2,427) 3,096 1,160 2,089 3,918
Income taxes -- -- -- (1,151) (1,151)
----------- ----------- ----------- ----------- -----------
Net (loss) income $ (2,427) $ 3,096 $ 1,160 $ 938 $ 2,767
=========== =========== =========== =========== ===========
Average assets $ 311,308 $ 579,427 $ 479,909 $ 743,399 $ 2,114,043
=========== =========== =========== =========== ===========
16
(Dollars in thousands, except per share data)
Three Months Ended March 31, 2003
Parent
Mortgage Commercial Retail And Other Consolidated
-------- ---------- ------ --------- ------------
Interest income $ 4,587 $ 7,466 $ 6,432 $ 7,416 $ 25,901
Interest expense -- -- (5,080) (6,738) (11,818)
Transfer pricing (3,009) (3,406) 6,825 (410) --
Loan fees 70 238 68 (376) --
----------- ----------- ----------- ----------- -----------
Net interest margin 1,648 4,298 8,245 (108) 14,083
Provision for loan losses (66) (1,452) (655) -- (2,173)
Non-interest income 2,621 456 8,009 3,176 14,262
Non-interest expense-direct (1,205) (1,546) (4,470) (6,452) (13,673)
----------- ----------- ----------- ----------- -----------
Direct contribution 2,998 1,756 11,129 (3,384) 12,499
Allocations (733) (188) (3,250) 4,171 --
----------- ----------- ----------- ----------- -----------
Income before taxes 2,265 1,568 7,879 787 12,499
Income taxes -- -- -- (3,838) (3,838)
----------- ----------- ----------- ----------- -----------
Net income $ 2,265 $ 1,568 $ 7,879 $ (3,051) $ 8,661
=========== =========== =========== =========== ===========
Average assets $ 315,999 $ 504,577 $ 380,247 $ 668,701 $ 1,869,524
=========== =========== =========== =========== ===========
17
(Dollars in thousands, except per share data)
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
General
Second Bancorp Incorporated (the "Corporation") is a one-bank financial holding
company headquartered in Warren, Ohio. The primary subsidiary, The Second
National Bank of Warren, (the "Bank") was originally established in 1880.
Operating through 33 retail banking centers and five loan production offices, we
offer a wide range of commercial and consumer banking and trust services
primarily to business and individual customers in various communities in a nine
county area in northeastern and east-central Ohio. Among other things, our
banking business includes a large and growing mortgage banking function. A
second operating subsidiary, Stouffer-Herzog Insurance Agency, Inc.
("Stouffer-Herzog"), operates primarily in northeast Ohio selling a wide-range
of personal and commercial property & casualty and life & health products.
Additional non-operating subsidiaries include Second National Capital
Corporation and Second National Financial Company, LLC, which were formed in
2002 to facilitate a capital conversion plan for the subsidiary Bank. The
Corporation also maintains an unconsolidated subsidiary, Second Bancorp Capital
Trust I which was established in 2001 to facilitate raising Tier I eligible
capital in the form of corporation-obligated mandatorily redeemable capital
securities of subsidiary trust for the primary purpose of funding our
acquisition of Commerce Exchange Bank.
Forward-looking Statements
The sections that follow contain certain forward-looking statements (as defined
in the Private Securities Litigation Reform Act of 1995). These forward-looking
statements may involve significant risks and uncertainties. Although the
Corporation believes that the expectations reflected in such forward-looking
statements are reasonable, actual results may differ materially from the
expectations discussed in these forward-looking statements.
Financial Condition
At March 31, 2004, the Corporation had consolidated total assets of $2.12
billion, deposits of $1.29 billion and shareholders' equity of $143 million.
Since March 31, 2003, total assets have increased by $208 million or 10.9%,
primarily through new loan generation and security acquisition, funded by time
deposits and FHLB advances. There has been a shift in the source of deposit
funding from lower cost core deposits (demand deposits and savings accounts) to
time deposits during the first quarter. The increase in funding from time
deposits has allowed the Corporation to increase liquidity and repay some of the
FHLB advances. The increase in time deposit funding also contributed to further
net interest margin compression during the quarter. During the first quarter of
2003, deposit generation efforts were effective, however the sale of two banking
centers in Jefferson County, Ohio reduced deposits by $88 million. The sale of
the banking centers was a part of a larger banking center reconfiguration
program which included the closing and/or consolidation of six banking centers
into two new locations, the relocation and expansion of two other banking
centers and the de novo opening of an additional banking center.
Gross loans have increased by $124 million since March 31, 2003, predominantly
in commercial loans, which increased by $91 million over that time frame. The
increase of 16.3% indicates the success of the increased sales focus in the
newer, higher-growth western regions of the Corporation's market area. Real
estate loans decreased $61 million since March 31, 2003 due to the continued low
interest rates and the high level of sales of mortgage loans into the secondary
market. Consumer lending was also strengthened by increased sales efforts and
success in the western regions. Consumer loan balances have increased by $94
million, or 28.9% over the past year. The loan mix has moved from a 46%, 27% and
27% mix of commercial, consumer and residential real estate loans, respectively,
as of March 31, 2003 to a 49%, 31% and 20% mix at the end of the most recent
quarter. The shift to higher consumer and commercial loan balances will have a
near-term negative impact on the net interest margin due to the shorter duration
of these assets. The shorter duration better positions the loan portfolio for
increased interest rates.
18
(Dollars in thousands, except per share data)
Deposits decreased by $165 million since March 31, 2003. During 2003 the
Corporation experienced a dramatic shift in the composition of the deposit
balances as the Corporation focused on core deposit generation and funding cost
reductions. During the first quarter of 2004, the focus shifted to improving
liquidity and raising deposits with longer durations. As a result time deposit
balances have increased by $192 million, or 42.2%. While time deposit balances
increased by $91 million since December 31, 2003, core deposits (demand and
savings accounts) have declined by only $19 million indicating an increase in
deposit market share for the Corporation. The increase in funding from time
deposits has allowed the Corporation to increase liquidity and repay some of the
FHLB advances. The increase in time deposit funding also contributed to further
net interest margin compression during the quarter.
Since December 31, 2003, total assets have remained virtually unchanged.
Commercial and consumer lending activities continue to be successful, especially
in the western-most counties. Commercial loan balances increased by $19 million,
or an annualized rate of 11.8%, while consumer loan balances increased by $21,
or an annualized rate of 20.9%.
Strong secondary mortgage activities have reduced real estate balances to 20% of
total loans. During the first quarter of 2004, real estate loan originations
totaled $113 million, while sales totaled $148 million. Mortgage originations
totaled $339 million in the first quarter of 2003. The reduction in originations
is a result of slightly higher long-term interest rates and a reduction in
origination sales force.
Direct consumer loan originations totaled $42 million in the first quarter of
2004 compared to $47 million for the first quarter of 2003. Indirect consumer
loan originations, which now include loans for boats and recreational vehicles
totaled $21 million in the first quarter of 2004 compared to $12 million for the
first quarter of 2003.
Asset Quality. The level of non-performing loans remained at elevated levels at
the end of first quarter of 2004. Non-performing loans were $23,416 as of March
31, 2004 compared to $23,244 as of December 31, 2003 and $19,706 as of March 31,
2003. The increase from a year ago is due continued weakness in commercial loan
delinquencies and a further increase in past due real estate loans. Non-accrual
loans have increased to $14,135 from $13,348 as of December 31, 2003. Loans past
due over 90 days and still accruing totaled $8,784 as of March 31, 2004, down
slightly from the previous year end and up 32.6% from a year ago. The increase
is reflective of the general economic slowdown in both the national and local
economies. The allowance allocated to impaired loans as of March 31, 2004 and
2003 was $4,937 and $4,174, respectively.
The allowance for loan losses represented 1.43% of loans as of March 31, 2004.
The determination of the allowance for loan losses is based on management's
evaluation of the potential losses in the loan portfolio at March 31, 2004
considering, among other relevant factors, repayment status, borrowers' ability
to repay, collateral and current economic conditions. With over $6 million of
non-performing loan balances represented by real estate loans as of March 31,
2004, it is Management's opinion that the allowance for loan losses is adequate
to absorb losses inherent with the loan portfolios. The allowance was 1.40% and
1.46% of total loans at December 31, 2003 and March 31, 2003, respectively.
Capital Resources. Shareholders' equity has increased by $6 million since
December 31, 2003 due primarily to an increase in other comprehensive income
associated with an increase in the unrealized gains of the Corporation's
securities portfolio. Retained earnings increased by only $1 million since year
end due to the lower level of earnings influenced by merger costs and a reduced
net interest margin. Treasury stock balances have remained unchanged since year
end 2003 due to the cessation of share repurchases as a result of the pending
merger with Sky Financial. Over 265,000 shares were repurchased during the first
quarter of 2003 at an average price of $24.68. Since March 31, 2003,
shareholders' equity has increased by nearly $7 million due to the retained
earnings of $10 million and an increase in common
19
(Dollars in thousands, except per share data)
stock of $1 million. Somewhat offsetting these increases were the addition of $2
million in treasury stock and a decrease in accumulated other comprehensive
income ("OCI") of $2 million.
Liquidity. Management of the Corporation's liquidity position is necessary to
ensure that funds are available to meet the cash flow needs of depositors and
borrowers as well as the operating cash needs of the Corporation. Funds are
available from a number of sources including maturing securities, payments made
on loans, the acquisition of new deposits, the sale of packaged loans, borrowing
from the FHLB and overnight lines of credit of $73 million through correspondent
banks. The parent company has three major sources of funding including dividends
from the Bank, $20 million in unsecured lines of credit with correspondent
banks, which are renewable annually, and access to the capital markets. There
were $13 million in outstanding balances against the unsecured lines of credit
as of March 31, 2004.
Results of Operations
Quarterly Comparison
The Corporation reported net operating income of $2,767 for the first quarter of
2004. Net income for the first quarter represented twenty-nine cents ($.29) per
share on a diluted basis. Return on average assets (ROA) and return on average
total shareholders' equity (ROE) were 0.52% and 7.93%, respectively, for the
first quarter of 2004 compared to 1.85% and 25.61% for last year's first
quarter. Part of the decrease in earnings was attributable to the aforementioned
sale of two banking centers in 2003 and costs associated with the pending merger
with Sky Financial. The 2003 sale generated $5.6 million in pre-tax and $3.65
million in after-tax profits. Absent this event, diluted earnings per share
would have been $.52, ROA would have been 1.07% and ROE would have been 14.81%.
The 2004 merger costs totaled $1.1 million in pre-tax and $1.0 million in
after-tax costs. Absent this event, diluted earnings per share would have been
$.39, ROA would have been 0.72% and ROE would have been 10.93%.
Net interest income decreased from $14,083 for the first quarter of 2003 to
$13,558 for this year's first quarter. The decline was due to a thinning net
interest margin brought on by continued low interest rates. The net interest
margin was 3.33% in the first quarter of 2003, 3.00% in the fourth quarter of
2003 and 2.84% for the most recent quarter. The efficiency ratio (excluding the
2003 banking center gain and 2004 merger costs) was higher in the most recently
completed quarter, increasing from 58.98% for the first quarter of 2003 to
68.29% for this year's first quarter. Reduced gains on the sale of loans and a
lower net interest margin were the primary reasons for the increase.
Commercial Lending. Commercial lending activities focus primarily on providing
local independent commercial and professional firms with commercial business
loans and loans secured by owner-occupied real estate. We primarily make secured
and unsecured commercial loans for general business purposes, including working
capital, accounts receivable financing, machinery and equipment acquisition, and
commercial real estate financing. These loans have both fixed and floating
interest rates and typically have maturities of three to seven years. To a
lesser extent, we also make construction loans and finance commercial equipment
leases. Commercial loans comprised approximately 49% of our total loan portfolio
at March 31, 2004, up from 46% at the end of the first quarter in 2003. Loan
volume generated for the first quarter of 2004 totaled $52 million versus $68
million for the same period in 2003. Loan balances have increased by $19 million
since the previous year end due to the volume of new loan generation. The
decrease in loan generation can be attributed to a slowdown in business activity
in the region as well as a slowdown in sales activity due to the integration
process associated with the merger with Sky Financial.
20
(Dollars in thousands, except per share data)
Retail Lending. The Corporation offers a full range of retail loans to
individuals, including the owners and principals of our commercial customers and
a wide range of retail customers in our market area. We offer consumer loans for
a variety of personal financial needs, including home equity, new and used
automobiles, boat and recreational vehicle loans, credit cards and overdraft
protection for checking account customers. At March 31, 2004, approximately 31%
of loans were consumer loans versus 27% as of March 31, 2003. Of the March 31,
2004 balances, 11% were related to indirect automobile lending compared to 23%
as of March 31, 2003. Another 22% of the consumer balances are now in indirect
boat and recreational vehicle lending, compared to 15% as of March 31, 2003. Our
indirect loans are originated through dealers in the local area. Indirect
originations, which now include higher quality boat and recreational vehicle
loans have increased from $10.3 million during the first quarter of 2003 to
$21.1 million during the first quarter of 2004. Direct consumer lending has
decreased from $47.0 million for the first quarter of 2003 to $42.2 million for
this year's first quarter, reflecting a reduction in marketing efforts.
Mortgage Banking. Our mortgage department underwrites and originates a wide
range of retail mortgage loan products and sells a significant volume of them
primarily on a servicing retained basis. Generally, the loans sold into the
secondary mortgage market make funds available for reuse in mortgage or other
lending activities. The sales generate a net gain (including origination fee
income and deferred origination costs), limit the interest rate risk caused by
holding long-term, fixed-rate loans, and build a portfolio of serviced loans
which generate a recurring stream of fee income. We originated $113 million in
loans and sold $148 million in loans during the first quarter of 2004,
generating net gains on sale of $1,026. Comparatively, we originated $339
million in residential real estate loans and sold approximately $297 million of
loans during the first quarter of 2003, generating a net gain of $4,188. We
service $1.81 billion in mortgage loans for others at March 31, 2004 versus
$1.46 billion as of March 31, 2003. Due to the continuation of lower mortgage
interest rates in the first quarter of 2004, the valuation allowance on mortgage
servicing rights associated with these serviced loans increased to a total of
$5,302 as of March 31, 2004, compared to an allowance of $4,783 as of March 31,
2003. Included in mortgage banking income during the first quarters of 2004 and
2003 were valuation allowance impairment charges of $2,909 and $989,
respectively. Typically the impact of the changes in the valuation allowance are
offset by the gains realized on new residential real estate production and sale.
The Corporation utilizes derivative activities designed to offset the income
statement impact of changes in the valuation allowance for the mortgage
servicing rights. Included in mortgage banking income in the first quarters of
2004 and 2003 were income from the changes in market values of the derivatives
of $3,738 and $1,655, respectively.
Trust. The trust department is a traditional provider of fiduciary services with
a focus on administration of estates, trusts and qualified employee benefit
plans. During the first quarter of 2004, personal trust accounts, employee
benefit accounts and investment management agency accounts (including
safekeeping) produced approximately 64%, 20% and 16% of the total revenues of
the department, respectively as compared to 47%, 39% and 14% of the total
revenues of the department, respectively in the first quarter of 2003. Fee
income is up 12.8% from the first quarter of 2003 due to an increase in assets
under management. Our trust department had approximately $501 million in total
managed and non-managed assets at March 31, 2004 as compared to $487 million at
March 31, 2003.
Insurance. The acquisition of Stouffer-Herzog on September 4, 2002 had a
relatively minor impact on earnings for the subsequent quarters. The agency has
provided insurance services to Ohio residents since 1956. Stouffer-Herzog has a
diverse income base by line of business. Commissions historically are derived
from personal lines (42%), commercial lines (35%) and life and health lines
(23%).
21
(Dollars in thousands, except per share data)
Provision for Loan Losses. The methodology for the provision for loan losses
includes analysis of various economic factors including loan losses and
portfolio growth. The provision for loan losses was $1,350 for the first quarter
of 2004 versus $2,173 during the same period in 2003. The reduction in the
provision is directly related to a reduced level of net charge-offs. Total net
charge-offs were $1,087 for the first quarter of 2004 versus $2,012 for the
first quarter of 2003. The annualized net charge-offs to average loans
outstanding ratio was .32% for the most recent quarter. Continued softness in
asset quality in the commercial and real estate lines of business will keep
pressure on net charge-off levels in the near future.
Non-interest Income. Non-interest income (excluding security and trading gains
and losses) totaled $6,061 for the first quarter of 2004 versus $14,211 for the
same period last year. Also excluding the non-recurring gain on the sale of the
two banking centers, non-interest income was $8,592 for the first quarter of
2003. The decline is primarily the result of a reduction in the gain on sale of
loans, which decreased to $1,928 in the first quarter of 2004 as compared to
$4,342 in the first quarter of 2003. Deposit service charges continued to
strengthen, increasing from $1,527 for the first quarter of 2003 to $1,620 for
the most recently completed quarter.
Non-interest Expense. Expenses for the first quarter of 2004 were $14,849 as
compared to $13,673 for the same period in 2003. Absent costs associated with
the pending Sky Financial merger, non-interest expenses totaled $13,711 for the
first quarter of 2004, virtually unchanged from a year ago. All expense
categories Modest increases in costs were recognized in salaries and benefits
(up 1.6%), net occupancy (up 4.4%), professional services (up 3.7%), assessments
on deposits and other taxes (up 9.7%). Costs reductions were realized in
equipment (down 2.3%), amortization of intangible assets (down 4.2%) and other
operating expenses (down 6.9%).
22
(Dollars in thousands, except per share data)
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Forward-looking statements
The section that follows contains certain forward-looking statements (as defined
in the Private Securities Litigation Reform Act of 1995). These forward-looking
statements may involve significant risks and uncertainties. Although the
Corporation believes that the expectations reflected in such forward-looking
statements are reasonable, actual results may differ materially from these
results discussed in these forward-looking statements. These forward-looking
statements also may be significantly affected by the proposed merger with Sky
Financial Group, Inc. (See Note 2).
Market Risk Management
Market risk is the risk of economic loss from adverse changes in the fair value
of financial instruments due to changes in (a) interest rates, (b) foreign
exchange rates, or (c) other factors that relate to market volatility of the
rate, index, or price underlying the financial instrument. The Corporation's
market risk is composed primarily of interest rate risk. The Corporation's
Asset/Liability Committee ("ALCO") is responsible for reviewing the interest
rate sensitivity position of the Corporation and establishing policies to
monitor and limit the exposure to interest rate risk. Since nearly the
Corporation's entire interest rate risk exposure relates to the financial
instrument activity of the Bank, the Bank's Board of Directors reviews the
policies and guidelines established by ALCO.
The primary objective of asset/liability management is to provide an optimum and
stable net interest margin, after-tax return on assets and return on equity
capital, as well as adequate liquidity and capital. Interest rate risk is
monitored through the use of two complementary measures: dynamic gap analysis
and earnings simulation models. While each of the measurement techniques has
limitations, taken together they represent a reasonably comprehensive tool for
measuring the magnitude of interest rate risk inherent in the Corporation.
The earnings simulation model forecasts earnings for a one-year horizon frame
under a variety of interest rate scenarios; including interest rate shocks,
stepped rates and yield curve shifts. Management evaluates the impact of the
various rate simulations against earnings in a stable interest rate environment.
The most recent model projects net interest income would increase by 0.4% if
interest rates would immediately rise by 200 basis points. It projects a
decrease in net interest income of 9.9% if interest rates would immediately fall
by 100 basis points. Management believes this reflects an acceptable level of
risk from interest rate movements based on the current level of interest rates.
The earnings simulation model includes assumptions about how the various
components of the balance sheet and rate structure are likely to react through
time in different interest rate environments. These assumptions are derived from
historical analysis and management's outlook. Management expects interest rates
to have a neutral to upward bias for the remainder of 2004. Additionally,
Management measures the expected impact on the economic value of equity ("EVE")
given various levels of interest rate shocks. While the net interest income
volatility measurement cited above gives Management a near-term view of interest
rate risk, the EVE analysis gives Management a longer-term view as EVE serves to
measure the net duration of assets and liabilities. The most recent model
projects EVE would decrease by 9.2% if interest rates would immediately rise by
200 basis points. It projects a decrease in EVE of 12.6% if interest rates would
immediately fall by 100 basis points. Management believes this reflects an
acceptable level of risk from interest rate movements based on the current level
of interest rates.
Interest rate sensitivity is managed through the use of security portfolio
management techniques, the use of fixed rate long-term borrowings from the FHLB,
the establishment of rate and term structures for time deposits and loans and
the sale of long-term fixed rate mortgages through the secondary mortgage
market. The Corporation also may use interest rate swaps, caps, floors or other
derivative products to manage interest rate risk.
23
(Dollars in thousands, except per share data)
Item 4. Controls and Procedures
The Management of Second Bancorp Incorporated is responsible for establishing
and maintaining effective disclosure controls and procedures, as defined under
Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of
March 31, 2004, an evaluation was performed under the supervision and with the
participation of management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Corporation's disclosure controls and procedures. Based on that evaluation, our
Chief Executive Officer and Chief Financial Officer concluded that such
disclosure controls and procedures as of March 31, 2004 were effective in
ensuring that material information relating to the Corporation and its
subsidiaries is made known to them, particularly during the period for which our
periodic reports, including this Quarterly Report on Form 10-Q, are being
prepared. Additionally, there were no significant changes in the Corporation's
internal control over financial reporting that occurred during the quarter ended
March 31, 2004 that have materially affected, or are reasonable likely to
materially affect, the Corporation's internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings -
The Corporation is subject to various pending and threatened lawsuits in the
ordinary course of business in which claims for monetary damages are asserted.
While any litigation involves an element of uncertainty, in the opinion of
management, liabilities, if any, arising from such litigation or threat thereof
will not have a material impact on the financial position or results of
operations of the Corporation.
Item 2. Changes in Securities and Use of Proceeds -
There were no issuer purchases of equity securities during the first quarter of
2004.
Item 3. Defaults upon Senior Securities - Not applicable
Item 4. Submission of Matters to a Vote of Security Holders - Not applicable
Item 5. Other Information - Not applicable
Item 6. Exhibits and Reports on Form 8-K:
a. Exhibit Index.
2.1 Agreement and Plan of Merger, dated as of January 8, 2004 by and
between Second Bancorp Incorporated and Sky Financial Group, Inc.
Incorporated herein by reference to Exhibit 2 of Second Bancorp
Incorporated's Current Report on Form 8-K/A dated January 15,
2004.
10.1 Form of Amended Management Severance Agreement (filed as Exhibit
10.1)
10.2 Form of Noncompetition, Nonsolicitation and Confidentiality
Agreement (filed as Exhibit 10.2)
11.1 Statement re: Computation of Earnings Per Share (filed as Exhibit
11.1)
31.1 Certification of Chief Executive Officer pursuant to Exchange Act
Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002 (filed as Exhibit 31.1)
31.2 Certification of Chief Financial Officer pursuant to Exchange Act
Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002 (filed as Exhibit 31.2)
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (furnished as Exhibit 32.1)
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (furnished as Exhibit 32.2)
b. Reports on Form 8-K. The Corporation filed the following reports on Form 8-K
during the quarter ended March 31, 2004: The Corporation filed a report on Form
8-K on January 9, 2004 announcing the execution of an agreement for Sky
Financial Group to acquire Second Bancorp and its wholly owned subsidiaries
including Second National Bank. A Form 8-K/A was filed on January 16, 2004
amending the previous filing to include the Agreement and Plan of Merger as an
exhibit. The Corporation filed a report on Form 8-K on January 22, 2004 to
announce earnings for the fourth quarter 2003. In the second quarter, the
Corporation filed the following report on Form 8-K: The Corporation filed a
report on Form 8-K on May 3, 2004 to announce earnings for the first quarter
2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
SECOND BANCORP INCORPORATED
Date: May 6, 2004 /s/ David L. Kellerman
-----------------------------------
David L. Kellerman, Chief Financial
Officer and Treasurer
Signing on behalf of the registrant and as principal accounting officer and
principal financial officer.
26