UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(MARK ONE)

ý                                 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2003

 

OR

 

o                                 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 0-5127

 

MERCANTILE BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 

Maryland

 

52-0898572

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

 

 

2 Hopkins Plaza

Baltimore, Maryland 21201

(Address of principal executive offices) (Zip Code)

 

(410) 237-5900

(Registrant’s telephone number, including area code)

 

NONE

(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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý  No o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.  As of October 21, 2003, registrant had outstanding 79,617,141 shares of Common Stock.

 

 



 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

 

MERCANTILE BANKSHARES CORPORATION

CONSOLIDATED BALANCE SHEET

 

(Dollars in thousands, except per share data)

 

September 30,
2003

 

December 31,
2002

 

September 30,
2002

 

ASSETS

 

 

 

 

 

 

 

Cash and due from banks

 

$

375,627

 

$

281,130

 

$

333,824

 

Interest-bearing deposits in other banks

 

50,518

 

358

 

358

 

Federal funds sold

 

350,825

 

264,293

 

272,134

 

Securities purchased under resale agreements

 

 

 

 

Total cash and cash equivalents

 

776,970

 

545,781

 

606,316

 

Investment securities available-for-sale (Note 4)

 

3,128,594

 

2,511,192

 

2,411,941

 

Investment securities held-to-maturity (Note 4)

 

56,057

 

53,391

 

52,454

 

Loans held-for-sale

 

26,288

 

 

94

 

Loans:

 

 

 

 

 

 

 

Commercial

 

5,145,346

 

4,317,263

 

4,213,108

 

Construction

 

1,043,522

 

810,985

 

790,318

 

Residential real estate

 

1,299,665

 

1,066,694

 

1,067,868

 

Consumer

 

1,445,004

 

1,014,905

 

1,009,040

 

Lease financing

 

81,545

 

102,180

 

120,456

 

Total loans

 

9,015,082

 

7,312,027

 

7,200,790

 

Less: allowance for loan losses

 

(155,754

)

(138,601

)

(136,587

)

Loans, net

 

8,859,328

 

7,173,426

 

7,064,203

 

Bank premises and equipment, less accumulated depreciation of $161,720 (2003), $119,666 (December 2002) and $116,687 (September 2002)

 

137,100

 

102,428

 

102,223

 

Other real estate owned, net

 

397

 

132

 

123

 

Goodwill, net

 

510,406

 

102,705

 

102,705

 

Other intangible assets, net (Note 7)

 

57,359

 

7,530

 

7,999

 

Other assets

 

323,649

 

293,791

 

234,816

 

Total assets

 

$

13,876,148

 

$

10,790,376

 

$

10,582,874

 

 

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

$

2,698,277

 

$

2,086,745

 

$

2,040,521

 

Interest-bearing deposits

 

7,597,565

 

6,174,195

 

6,004,976

 

Total deposits

 

10,295,842

 

8,260,940

 

8,045,497

 

Short-term borrowings

 

958,506

 

823,385

 

811,840

 

Accrued expenses and other liabilities

 

140,913

 

94,479

 

105,803

 

Long-term debt

 

658,565

 

287,214

 

289,313

 

Total liabilities

 

12,053,826

 

9,466,018

 

9,252,453

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding - None

 

 

 

 

 

 

 

Common stock, $2 par value; authorized 130,000,000 shares; issued shares - 79,602,236 (2003), 68,836,092 (December 2002) and 69,612,217 (September 2002); restricted shares - 123,442 (2003), 76,250 (December 2002) and 67,215 (September 2002)

 

159,204

 

137,672

 

139,224

 

Capital surplus

 

544,818

 

120,577

 

150,592

 

Retained earnings

 

1,085,979

 

1,010,248

 

982,408

 

Accumulated other comprehensive income (loss)

 

32,321

 

55,861

 

58,197

 

Total shareholders’ equity

 

1,822,322

 

1,324,358

 

1,330,421

 

Total liabilities and shareholders’ equity

 

$

13,876,148

 

$

10,790,376

 

$

10,582,874

 

 

See notes to consolidated financial statements

 

2



 

MERCANTILE BANKSHARES CORPORATION

STATEMENT OF CONSOLIDATED INCOME

 

 

 

For the 9 Months
Ended September 30,

 

For the 3 Months
Ended September 30,

 

(Dollars in thousands, except per share data)

 

2003

 

2002

 

2003

 

2002

 

INTEREST INCOME

 

 

 

 

 

 

 

 

 

Interest and fees on loans

 

$

343,091

 

$

352,220

 

$

120,137

 

$

118,398

 

Interest and dividends on investment securities:

 

 

 

 

 

 

 

 

 

Taxable interest income

 

81,107

 

82,478

 

27,285

 

27,487

 

Tax-exempt interest income

 

1,747

 

1,429

 

783

 

470

 

Dividends

 

640

 

800

 

212

 

258

 

Other investment income

 

4,390

 

156

 

1,508

 

52

 

Total interest and dividends on investment securities

 

87,884

 

84,863

 

29,788

 

28,267

 

Other interest income

 

3,331

 

4,039

 

1,291

 

1,372

 

Total interest income

 

434,306

 

441,122

 

151,216

 

148,037

 

INTEREST EXPENSE

 

 

 

 

 

 

 

 

 

Interest on deposits

 

70,892

 

94,268

 

22,313

 

30,659

 

Interest on short-term borrowings

 

4,317

 

9,074

 

1,303

 

2,834

 

Interest on long-term debt

 

13,016

 

8,253

 

5,368

 

2,630

 

Total interest expense

 

88,225

 

111,595

 

28,984

 

36,123

 

NET INTEREST INCOME

 

346,081

 

329,527

 

122,232

 

111,914

 

Provision for loan losses

 

9,072

 

11,443

 

3,005

 

3,244

 

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

 

337,009

 

318,084

 

119,227

 

108,670

 

NONINTEREST INCOME

 

 

 

 

 

 

 

 

 

Investment and wealth management

 

57,450

 

51,521

 

20,577

 

17,166

 

Service charges on deposit accounts

 

26,072

 

23,161

 

9,701

 

7,972

 

Mortgage banking related fees

 

8,298

 

7,395

 

3,403

 

2,306

 

Investment securities gains and (losses)

 

7,015

 

846

 

(336

)

(203

)

Other income

 

30,358

 

24,107

 

12,558

 

8,145

 

Total noninterest income

 

129,193

 

107,030

 

45,903

 

35,386

 

NONINTEREST EXPENSES

 

 

 

 

 

 

 

 

 

Salaries

 

114,602

 

98,825

 

43,870

 

32,809

 

Employee benefits

 

28,891

 

25,076

 

10,144

 

8,476

 

Net occupancy expense of bank premises

 

13,451

 

12,214

 

5,136

 

4,245

 

Furniture and equipment expenses

 

21,974

 

18,062

 

8,432

 

6,003

 

Communications and supplies

 

10,506

 

10,014

 

3,889

 

3,351

 

Other expenses

 

48,595

 

38,567

 

19,718

 

13,753

 

Total noninterest expenses

 

238,019

 

202,758

 

91,189

 

68,637

 

Income before income taxes

 

228,183

 

222,356

 

73,941

 

75,419

 

Applicable income taxes

 

82,014

 

80,621

 

26,768

 

26,804

 

NET INCOME

 

$

146,169

 

$

141,735

 

$

47,173

 

$

48,615

 

NET INCOME PER SHARE OF COMMON STOCK (Note 3):

 

 

 

 

 

 

 

 

 

Basic

 

$

2.07

 

$

2.03

 

$

.64

 

$

.70

 

Diluted

 

$

2.05

 

$

2.02

 

$

.63

 

$

.69

 

DIVIDENDS PAID PER COMMON SHARE

 

$

.96

 

$

.88

 

$

.33

 

$

.30

 

 

See notes to consolidated financial statements

 

3



 

MERCANTILE BANKSHARES CORPORATION

STATEMENT OF CONSOLIDATED CASH FLOW

 

Increase (Decrease) in Cash and Cash Equivalents

 

For The 9 Months Ended
September 30,

 

(Dollars in thousands)

 

2003

 

2002

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

146,169

 

$

141,735

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Provision for loan losses

 

9,072

 

11,443

 

Depreciation and amortization

 

10,028

 

9,679

 

Amortization of other intangible assets

 

3,097

 

1,561

 

Investment securities gains

 

(7,015

)

(846

)

Write-downs of investments in private equity funds

 

78

 

2,494

 

Write-downs of other real estate owned

 

7

 

2

 

Gains on sales of other real estate owned

 

(350

)

(51

)

Gains on sales of buildings

 

(228

)

(456

)

Net (increase) decrease in assets:

 

 

 

 

 

Interest receivable

 

2,727

 

(2,170

)

Other receivables

 

(10,743

)

(2,999

)

Bank owned life insurance

 

(1,337

)

(868

)

Other assets

 

(16,485

)

(15,529

)

Loans held-for-sale

 

19,733

 

137,856

 

Net increase (decrease) in liabilities:

 

 

 

 

 

Interest payable

 

8,422

 

(3,520

)

Accrued expenses

 

(18,974

)

(5,262

)

Taxes payable

 

(12,496

)

(588

)

Net cash provided by operating activities

 

131,705

 

272,481

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from maturities of investment securities held-to-maturity

 

8,406

 

2,667

 

Proceeds from maturities of investment securities available-for-sale

 

772,637

 

419,357

 

Proceeds from sales of investment securities  available-for-sale

 

558,481

 

79,253

 

Purchases of investment securities held-to-maturity

 

(2,486

)

(2,852

)

Purchases of investment securities available-for-sale

 

(1,274,441

)

(570,227

)

Net increase in customer loans

 

(403,404

)

(310,983

)

Proceeds from sales of other real estate owned

 

748

 

227

 

Capital expenditures

 

(9,311

)

(11,126

)

Proceeds from sales of buildings

 

602

 

975

 

Purchase of bank owned life insurance

 

 

(50,000

)

Business acquisitions

 

(152,654

)

 

Cash from acquired bank

 

70,450

 

 

Other investing activity

 

(3,515

)

(11,654

)

Net cash used in investing activities

 

(434,487

)

(454,363

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net increase in noninterest-bearing deposits

 

315,196

 

156,643

 

Net increase in checking plus interest and savings accounts

 

110,249

 

398,525

 

Net (decrease) increase in certificates of deposit

 

(82,637

)

42,957

 

Net decrease in short-term borrowings

 

(37,889

)

(41,438

)

Proceeds from issuance of long-term debt

 

300,000

 

 

Repayment of long-term debt

 

(8,400

)

(8,300

)

Proceeds from issuance of shares

 

7,232

 

6,566

 

Repurchase of common shares

 

(212

)

(19,754

)

Dividends paid

 

(69,568

)

(61,348

)

Net cash provided by financing activities

 

533,971

 

473,851

 

Net increase in cash and cash equivalents

 

231,189

 

291,969

 

Cash and cash equivalents at beginning of period

 

545,781

 

314,347

 

Cash and cash equivalents at end of period

 

$

776,970

 

$

606,316

 

 

See notes to consolidated financial statements

 

4



 

MERCANTILE BANKSHARES CORPORATION

STATEMENT OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

 

FOR THE 9 MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

 

(Dollars in thousands, except per share data)

 

Total

 

Common
Stock

 

Capital
Surplus

 

Retained
Earnings

 

Accumulated Other
Comprehensive
Income (Loss)

 

BALANCE, DECEMBER 31, 2001

 

$

1,230,206

 

$

139,551

 

$

159,947

 

$

904,479

 

$

26,229

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

141,735

 

 

 

 

 

141,735

 

 

 

Unrealized gains(losses) on securities available-for-sale, net of reclassification adjustment, net of taxes

 

31,968

 

 

 

 

 

 

 

31,968

 

Comprehensive income

 

173,703

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.88 per share)

 

(61,348

)

 

 

 

 

(61,348

)

 

 

Issuance of 80,889 shares for dividend reinvestment and stock purchase plan

 

2,889

 

162

 

2,727

 

 

 

 

 

Issuance of 16,981 shares for employee stock purchase dividend reinvestment plan

 

684

 

34

 

650

 

 

 

 

 

Issuance of 175,922 shares for employee stock option plan

 

2,993

 

352

 

2,641

 

 

 

 

 

Issuance of 67,215 shares for restricted stock awards

 

3,019

 

134

 

2,885

 

 

 

 

 

Deferred compensation - restricted stock awards

 

(2,458

)

 

 

 

 

(2,458

)

 

 

Purchase of 504,500 shares under stock repurchase plan

 

(19,754

)

(1,009

)

(18,745

)

 

 

 

 

Vested stock options

 

487

 

 

487

 

 

 

BALANCE, SEPTEMBER 30, 2002

 

$

1,330,421

 

$

139,224

 

$

150,592

 

$

982,408

 

$

58,197

 

BALANCE, DECEMBER 31, 2002

 

$

1,324,358

 

$

137,672

 

$

120,577

 

$

1,010,248

 

$

55,861

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

146,169

 

 

 

 

 

146,169

 

 

 

Unrealized gains(losses) on securities available-for-sale, net of reclassification adjustment, net of taxes (Note 8)

 

(23,540

)

 

 

 

 

 

 

(23,540

)

Comprehensive income

 

122,629

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.96 per share)

 

(69,568

)

 

 

 

 

(69,568

)

 

 

Issuance of 10,379,710 shares for bank acquisition

 

428,059

 

20,759

 

407,300

 

 

 

 

 

Fair value of 322,528 converted options related to employee stock option plan of acquired bank

 

5,944

 

 

 

5,944

 

 

 

 

 

Issuance of 95,070 shares for dividend reinvestment and stock purchase plan

 

3,427

 

190

 

3,237

 

 

 

 

 

Issuance of 17,185 shares for employee stock purchase dividend reinvestment plan

 

675

 

35

 

640

 

 

 

 

 

Issuance of 178,512 shares for employee stock option plan

 

3,130

 

357

 

2,773

 

 

 

 

 

Issuance of 100,537 shares for restricted stock awards

 

3,561

 

202

 

3,359

 

 

 

 

 

Deferred compensation - restricted stock awards

 

(870

)

 

 

 

 

(870

)

 

 

Purchase of 5,500 shares under stock repurchase plan

 

(212

)

(11

)

(201

)

 

 

 

 

Vested stock options

 

1,189

 

 

1,189

 

 

 

BALANCE, SEPTEMBER 30, 2003

 

$

1,822,322

 

$

159,204

 

$

544,818

 

$

1,085,979

 

$

32,321

 

 

See notes to consolidated financial statements

 

5



 

MERCANTILE BANKSHARES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation

 

The consolidated financial statements, which include the accounts of Mercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates, are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practice within the banking industry.  In the opinion of management, the consolidated financial statements include all adjustments necessary for a fair presentation of the interim period.  These adjustments are of a normal nature and include adjustments to eliminate all significant intercompany transactions.  In view of the changing conditions in the national economy, the effect of actions taken by regulatory authorities and normal seasonal factors, the results for the interim period are not necessarily indicative of annual performances.  For comparability, certain prior period amounts have been reclassified to conform with current period presentation.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities in the financial statements, and the disclosure of revenue and expenses during the reporting period.  These assumptions are based on information available as of the date of the financial statements and could differ from actual results.  See Form 10-K for more detail.

 

2. Mergers and Acquisitions

 

In March and April 2003, Bankshares acquired in separate transactions, Boyd Watterson Asset Management, LLC (“BW”), an investment management firm, and Peremel & Company (“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies were purchased for approximately $29 million in cash.  The Boyd Watterson acquisition has a potential additional contingent payment of up to $8.6 million.  The contingent payment will be recorded when amounts are resolved and become payable three years from the acquisition date.  Bankshares finalized and recorded approximately $10.1 million of identified intangibles, mostly client relationships, as a result of these acquisitions.  These intangibles are being amortized on a straight-line basis over a range of 3 to 8 years.  Goodwill recorded on these transactions totaled approximately $17.0 million at September 30, 2003.

 

On August 12, 2003, Bankshares completed its acquisition of F&M Bancorp (“F&M”), a bank holding company headquartered in Frederick, Maryland.  The total consideration to be paid to F&M stockholders in connection with the acquisition was fixed at the time the merger agreement was executed at approximately $123.5 million in cash and 10.3 million shares of Bankshares common stock.  F&M transactions have been included in Bankshares’ financial results since August 13, 2003.  Acquired assets on August 12, 2003 totaled $2.2 billion, including $1.4 billion of loans and leases; liabilities assumed were $2.0 billion, including $1.7 billion of deposits.  As part of the purchase price allocation at August 12, 2003, Bankshares recorded $41.7 million of core deposit intangible, and goodwill totaled approximately $390.6 million.  This is a preliminary estimate pending final analysis that is due in the fourth quarter and is subject to change pending the results. The weighted average amortization period for newly acquired core deposit intangible is seven years and is also subject to change pending final results of analysis.

 

On October 24, 2003, certain assets and liabilities of F&M were transferred to other Bankshares affiliates in order to align customers’ accounts with the Bankshares affiliate serving the geographic area where those customers reside.  As a result of the transfers, future financial statements of Bankshares will not report results of the former F&M as a stand-alone entity.

 

6



 

F&M, newly acquired in a business combination, falls under the guidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. “Exit costs” are defined to include those costs recorded by F&M prior to the merger date and therefore are not included in Bankshares results of operations.  F&M has recorded exit costs of $34.0 million relating to severance, systems conversion, branch consolidation and costs associated with terminating contracts (including leases). $18.1 million of these exit costs were paid as of September 30, 2003.

 

Bankshares’ exit costs, referred to herein as “merger-related” costs, are defined to include those costs for its branch closings and related severance, combining operations such as systems conversions, integration planning consultant’s fees and marketing consultant’s fees incurred by Bankshares prior to and after the merger date and are included in Bankshares results of operations.  Bankshares expensed merger-related costs totaling $3.3 million and $2.4 million for the nine and three-month periods ended September 30, respectively. The costs associated with these activities are included in noninterest expenses. Merger-related expenses incurred year to date consisted largely of expenses for professional services rendered in connection with the merger integration plan. Bankshares will incur additional merger-related expenses in the fourth quarter as systems conversions, branch closings and integration of operations continue and will be reflected as expense when incurred.

 

Disclosed below is certain pro forma information for 2003 as if F&M had been acquired on January 1, 2003 and 2002. These results combine the historical results of F&M into Bankshares consolidated statement of income.  This table reflects noninterest expenses adjusted for exit costs and intangible amortization. This is not necessarily what would have occurred had the acquisition taken place on the indicated dates and is not indicative of future results.

 

 

 

For the 9 Months
Ended September 30,

 

For the 3 Months
Ended September 30,

 

(Dollars in thousands)

 

2003

 

2002

 

2003

 

2002

 

Interest income

 

$

500,141

 

$

525,206

 

$

163,344

 

$

176,339

 

Interest expense

 

106,950

 

139,701

 

32,382

 

45,061

 

NET INTEREST INCOME

 

393,191

 

385,505

 

130,962

 

131,278

 

Noninterest income

 

151,291

 

130,633

 

50,424

 

43,046

 

Noninterest expenses

 

283,219

 

257,771

 

100,328

 

87,096

 

NET INCOME

 

160,369

 

156,069

 

49,316

 

53,647

 

 

Disclosed below is certain pro forma information for 2003 as if F&M had been included in each interim period presented as of January 1, 2003 and 2002. These results combine the historical results of F&M into Bankshares consolidated balance sheet statement. This is not necessarily what would have occurred had the acquisition taken place on the indicated dates.

 

(Dollars in thousands)

 

September 30,
2003

 

December 31,
2002

 

September 30,
2002

 

Total loans

 

$

9,015,082

 

$

8,617,375

 

$

8,434,582

 

Total earning assets

 

12,627,364

 

12,097,158

 

11,808,689

 

Total assets

 

13,876,148

 

13,135,104

 

12,826,592

 

Total deposits

 

10,295,842

 

9,856,079

 

9,606,415

 

Shareholders’ equity

 

1,822,322

 

1,758,356

 

1,764,419

 

 

7



 

3. Earnings Per Share

 

Basic earnings per share (“EPS”) are computed by dividing income available to common shareholders by weighted average common shares outstanding.  Diluted EPS are computed using the same components as basic EPS with the denominator adjusted for the dilutive effect of stock awards.  The following tables provide reconciliation between the computation of basis EPS and diluted EPS for the nine months and quarter ended September 30, 2003 and 2002, respectively.

 

 

 

For the 9 Months Ended September 30,

 

 

 

2003

 

2002

 

(In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

146,169

 

70,647

 

$

2.07

 

$

141,735

 

69,750

 

$

2.03

 

Dilutive effect of stock options and restricted stock awards

 

 

 

510

 

 

 

 

 

530

 

 

 

Diluted EPS

 

$

146,169

 

71,157

 

$

2.05

 

$

141,735

 

70,280

 

$

2.02

 

 

 

 

For the 3 Months Ended September 30,

 

 

 

2003

 

2002

 

(In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

47,173

 

74,253

 

$

.64

 

$

48,615

 

69,637

 

$

.70

 

Dilutive effect of stock options and restricted stock awards

 

 

 

587

 

 

 

 

 

474

 

 

 

Diluted EPS

 

$

47,173

 

74,840

 

$

.63

 

$

48,615

 

70,111

 

$

.69

 

 

Antidilutive options and awards excluded in the computation of diluted earnings per share were 238,838 and 129,657 for year-to-date September 30, 2003 and 2002, respectively, and 170,313 and 261,875 for quarter-to-date September 30, 2003 and 2002, respectively.

 

4. Investment Securities

 

The amortized cost and fair value of investment securities at September 30, 2003, December 31, 2002 and September 30, 2002 are shown below:

 

 

 

September 30, 2003

 

December 31, 2002

 

September 30, 2002

 

(Dollars in thousands)

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

869,760

 

$

901,384

 

$

1,375,703

 

$

1,421,890

 

$

1,437,544

 

$

1,488,636

 

U.S. Government agencies

 

752,861

 

773,894

 

695,970

 

727,627

 

677,547

 

708,647

 

Mortgage-backed securities

 

1,243,745

 

1,240,215

 

341,805

 

348,323

 

194,984

 

201,718

 

States and political subdivisions

 

88,691

 

90,696

 

549

 

577

 

549

 

579

 

Other investments

 

121,377

 

122,405

 

7,683

 

12,775

 

7,716

 

12,361

 

Total

 

$

3,076,434

 

$

3,128,594

 

$

2,421,710

 

$

2,511,192

 

$

2,318,340

 

$

2,411,941

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securities held-to-maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

$

33,421

 

$

36,030

 

$

38,299

 

$

41,150

 

$

36,993

 

$

40,071

 

Other investments

 

22,636

 

22,636

 

15,092

 

15,092

 

15,461

 

15,461

 

Total

 

$

56,057

 

$

58,666

 

$

53,391

 

$

56,242

 

$

52,454

 

$

55,532

 

 

8



 

5. Impaired Loans

 

A loan is considered impaired, based on current information and events, if it is probable that Bankshares will not collect all principal and interest payments according to the contractual terms of the loan agreement.  Generally, a loan is considered impaired once either principal or interest payments become 90 days past due at the end of a calendar quarter.  A loan may be considered impaired sooner if, in management’s judgment, such action is warranted.  The impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or fair value of the collateral if the repayment is expected to be provided predominantly by the underlying collateral.  A majority of Bankshares’ impaired loans are measured by reference to the fair value of the collateral.  If a loan is deemed to be impaired a valuation allowance is established for the amount of the impairment.  Accrued interest on impaired loans is reversed and is recognized on a cash basis.  Information with respect to impaired loans and the related valuation allowance (if the measure of the impaired loan is less that the recorded investment) at September 30, and June 30, 2003 and at the end of December 2002, is shown below.  See Form 10-K for more detail.

 

(Dollars in thousands)

 

September 30,
2003

 

June 30,
2003

 

December 31,
2002

 

Impaired loans with a specific valuation allowance

 

$

27,869

 

$

18,523

 

$

13,751

 

All other impaired loans

 

18,609

 

15,066

 

16,813

 

Total impaired loans

 

$

46,478

 

$

33,589

 

$

30,564

 

 

 

 

 

 

 

 

 

Specific allowance for loan losses applicable to impaired loans

 

$

14,766

 

$

8,840

 

$

5,251

 

Allowance for loan losses applicable to other than impaired loans

 

140,988

 

133,421

 

133,350

 

Total allowance for loan losses

 

$

155,754

 

$

142,261

 

$

138,601

 

 

 

 

 

 

 

 

 

Year-to-date interest income on impaired loans recorded on the cash basis

 

$

220

 

$

155

 

$

563

 

Year-to-date average recorded investment in impaired loans during the period

 

$

29,194

 

$

26,438

 

$

53,777

 

Quarter-to-date interest income on impaired loans recorded on the cash basis

 

$

65

 

$

58

 

$

143

 

Quarter-to-date average recorded investment in impaired loans during the period

 

$

34,707

 

$

28,822

 

$

44,263

 

 

Note: Impaired loans do not include large groups of smaller balance homogeneous loans that are evaluated collectively for impairment (e.g., residential mortgages and consumer installment loans).  The allowance for loan losses related to these loans is included in the allowance for loan losses applicable to other than impaired loans.

 

6. Commitments

 

Various commitments to extend credit (lines of credit) are made in the normal course of the banking business. Total unused lines of credit approximated $3.4 billion, $3.0 billion and $2.9 billion at September 30, 2003, December 31, 2002 and September 30, 2002, respectively.  The lines of credit commitments are shown at fair value.  These amounts are not recorded on the books of Bankshares.  In addition, letters of credit are issued for the benefit of customers by affiliated banks. These outstanding letters of credit were $284.3 million at September 30, 2003, $241.1 million at December 31, 2002 and $232.9 million at September 30, 2002.  In accordance with FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, the fees received for issuing letters of credit are deferred and amortized over the life of the commitment.  The letters of credit at September 30, 2003 had a carrying value of $745 thousand representing unamortized fees.

 

9



 

Bankshares’ mortgage banking subsidiary, as a Fannie Mae Delegated Underwriting and Servicing lender, has a loss sharing arrangement for loans originated on behalf of and sold to Fannie Mae.  The unamortized principal balance of the underlying loans totaled $150.0 million at September 30, 2003.  No allowance has been established for possible losses since there have been no losses recognized during the six-year history of the arrangement and none are expected as of September 30, 2003. The mortgage subsidiary has also originated and loans sold with recourse in the event of foreclosure on the underlying real estate.  The unamortized amount of principal balance of loans sold with recourse totaled $2.5 million at September 30, 2003.  These mortgages are generally in good standing and are well collateralized, no loss has ensued and no future loss is expected.

 

Bankshares has committed to invest funds in third-party private equity investments.  At September 30, 2003, December 31, 2002 and September 30, 2002, $17.8 million, $15.2 million and $10.4 million, respectively, remained unfunded.

 

7. Intangible Assets

 

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at September 30, 2003 and December 31, 2002:

 

 

 

September 30, 2003

 

December 31, 2002

 

(Dollars in thousands)

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Net
Amount

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Net
Amount

 

Deposit intangibles

 

$

55,556

 

$

(7,679

)

$

47,877

 

$

13,846

 

$

(6,581

)

$

7,265

 

Mortgage servicing rights

 

1,914

 

(1,524

)

390

 

1,543

 

(1,282

)

261

 

Customer list

 

10,110

 

(1,018

)

9,092

 

50

 

(46

)

4

 

Total

 

$

67,580

 

$

(10,221

)

$

57,359

 

$

15,439

 

$

(7,909

)

$

7,530

 

 

The projections of amortization expense shown for mortgage servicing rights are based on asset balances and the interest rate environment as of September 30, 2003. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

 

The following table shows the current period and estimated future amortization expense for amortized intangible assets. Core deposit intangibles are amortized based on useful lives of up to seven years. Bankshares recorded an estimated $41.7 million of core deposit intangibles in conjunction with the F&M acquisition.  Future estimated amortization expense amounts are contingent on the final results of the valuation study being conducted in concert with the previously mentioned planned transfer of selected F&M assets and liabilities to Bankshares affiliates in the fourth quarter. Management reviews other intangible assets for impairment yearly (except mortgage servicing rights, which are reviewed monthly), or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. For those intangible assets subject to amortization, impairment is indicated if the sum of undiscounted estimated future net cash flow is less than the carrying amount of the asset. Impairment is recognized by accelerating the write off of the asset to the extent that the carrying value exceeds the estimated fair value.

 

10



 

(Dollars in thousands)

 

Core
deposit
intangibles

 

Mortgage
servicing
intangibles

 

Customer list
intangibles

 

Total

 

Nine months ended September 30, 2003 (actual)

 

$

1,904

 

$

218

 

$

975

 

$

3,097

 

Quarter ended December 31, 2003 (estimated)

 

1,883

 

98

 

420

 

2,727

 

 

 

 

 

 

 

 

 

 

 

Estimate for year ended December 31,

2003

 

3,787

 

316

 

1,395

 

5,824

 

 

2004

 

7,531

 

292

 

1,659

 

9,580

 

 

2005

 

7,531

 

 

1,659

 

9,190

 

 

2006

 

7,531

 

 

1,494

 

9,025

 

 

2007

 

7,384

 

 

1,323

 

8,707

 

 

2008

 

6,669

 

 

1,317

 

7,986

 

 

8. Comprehensive Income

 

The following table summarizes the related tax effect of unrealized gains (losses) on securities available-for-sale for the nine months ended September 30, 2003 and 2002.  The net amount is included in accumulated other comprehensive income (loss) in the Statement of Changes in Consolidated Shareholders’ Equity.

 

 

 

For the 9 Months Ended September 30,

 

 

 

2003

 

2002

 

(Dollars in thousands)

 

Pretax
Amount

 

Tax
(Expense)
 Benefit

 

Net
Amount

 

Pretax
Amount

 

Tax
(Expense)
 Benefit

 

Net
Amount

 

Unrealized gains (losses) on securities available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized holding gains (losses) arising during the period

 

$

(30,309

)

$

11,010

 

$

(19,299

)

$

51,629

 

$

(19,150

)

$

32,479

 

Reclassification adjustment for (gains) losses included in net income

 

(7,015

)

2,774

 

(4,241

)

(846

)

335

 

(511

)

Total

 

$

(37,324

)

$

13,784

 

$

(23,540

)

$

50,783

 

$

(18,815

)

$

31,968

 

 

9. Capital Adequacy

 

Bankshares and its bank affiliates are subject to various regulatory capital adequacy requirements administered by federal and state banking agencies.  These requirements include maintaining certain capital ratios above minimum levels.  These capital ratios include tier I capital and total risk-based capital as percents of net risk-weighted assets and tier I capital as a percent of adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacy purposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital and leverage ratios, respectively.  To be categorized as well capitalized, a bank must maintain minimum ratios of 6.00%, 10.00% and 5.00%, for its tier I capital, total capital and leverage ratios, respectively.  As of September 30, 2003, Bankshares and all of its bank affiliates except one, F&M, exceeded all capital adequacy requirements to be considered well capitalized.   Although adequately capitalized, F&M did not meet the total risk-based capital threshold to be considered well capitalized.  As part of the purchase price allocation F&M recorded core deposit intangibles of $41.7 million, which is deducted from regulatory capital.  This deduction reduced F&M’s total risk-based capital ratio to 9.3%, slightly below the 10.0% threshold needed to be considered well capitalized.  As a result of the transfers referred to in Footnote 2 to the Consolidated Financial Statements, F&M’s total risk-based capital ratio was 18.0% at October 31, 2003.

 

11



 

Capital ratios and the amounts used to calculate them are presented in the following table for Bankshares and Mercantile-Safe Deposit & Trust Company (MSD&T), the lead bank, as of September 30, 2003 and December 31, 2002.

 

 

 

September 30, 2003

 

December 31, 2002

 

(Dollars in thousands)

 

Bankshares

 

MSD&T

 

Bankshares

 

MSD&T

 

Tier I capital

 

$

1,215,504

 

$

394,407

 

$

1,151,831

 

$

430,375

 

Total risk-based capital

 

1,638,254

 

438,456

 

1,250,550

 

473,185

 

Net risk-weighted assets

 

9,824,821

 

3,515,440

 

7,677,476

 

3,407,691

 

Adjusted average total assets

 

11,966,146

 

4,473,499

 

10,281,071

 

4,246,480

 

 

 

 

 

 

 

 

 

 

 

Tier I capital ratio

 

12.37

%

11.22

%

15.00

%

12.63

%

Total capital ratio

 

16.67

%

12.47

%

16.29

%

13.89

%

Leverage ratio

 

10.16

%

8.82

%

11.20

%

10.13

%

 

10. Segment Reporting

 

Operating segments as defined by SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information are components of an enterprise with separate financial information.  The component engages in business activities, from which it derives revenues and incurs expenses and whose operating results management relies on for decision-making and performance assessment. Bankshares has three reportable segments – the twenty Community Banks, the Banking Division of MSD&T and the Investment and Wealth Management Division (IWM) of MSD&T.

 

The following table presents selected segment information for the nine months ended September 30, 2003 and 2002.  The components in the “Other” column consist of amounts for the nonbanking affiliates and intercompany eliminations.   Certain expense amounts such as operations overhead have been reclassified from internal financial reporting in order to provide for full cost absorption.  These reclassifications are shown in the “Adjustments” line.  F&M is included in the column “Community Banks” whereas BW and Peremel are included in the column “MSD&T IWM”.

 

 

 

For the 9 Months Ended September 30, 2003

 

(Dollars in thousands)

 

MSD&T
Banking

 

MSD&T
IWM

 

Total
MSD&T

 

Community
Banks

 

Other

 

Total

 

Net interest income

 

$

106,701

 

$

 

$

106,701

 

$

240,278

 

$

(898

)

$

346,081

 

Provision for loan losses

 

(5,253

)

 

(5,253

)

(3,819

)

 

(9,072

)

Noninterest income

 

32,070

 

57,560

 

89,630

 

50,151

 

(10,588

)

129,193

 

Noninterest expenses

 

(69,145

)

(50,014

)

(119,159

)

(127,627

)

8,767

 

(238,019

)

Adjustments

 

13,589

 

(2,457

)

11,132

 

(7,796

)

(3,336

)

 

Income (loss) before income taxes

 

77,962

 

5,089

 

83,051

 

151,187

 

(6,055

)

228,183

 

Income tax (expense) benefit

 

(28,075

)

(2,035

)

(30,110

)

(52,125

)

221

 

(82,014

)

Net income (loss)

 

$

49,887

 

$

3,054

 

$

52,941

 

$

99,062

 

$

(5,834

)

$

146,169

 

Average assets

 

 

 

 

 

$

4,390,264

 

$

7,156,379

 

$

(145,612

)

$

11,401,031

 

Average equity

 

 

 

 

 

454,583

 

846,404

 

90,134

 

1,391,121

 

 

12



 

 

 

For the 9 Months Ended September 30, 2002

 

(Dollars in thousands)

 

MSD&T
Banking

 

MSD&T
IWM

 

Total
MSD&T

 

Community
Banks

 

Other

 

Total

 

Net interest income

 

$

109,942

 

$

 

$

109,942

 

$

221,296

 

$

(1,711

)

$

329,527

 

Provision for loan losses

 

(6,800

)

 

(6,800

)

(4,643

)

 

(11,443

)

Noninterest income

 

29,987

 

51,195

 

81,182

 

37,375

 

(11,527

)

107,030

 

Noninterest expenses

 

(68,215

)

(32,261

)

(100,476

)

(112,988

)

10,706

 

(202,758

)

Adjustments

 

12,720

 

(1,252

)

11,468

 

(6,376

)

(5,092

)

 

Income (loss) before income taxes

 

77,634

 

17,682

 

95,316

 

134,664

 

(7,624

)

222,356

 

Income tax (expense) benefit

 

(28,045

)

(7,073

)

(35,118

)

(47,035

)

1,532

 

(80,621

)

Net income (loss)

 

$

49,589

 

$

10,609

 

$

60,198

 

$

87,629

 

$

(6,092

)

$

141,735

 

Average assets

 

 

 

 

 

$

4,101,243

 

$

6,157,184

 

$

(253,236

)

$

10,005,191

 

Average equity

 

 

 

 

 

435,080

 

774,514

 

42,913

 

1,252,507

 

 

11. Derivative Instruments and Hedging Activities

 

FASB Statement No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, FASB Statement No. 138 (SFAS No. 138), Accounting for Certain Derivative Instruments and Certain Hedging Activities – an amendment to FASB Statement No. 133 and FASB Statement No. 149 (SFAS No. 149), Amendment of Statement 133 on Derivative Instruments and Hedging Activities  (collectively referred to as derivatives), establishes accounting and reporting standards for derivative instruments and for hedging activities. Bankshares maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  Derivative instruments that are used as part of the interest rate risk management strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve the exchange of fixed-rate and variable-rate interest payments between two parties, based on a common notional principal amount and maturity date. Bankshares entered into interest rate swaps to convert fixed-rate loans made to borrowers to floating-rate loans and convert its nonprepayable fixed-rate debt to floating-rate debt.

 

The fair value of derivative instruments recorded in other assets was $14.1 million (notional $203.1 million) and $11.4 million (notional $203.2 million) at September 30, 2003 and December 31, 2002, respectively.  The fair value of derivative instruments recorded in other liabilities was $5.4 million (notional $100.0 million) and $0 at September 30, 2003 and December 31, 2002, respectively.  For the nine months ended September 30, 2003, Bankshares recognized a net gain of $50 thousand, included in interest and fees on loans, which represented the ineffective portion of the fair-value hedge of fixed-rate loans made to borrowers.  For the year ended December 31, 2002, Bankshares recognized a net loss of $40 thousand.  The fair-value hedges of nonprepayable fixed-rate debt were 100% effective for the reported periods.

 

12. Stock-based Compensation Expense

 

Bankshares has several stock-based compensation programs for its directors, management and employees.  These programs include the use of stock options, restricted stock awards and phantom stock.  The compensation costs associated with Bankshares’ Omnibus Stock Plan and the granting of restricted stock awards are included in salary expense.  Restricted stock award expense for the third quarter of 2003 includes $1.0 million related to the accelerated vesting of certain awards in the IWM Division.  The costs associated with Bankshares’ deferred directors’ compensation plan are included in professional fees as part of other expenses on the income statement.  These amounts are summarized in the table below:

 

13



 

 

 

For the 9 Months
Ended September 30,

 

For the 3 Months
Ended September 30,

 

(Dollars in thousands)

 

2003

 

2002

 

2003

 

2002

 

Option related expense

 

$

1,218

 

$

981

 

$

353

 

$

269

 

Restricted stock award expense

 

2,576

 

561

 

1,654

 

262

 

Sub-total included in salaries expense

 

3,794

 

1,542

 

2,007

 

531

 

Directors’ deferred compensation expense

 

512

 

(615

)

198

 

(354

)

Total stock-based compensation expense

 

$

4,306

 

$

927

 

$

2,205

 

$

177

 

 

13.  Recent Accounting Standards

 

In April 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 149 (SFAS No. 149), Amendment of Statement No.133 on Derivative Instruments and Hedging Activities.  SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133.  In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. This Statement is generally effective for contracts entered into or modified after June 30, 2003 and did not have a material impact on Bankshares’ financial statements.

 

In May 2003, the FASB issued SFAS No. 150 (SFAS No. 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity.  This Statement is not expected to have a material impact on Bankshares’ financial statements.

 

On January 17, 2003, FASB issued FASB Interpretation No. 46 Consolidation of Variable Interest Entities __ an interpretation of ARB No. 51 (FIN 46).  The FASB has deferred the implementation of FIN 46 for all public entities to the first reporting period ending after December 15, 2003.  This deferral applies to all variable interest entities both financial and non-financial in nature.  Bankshares is currently in the process of evaluating the impact of FIN 46. This Statement is not expected to have a material impact on Bankshares’ financial statements.

 

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

MERCANTILE BANKSHARES CORPORATION

 

Consolidated Financial Results

 

In March, April and August of 2003, Bankshares acquired in separate transactions, Boyd Watterson Asset Management, LLC (“BW”), Peremel & Company (“Peremel”), and F&M Bancorp (“F&M”), respectively, which are collectively referred to herein as, “the Acquisitions”.  The Acquisitions were accounted for under the purchase method of accounting and their transactions have been included in Bankshares’ financial results since their respective closings. On October 24, 2003, certain assets and liabilities of F&M were transferred to other Bankshares affiliates in order to align customers’ accounts with the Bankshares affiliate serving the geographic area where those customers reside.  As a result of the transfers, future financial statements of Bankshares will

 

14



 

not report results of the former F&M as a stand-alone entity.  (See Footnote 2 to the Consolidated Financial Statements included in this report.)

 

Net income for the quarter ended September 30, 2003 was $47.2 million, a 3.0% decrease from net income of $48.6 million for the same period in 2002.  For the quarter ended September 30, 2003, diluted net income per share was $.63, a decrease of 8.7% from the $.69 reported for the third quarter last year.  Weighted average shares outstanding increased from 69,637,482 for the quarter ended September 30, 2002, to 74,252,653 for the quarter ended September 30, 2003 as a result of the Acquisitions.  The results of operations for the Acquisitions are included from their respective merger dates forward.

 

Factors affecting earnings for the third quarter included: $1.5 million or $.02 per share of after-tax expenses related to F&M; $2.2 million or $.03 per share of after-tax severance expenses related to the Investment & Wealth Management Division and continued compression of the net interest margin to 4.19% in the third quarter 2003 from 4.60% in the third quarter 2002.

 

Bankshares also reports operating earnings, defined as “GAAP” (Generally Accepted Accounting Principles) earnings excluding the amortization of intangible assets associated with purchase accounting for business combinations, securities gains and losses, and other significant gains, losses or expenses that are unusual in nature (such as merger-related expenses).  Net operating earnings totaled $49.9 million for the quarter, an increase of 1.7% compared to $49.0 million in the same period for 2002.  Diluted net operating earnings per share for the third quarter were $.67, a decrease of 4.3% from $.70 earned in the third quarter of 2002.  A reconciliation of net income (GAAP basis) to net operating earnings can be found on page 23 of this filing.

 

For the three months ended September 30, 2003, return on average tangible assets was 1.56%, return on average tangible equity was 15.70% and average tangible equity to average tangible assets was 9.91%.  Comparable ratios for the three months ended September 30, 2002 were 1.90%, 16.67% and 11.42%, respectively.  A reconciliation of these ratios to their respective GAAP basis ratios can be found on page 23 of this filing.

 

For the nine months ended September 30, 2003, net income was $146.2 million, an increase of 3.1% over the $141.7 million reported for the comparable period in 2002.  Diluted net income per share for the first three quarters of 2003 was $2.05, a 1.5% increase over the $2.02 reported for the same period last year. The Acquisitions added $10.7 million to net interest income, $9.9 million to noninterest income and $14.0 million to noninterest expenses for the nine months ended September 30, 2003.

 

For the nine months ended September 30, 2003, return on average assets was 1.71%, return on average equity was 14.05% and average equity to average assets was 12.20%.  Comparable ratios for the nine months ended September 30, 2002 were 1.89%, 15.13% and 12.52%, respectively.

 

Management believes that reporting several key measures based on tangible equity (equity less intangible assets) is important, as this is the basis for measuring the adequacy of capital for regulatory purposes.  For the nine months ended September 30, 2003, return on average tangible assets was 1.77% compared to 1.93% for the same period last year.  The ratio of average tangible equity to average tangible assets was 10.66% compared to 11.53% for the same period last year.  The return on average tangible equity for the nine months ended September 30, 2003 and 2002 was 16.57% and 16.72%, respectively.

 

On the date of purchase, F&M had total loans of  $1.4 billion, total earning assets of $2.0 billion, and total deposits of $1.7 billion.  There were 10,379,710 shares issued for the acquisition, accounted for under the purchase method, resulting in total consideration paid of $558.1 million giving rise to the creation of approximately $432.4 million of intangible assets. See Footnote No. 2 for more details on the impact of the Acquisitions on Bankshares’ consolidated financial statements.  The following tables set forth information regarding the F&M portion of the Acquisitions for the periods indicated.

 

15



 

Supplemental Information

Farmers & Mechanics Affiliate

Selected Balance Sheet Data

 

(Dollars in thousands)

 

At
September 30, 2003

 

Average for the
3 months ended
September 30, 2003 (1)

 

Investment securities available-for-sale

 

$

442,003

 

$

292,535

 

Loans:

 

 

 

 

 

Commercial

 

623,808

 

336,508

 

Construction

 

107,755

 

59,191

 

Residential real estate

 

194,917

 

103,446

 

Consumer

 

392,416

 

213,234

 

Lease financing

 

 

 

Total loans

 

1,318,896

 

712,379

 

Less: allowance for loan losses

 

(12,660

)

(7,107

)

Loans, net

 

1,306,236

 

705,272

 

Total assets

 

2,117,364

 

1,177,084

 

Deposits:

 

 

 

 

 

Noninterest-bearing deposits

 

310,542

 

167,133

 

Interest-bearing deposits

 

1,353,723

 

740,578

 

Total deposits

 

1,664,265

 

907,711

 

Total liabilities

 

1,948,448

 

1,085,024

 

 

Selected Income Statement Data

 

(Dollars in thousands)

 

For the
3 months ended
September 30, 2003 (1)

 

Total interest income

 

$

13,151

 

Total interest expense

 

2,242

 

NET INTEREST INCOME

 

10,909

 

NONINTEREST INCOME

 

 

 

Investment and wealth management

 

266

 

Service charges on deposit accounts

 

1,232

 

Mortgage banking related fees

 

1,011

 

Investment securities gains and (losses)

 

(335

)

Other income

 

2,177

 

Total noninterest income

 

4,351

 

NONINTEREST EXPENSES

 

 

 

Salaries

 

4,278

 

Employee benefits

 

700

 

Net occupancy expense of bank premises

 

790

 

Furniture and equipment expenses

 

660

 

Communications and supplies

 

394

 

Other expenses

 

2,125

 

Total noninterest expenses

 

8,947

 

NET INCOME

 

4,305

 

 


(1) F&M is included from acquisition date, August 12, 2003, through September 30, 2003.

 

Note: Although not a required disclosure, this is intended solely as an aid to help the readers’ understanding of the impact of F&M on Bankshares’ third quarter results.  As a result of the transfers discussed in Footnote 2 to the Consolidated Financial Statements, future financial statements of Bankshares will not report financial data of the former F&M as a stand-alone entity.

 

16



 

Net Interest Income and Net Interest Margin

 

Net interest income for the quarter ended September 30, 2003 increased 9.2% or $10.3 million from the third quarter last year primarily as a result of the Acquisitions ($10.7 million).  Net interest income is affected by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities and by changes in the level of interest rates. The growth in net interest income was attributable to the growth in average earning assets, particularly in the loan portfolio largely as a result of F&M.  Average total loans increased $1.2 billion or 16.3% compared to the prior period.  Included in this increase is $712.4 million relating to F&M.  While the growth in the average loan portfolio shows signs of improvement, management expects loan growth to remain in the mid-single digit range for the next several quarters.  Average investment securities for the third quarter 2003 increased by $598.4 million or 25.1% to $3.0 billion compared to the third quarter 2002.  Approximately one half of the increase in average securities was due to F&M.

 

Growth in net interest income was partially offset by a 41 basis point (bp) decline in net interest margin from 4.60% for the third quarter 2002 to 4.19% for the current quarter.  The year-over-year decline in net interest income was negatively affected by the Federal Reserve’s 75 bp reduction in short-term interest rates in the last twelve months.  In addition, historically low interest rates led to increased refinancing activity, particularly in the residential real estate loan portfolio, commercial and consumer portfolios.  Finally, lower reinvestment yields on maturing investment securities and prepayments of mortgage-related securities reduced yields in the investment portfolio.  Based on current market conditions, which include a recent slowing of mortgage refinancing activity and a steepening of the yield curve, management expects the net interest margin to begin to stabilize in the fourth quarter of 2003.

 

Net interest income for the nine months ended September 30, 2003 increased $16.6 million or 5.0% over the prior nine month period.  The growth in net interest income was attributable to a 9.9% growth in average loans and a 16.8% growth in average securities. Core internal growth accounted for two-thirds of the growth in average loans and three-fourths of the growth in average securities for the nine months ended September 30, 2003 over the nine months ended September 30, 2002.  Growth in net interest income was partially offset by a 31 bp decline in the net interest margin from 4.68% for the nine months ended September 30, 2002 to 4.37% for the nine months ended September 30, 2003.  Nearly two-thirds of the decline in the net interest margin was attributable to the reduced benefit derived from noninterest-bearing funds.  This benefit fell from 61 bp for the nine months ended September 30, 2002 to 42 bp for the nine months ended September 30, 2003.

 

The Analysis of Interest Rates and Interest Differentials and The Rate/Volume Analysis on pages 25 through 27 present further details supporting this discussion.

 

Noninterest Income

 

 

 

For the 9 Months Ended September 30,
2003 vs. 2002

 

For the 3 Months Ended September 30,
2003 vs. 2002

 

 

 

Increase /
(Decrease)

 

Increase /
(Decrease)

 

(Dollars in thousands)

 

Amount

 

%

 

Amount

 

%

 

Investment and wealth management

 

$

5,929

 

11.5

 

$

3,411

 

19.9

 

Service charges on deposit accounts

 

2,911

 

12.6

 

1,729

 

21.7

 

Mortgage banking related fees

 

903

 

12.2

 

1,097

 

47.6

 

Investment securities gains and (losses)

 

6,169

 

729.2

 

(133

)

(65.5

)

Other income

 

6,251

 

25.9

 

4,413

 

54.2

 

Total noninterest income

 

$

22,163

 

20.7

 

$

10,517

 

29.7

 

 

17



 

Noninterest income increased $10.5 million or 29.7% to $45.9 million for the third quarter 2003 versus the comparable period in 2002.  The Acquisitions added $6.9 million to noninterest income for the third quarter, of which $4.4 million was attributable to F&M.  Investment and wealth management (“IWM”) revenues increased 19.9% to $20.6 million for the quarter ended September 30, 2003, $2.8 million of which is attributable to the Acquisitions.

 

Service charges on deposit accounts increased 21.7% to $9.7 million for the current quarter compared to the prior year, of which $1.2 million was attributable to F&M.  Business checking, overdraft and ATM fees are the major contributors to this growth.  Mortgage banking fees increased to $3.4 million for the quarter, of which $1.0 million related to F&M while $2.4 million was attributable to continuing production in Bankshares.

 

Other income, which includes non-deposit fees, insurance income and bank owned life insurance, increased 54.2% to $12.6 million for the quarter compared to the same period of 2002. F&M contributed $2.2 million of this increase, the largest portion being insurance revenue totaling $1.4 million.

 

For the nine months ended September 30, 2003 noninterest income increased $22.2 million, or 20.7%.  Excluding gains from the sale of investment securities resulting from the ongoing balance sheet management process, noninterest income rose 15.1%.  This was due to a $5.9 million increase in IWM fees, a $2.9 million increase in service charges on deposit accounts and a $6.3 million increase in other income.  The Acquisitions contributed $5.8 million, nearly all of the increase, in IWM revenues for the nine months ended September 30, 2003.  The improvement in other income is due to reduced writedowns in private equity fund investments.

 

Noninterest Expenses

 

 

 

For the 9 Months Ended September 30,
2003 vs. 2002

 

For the 3 Months Ended September 30,
2003 vs. 2002

 

(Dollars in thousands)

 

Increase /
(Decrease)
Amount

 

%

 

Increase /
(Decrease)
Amount

 

%

 

Salaries

 

$

15,777

 

16.0

 

$

11,061

 

33.7

 

Employee benefits

 

3,815

 

15.2

 

1,668

 

19.7

 

Net occupancy expense of bank premises

 

1,237

 

10.1

 

891

 

21.0

 

Furniture and equipment expense

 

3,912

 

21.7

 

2,429

 

40.5

 

Communication and supplies

 

492

 

4.9

 

538

 

16.1

 

Other expenses

 

10,028

 

26.0

 

5,965

 

43.4

 

Total noninterest expenses

 

$

35,261

 

17.4

 

$

22,552

 

32.9

 

 

Noninterest expenses for the quarter ended September 30, 2003, increased by $22.6 million or 32.9% over the third quarter of 2002.  Acquisitions added $11.4 million to noninterest expenses in the third quarter 2003.  With respect to the elements of noninterest expenses, salaries increased approximately $11.1 million or 33.7%, primarily as a result of the Acquisitions ($5.5 million) and IWM severance expense ($3.6 million).  Pre-operational merger-related staffing costs that are reflected in the third quarter expenses are expected to diminish in the fourth quarter as we begin to realize the contemplated reductions in head-count relating to the integration of F&M.  Bankshares is also on track to realize the other targeted cost-savings from the integration of F&M in the fourth quarter of 2003 and into early 2004.

 

18



 

The employee benefit increase over the third quarter 2002 is primarily due to an increase of $1.4 million in pension and 401-K expenses.  Acquisitions added $800 thousand of benefit expense in the third quarter of 2003.

 

The $2.4 million, or 40.5%, increase in furniture and equipment expenses is attributable to technology improvements that have been made in the IWM Division, expenses incurred as a result of the Acquisitions and increased costs related to handling normal volume growth by the main bank operating systems.

 

Other expenses for the third quarter increased by $6.0 million, or 43.4% over the prior year.  The increase includes $3.1 million related to the Acquisitions of which, $1.1 million is amortization of identifiable intangibles.  There were also $1.5 million of merger-related professional fees and an additional $600 thousand for the Directors’ Deferred Compensation plan expense in the third quarter of 2003.  The cost of this plan fluctuates with changes in the market value of Bankshares common stock.

 

Noninterest expenses for the nine months ended September 30, 2003 increased $35.3 million, or 17.4%.  Acquisitions added $14.0 million to noninterest expenses for the nine months ended September 30, 2003.  With respect to the elements of noninterest expenses, salaries increased approximately $15.8 million or 16.0%, primarily as a result of the Acquisitions ($6.8 million) and IWM severance expense ($1.9 million).  Pre-operational merger-related staffing costs are expected to diminish in the fourth quarter as we begin to realize the contemplated reductions in head-count.

 

The $3.8 million employee benefit increase over the nine months ended September 30, 2002 is largely due to an increase of $3.2 million in pension and 401-K expenses.  $346 thousand of the pension and 401-K expense increase was attributable to the Acquisitions.

 

The $3.9 million, or 21.7%, increase in furniture and equipment expenses for the nine months ended September 30, 2003 over the same period one year ago, is primarily attributable to technology improvements that have been made in the IWM Division, expenses incurred as a result of the Acquisitions and increased costs related to handling normal volume growth by the main bank operating systems.

 

Other expenses for the nine months ended September 30, 2003 increased by $10.0 million, or 26.0% over the nine months ended September 30, 2002.  The increase includes $4.1 million related to the Acquisitions of which $1.5 million is due to amortization of identifiable intangibles, and $2.3 million of merger-related professional fees.  Also included in the increase is an additional $1.1 million for the Directors’ Deferred Compensation plan.  The cost of this plan fluctuates with changes in the market value of Bankshares common stock.

 

As a result of the increased level of expenses, the operating efficiency ratio, a key measure of expense management, was 48.95% for the nine months ended September 30, 2003 versus 45.69% for the comparable period last year.  The efficiency ratio is measured by dividing noninterest expenses by the sum of net interest income on a fully taxable-equivalent basis and noninterest income.  When computing the efficiency ratio, management excludes the amortization of intangible assets, merger-related expenses and gains and losses from sales of investment securities because of the uncertainty as to timing and amount of gain or loss to be recognized.  See page 23 for a reconciliation of this measure to the GAAP basis calculation.

 

Analysis of Financial Condition

 

At September 30, 2003 compared to December 31, 2002, total assets increased 28.6% or $3.1 billion.  Total loans increased 23.3% or $1.7 billion.  The Acquisitions contributed $2.1 billion in total assets and $1.3 billion in total loans.

 

At September 30, 2003, total assets increased 31.1% or $3.3 billion compared to one year earlier.  Total loans increased 25.2% or $1.8 billion at September 30, 2003, compared to one year earlier.

 

19



 

Total deposits at September 30, 2003, were $10.3 billion, an increase of 24.6% or $2.0 billion over December 31, 2002.  Interest-bearing deposits were $7.6 billion, an increase of 23.1% or $1.4 billion from the end of last year. Noninterest-bearing deposits were $2.7 billion, an increase of 29.3% or $611.5 million compared to December 31, 2002. A large part of the growth in deposits was due to the Acquisitions.  The Acquisitions added $1.7 billion in total deposits, of which $1.4 billion were interest-bearing  and $310.5 million were noninterest-bearing deposits.  The additional growth in deposits was in core deposits from customers in the local markets. The affiliate banking structure positions Bankshares to compete not only with the large national and regional competition in the gathering of these funds, but also with local community banks. Management believes the company is positioned to retain these deposits in a rising interest rate scenario.  However, should the company experience an outflow of deposits, a reversal of recent trends, the investment portfolio should provide adequate liquidity to fund such outflows.

 

Shareholders’ equity at September 30, 2003 was $1.8 billion, an increase of 37.6% from December 31, 2002.  Bankshares has repurchased 5,500 shares year to date, and has authorization enabling it to repurchase up to 1.5 million additional shares.  There were no share repurchases during the quarter. Historically, shares repurchased have been open market purchases.  For more details see the Statement of Changes in Consolidated Shareholders’ Equity on page 5.  Since the share repurchase program began in the mid-1990’s, Management has generally targeted 40% of net income for cash dividends to shareholders and 30% of net income for potential share repurchases.  At September 30, 2003 and December 31, 2002 the cash dividend payout ratio was 46.38% and 43.07% respectively.

 

Asset Quality

 

Nonperforming Assets

 

Nonperforming assets consist of nonaccrual loans, renegotiated loans and other real estate owned (i.e., real estate acquired in foreclosure or in lieu of foreclosure).  With respect to nonaccrual loans, Bankshares policy is that, regardless of the value of the underlying collateral and/or guarantees, no interest is accrued on the entire balance once either principal or interest payments on any loan become 90 days past due at the end of a calendar quarter.  All accrued and uncollected interest on such loans is eliminated from the income statement and is recognized only as collected.  A loan may be put on nonaccrual status sooner than this standard if, in management’s judgment, such action is warranted.

 

During the three months ended September 30, 2003, nonperforming assets increased $13.3 million to $51.4 million.  Nonaccrual loans were $51.0 million at September 30, 2003 and increased $17.6 million over year end.  Other real estate owned, the other component of nonperforming assets, increased $265 thousand to $397 thousand from year end.  Nonperforming assets as a percent of period-end loans and other real estate owned was .57% at September 30, 2003 and .46% at December 31, 2002, respectively.  The increase in nonperforming loans was due primarily to a customer of Mercantile – Safe Deposit and Trust Company (“MSD&T”), the lead bank, engaged in the air pollution control system business.   These loans were moved from monitored to nonaccrual status.  The loans to this customer totaled approximately $10.3 million.  The Acquisitions added $3.6 million to nonperforming assets.

 

At September 30, 2003 and December 31, 2002, monitored loans, or loans with characteristics suggesting that they could be classified as nonperforming in the near future, were $30.5 million and $24.9 million, respectively. Net additions to the monitored loan category were primarily attributable to several customers of MSD&T.  The largest component of monitored loans continues to be the two commercial aircraft-related loans added to this category during the fourth quarter of 2002.  These two loans are performing and current with a balance of approximately $18.7 million at September 30, 2003. They remain in the monitored category because of continuing pressure on the airline industry overall.  The amount of loans past due 30-89 days decreased from

 

20



 

 

$104.2 million at December 31, 2002 to $40.7 million at September 30, 2003. The Acquisitions accounted for approximately $9.1 million of loans past due 30-89 days. In general, credit quality indicators remain stable at the community banks with greater fluctuations occurring at MSD&T.

 

The table below presents a comparison of nonperforming assets at September 30, 2003, June 30, 2003 and December 31, 2002.

 

Nonperforming Assets
(Dollars in thousands)

 

September 30,
2003

 

June 30,
2003

 

December 31,
2002

 

Nonaccrual loans (1)

 

 

 

 

 

 

 

Commercial

 

$

44,094

 

$

30,717

 

$

25,260

 

Construction

 

935

 

1,178

 

1,365

 

Residential real estate

 

3,589

 

4,001

 

2,479

 

Consumer

 

818

 

178

 

261

 

Lease financing

 

1,565

 

1,694

 

4,006

 

Total nonaccrual loans

 

51,001

 

37,768

 

33,371

 

Renegotiated loans (1)

 

 

 

 

Loans contractually past due 90 days or more and still accruing interest

 

 

 

 

Total nonperforming loans

 

51,001

 

37,768

 

33,371

 

Other real estate owned

 

397

 

376

 

132

 

Total nonperforming assets

 

$

51,398

 

$

38,144

 

$

33,503

 

 

 

 

 

 

 

 

 

Nonperforming assets as a percent of period-end loans and other real estate owned

 

.57

%

.50

%

.46

%

 


(1)          Aggregate gross interest income of $2.8 million, $1.5 million and $2.8 million for the nine months ended September 30, 2003, the first six months of 2003 and the year 2002, respectively, on nonaccrual and renegotiated loans, would have been recorded if these loans had been accruing on their original terms throughout the period or since origination if held for part of the period.  The amount of interest income on the nonaccrual and renegotiated loans that was recorded totaled $1.1 million, $648 thousand and $641 thousand for the nine months ended September 30, 2003, the first six months of 2003 and the year 2002, respectively.

 

Note: Bankshares was monitoring loans estimated to aggregate $30.5 million at September 30, 2003, $34.5 million at June 30, 2003 and $24.9 million at December 31, 2002, not classified as nonaccrual or renegotiated loans.  These loans had characteristics that indicated they might result in such classification in the future.

 

Allowance and Provision for Loan Losses

 

Each Bankshares affiliate is required to maintain an allowance for loan losses adequate to absorb losses inherent in the loan portfolio.  Management at each affiliate, along with Bankshares management, conducts a regular review to assure that adequacy.  On a periodic basis, significant credit exposures, nonperforming loans, impaired loans, historical losses by loan type and various statistical measurements of asset quality are examined to assure the adequacy of the allowance for loan losses.

 

The allowance for loan losses has been established through provisions for loan losses charged against income. Loans deemed uncollectible are charged against the allowance for loan losses and any subsequent recoveries are credited to the allowance.  Intensive collection efforts continue after charge-off in order to maximize recovery amounts.  The provision for loan losses for the third quarter of 2003 was $3.0 million, a 7.4% decrease from the same period last year. Net charge-offs were $2.7 million, a 32.5% increase for the third quarter of 2003 compared to the same period in 2002. The allowance for loans as a percent of period-end loans decreased to 1.73% at September 30, 2003 from 1.90% at the end of the third quarter last year.

 

The provision for loan losses for the nine months ended September 30, 2003 was $9.1 million, a decrease of 20.7% from last year’s provision.  The provision increased last year as credit quality issues were identified and addressed within the leasing business.  Nonperforming assets in the leasing business have declined from $4.5

 

21



 

million at September 30, 2002 to $1.6 million at September 30, 2003.  Net charge-offs for the nine months ended September 30, 2003 were $5.1 million, a 68.6% decrease compared to the same period last year.

 

The following table presents a summary of the activity in the Allowance for Loan Losses.

 

Allowance for Loan Losses

 

For the 9 Months
Ended September 30,

 

For the 3 Months
Ended September 30,

 

(Dollars in thousands)

 

2003

 

2002

 

2003

 

2002

 

Allowance balance - beginning

 

$

138,601

 

$

141,463

 

$

142,261

 

$

135,394

 

Allowance of acquired bank

 

13,205

 

 

 

13,205

 

 

 

Charge-offs:

 

 

 

 

 

 

 

 

 

Commercial

 

(3,362

)

(11,522

)

(2,301

)

(2,136

)

Construction

 

(160

)

 

(160

)

 

Residential real estate

 

(54

)

(117

)

(4

)

(7

)

Consumer

 

(2,860

)

(2,234

)

(1,287

)

(702

)

Lease financing

 

(1,188

)

(4,800

)

 

 

Total

 

(7,624

)

(18,673

)

(3,752

)

(2,845

)

Recoveries:

 

 

 

 

 

 

 

 

 

Commercial

 

869

 

675

 

343

 

158

 

Construction

 

136

 

148

 

1

 

11

 

Residential real estate

 

111

 

77

 

72

 

19

 

Consumer

 

1,379

 

1,244

 

614

 

396

 

Lease financing

 

5

 

210

 

5

 

210

 

Total

 

2,500

 

2,354

 

1,035

 

794

 

Net charge-offs

 

(5,124

)

(16,319

)

(2,717

)

(2,051

)

Provision for loan losses

 

9,072

 

11,443

 

3,005

 

3,244

 

Allowance balance - ending

 

$

155,754

 

$

136,587

 

$

155,754

 

$

136,587

 

Average loans

 

7,738,388

 

7,041,412

 

8,331,265

 

7,162,156

 

Net charge-offs (annualized) as a percent of average loans

 

.08

%

.30

%

.12

%

.11

%

Period-end loans

 

9,015,082

 

7,200,790

 

 

 

 

 

Allowance for loan losses as a percent of period-end loans

 

1.73