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 March 31, 2004

 

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 April 30, 2004, registrant had outstanding 78,993,784 shares of Common Stock.

 



 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

 

MERCANTILE BANKSHARES CORPORATION

CONSOLIDATED BALANCE SHEETS

 

(Dollars in thousands, except per share data)

 

March 31,
2004

 

December 31,
2003

 

March 31,
2003

 

ASSETS

 

 

 

 

 

 

 

Cash and due from banks

 

$

296,077

 

$

321,882

 

$

307,404

 

Interest-bearing deposits in other banks

 

158

 

14,583

 

358

 

Federal funds sold

 

353,893

 

26,236

 

245,513

 

Total cash and cash equivalents

 

650,128

 

362,701

 

553,275

 

Investment securities available-for-sale (Note 4)

 

3,090,089

 

3,123,514

 

2,641,976

 

Investment securities held-to-maturity (Note 4)

 

52,524

 

49,417

 

53,918

 

Total investment securities

 

3,142,613

 

3,172,931

 

2,695,894

 

Loans held-for-sale

 

38,741

 

14,925

 

 

Loans:

 

 

 

 

 

 

 

Commercial

 

5,403,538

 

5,315,853

 

4,403,330

 

Construction

 

1,105,346

 

1,064,021

 

850,420

 

Residential real estate

 

1,387,647

 

1,335,375

 

1,087,207

 

Consumer

 

1,473,491

 

1,482,860

 

1,011,637

 

Lease financing

 

64,398

 

74,051

 

93,959

 

Total loans

 

9,434,420

 

9,272,160

 

7,446,553

 

Less: allowance for loan losses

 

(156,635

)

(155,337

)

(140,427

)

Loans, net

 

9,277,785

 

9,116,823

 

7,306,126

 

Bank premises and equipment, less accumulated depreciation of $154,468 (2004), $152,771 (December 2003) and $122,073 (March 2003)

 

141,482

 

140,922

 

103,847

 

Other real estate owned, net

 

134

 

191

 

194

 

Goodwill, net

 

522,226

 

522,173

 

115,407

 

Other intangible assets, net (Note 7)

 

54,223

 

56,223

 

17,740

 

Other assets

 

315,050

 

308,583

 

226,138

 

Total assets

 

$

14,142,382

 

$

13,695,472

 

$

11,018,621

 

 

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

$

2,769,189

 

$

2,750,721

 

$

2,121,444

 

Interest-bearing deposits

 

7,774,398

 

7,511,832

 

6,374,039

 

Total deposits

 

10,543,587

 

10,262,553

 

8,495,483

 

Short-term borrowings

 

904,327

 

809,021

 

768,476

 

Accrued expenses and other liabilities

 

149,052

 

134,735

 

111,792

 

Long-term debt

 

657,411

 

647,722

 

290,576

 

Total liabilities

 

12,254,377

 

11,854,031

 

9,666,327

 

 

 

 

 

 

 

 

 

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 - 79,974,797 (2004), 79,772,705 (December 2003) and 68,919,397 (March 2003); restricted shares - 112,485 (2004), 101,932 (December 2003) and 91,127 (March 2003)

 

159,950

 

159,545

 

137,839

 

Capital surplus

 

553,955

 

548,664

 

124,029

 

Retained earnings

 

1,139,360

 

1,110,748

 

1,038,143

 

Accumulated other comprehensive income

 

34,740

 

22,484

 

52,283

 

Total shareholders’ equity

 

1,888,005

 

1,841,441

 

1,352,294

 

Total liabilities and shareholders’ equity

 

$

14,142,382

 

$

13,695,472

 

$

11,018,621

 

 

See notes to consolidated financial statements

 

2



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED INCOME

 

 

 

For the 3 Months Ended
March 31,

 

(Dollars in thousands, except per share data)

 

2004

 

2003

 

INTEREST INCOME

 

 

 

 

 

Interest and fees on loans

 

$

129,060

 

$

110,992

 

Interest and dividends on investment securities:

 

 

 

 

 

Taxable interest income

 

27,401

 

27,184

 

Tax-exempt interest income

 

877

 

467

 

Dividends

 

261

 

229

 

Other investment income

 

3,341

 

564

 

Total interest and dividends on investment securities

 

31,880

 

28,444

 

Other interest income

 

175

 

726

 

Total interest income

 

161,115

 

140,162

 

INTEREST EXPENSE

 

 

 

 

 

Interest on deposits

 

20,767

 

25,129

 

Interest on short-term borrowings

 

1,419

 

1,545

 

Interest on long-term debt

 

5,255

 

2,362

 

Total interest expense

 

27,441

 

29,036

 

NET INTEREST INCOME

 

133,674

 

111,126

 

Provision for loan losses

 

2,426

 

3,016

 

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

 

131,248

 

108,110

 

NONINTEREST INCOME

 

 

 

 

 

Investment and wealth management

 

21,983

 

17,365

 

Service charges on deposit accounts

 

10,119

 

8,060

 

Mortgage banking related fees

 

2,940

 

2,388

 

Investment securities gains and (losses)

 

(55

)

815

 

Other income

 

14,898

 

9,225

 

Total noninterest income

 

49,885

 

37,853

 

NONINTEREST EXPENSES

 

 

 

 

 

Salaries

 

44,788

 

34,415

 

Employee benefits

 

12,513

 

9,428

 

Net occupancy expense of bank premises

 

6,060

 

4,096

 

Furniture and equipment expenses

 

7,364

 

6,799

 

Communications and supplies

 

4,304

 

3,436

 

Other expenses

 

18,357

 

11,607

 

Total noninterest expenses

 

93,386

 

69,781

 

Income before income taxes

 

87,747

 

76,182

 

Applicable income taxes

 

32,050

 

27,196

 

NET INCOME

 

$

55,697

 

$

48,986

 

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

 

 

 

 

 

Basic

 

$

0.70

 

$

0.71

 

Diluted

 

$

0.69

 

$

0.71

 

DIVIDENDS PAID PER COMMON SHARE

 

$

0.33

 

$

0.30

 

 

See notes to consolidated financial statements

 

3



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY

 

For The Three Months Ended March 31, 2004 and 2003

 

(Dollars in thousands, except per share data)

 

Total

 

Common
Stock

 

Capital
Surplus

 

Retained
Earnings

 

Accumulated
Other
Comprehensive
Income (Loss)

 

BALANCE, DECEMBER 31, 2002

 

$

1,324,358

 

$

137,672

 

$

120,577

 

$

1,010,248

 

$

55,861

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

48,986

 

 

 

 

 

48,986

 

 

 

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

 

(3,578

)

 

 

 

 

 

 

(3,578

)

Comprehensive income

 

45,408

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.30 per share)

 

(20,637

)

 

 

 

 

(20,637

)

 

 

Issuance of 31,759 shares for dividend reinvestment and stock purchase plan

 

1,029

 

64

 

965

 

 

 

 

 

Issuance of 5,728 shares for employee stock purchase dividend reinvestment plan

 

207

 

11

 

196

 

 

 

 

 

Issuance of 31,023 shares for employee stock option plan

 

656

 

62

 

594

 

 

 

 

 

Issuance of 20,295 shares for restricted stock awards

 

750

 

41

 

709

 

 

 

 

 

Deferred compensation - restricted stock awards

 

(454

)

 

 

 

 

(454

)

 

 

Purchase of 5,500 shares under stock repurchase plan

 

(212

)

(11

)

(201

)

 

 

 

 

Vested stock options

 

1,189

 

 

1,189

 

 

 

BALANCE, MARCH 31, 2003

 

$

1,352,294

 

$

137,839

 

$

124,029

 

$

1,038,143

 

$

52,283

 

BALANCE, DECEMBER 31, 2003

 

$

1,841,441

 

$

159,545

 

$

548,664

 

$

1,110,748

 

$

22,484

 

Net income

 

55,697

 

 

 

 

 

55,697

 

 

 

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

 

12,256

 

 

 

 

 

 

 

12,256

 

Comprehensive income

 

67,953

 

 

 

 

 

 

 

 

 

Cash dividends paid:

 

 

 

 

 

 

 

 

 

 

 

Common stock ($.33 per share)

 

(26,335

)

 

 

 

 

(26,335

)

 

 

Issuance of 31,674 shares for dividend reinvestment and stock purchase plan

 

1,298

 

63

 

1,235

 

 

 

 

 

Issuance of 5,873 shares for employee stock purchase dividend reinvestment plan

 

257

 

12

 

245

 

 

 

 

 

Issuance of 138,251 shares for employee stock option plan

 

2,431

 

277

 

2,154

 

 

 

 

 

Issuance of 26,294 shares for restricted stock awards

 

1,199

 

53

 

1,146

 

 

 

 

 

Deferred compensation - restricted stock awards

 

(750

)

 

 

 

 

(750

)

 

 

Vested stock options

 

511

 

 

511

 

 

 

BALANCE, MARCH 31, 2004

 

$

1,888,005

 

$

159,950

 

$

553,955

 

$

1,139,360

 

$

34,740

 

 

See notes to consolidated financial statements

 

4



 

MERCANTILE BANKSHARES CORPORATION

STATEMENTS OF CONSOLIDATED CASH FLOW

 

 

Increase (decrease) in cash and cash equivalents

 

For the 3 Months Ended March 31,

 

(Dollars in thousands)

 

2004

 

2003

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

55,697

 

$

48,986

 

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

 

 

 

 

 

Provision for loan losses

 

2,426

 

3,016

 

Depreciation and amortization

 

3,900

 

3,122

 

Amortization of other intangible assets

 

2,032

 

560

 

Investment securities losses and (gains)

 

55

 

(815

)

(Income) write-downs of investments in private equity funds

 

(141

)

103

 

Gains on sales of other real estate owned

 

(13

)

(268

)

Gains on sales of buildings

 

(564

)

(142

)

Net (increase) decrease in assets:

 

 

 

 

 

Interest receivable

 

(1,939

)

238

 

Other receivables

 

2,991

 

(1,817

)

Bank owned life insurance

 

(794

)

(429

)

Other assets

 

(11,126

)

807

 

Loans held-for-sale

 

(23,816

)

 

Net increase (decrease) in liabilities:

 

 

 

 

 

Interest payable

 

6,052

 

3,189

 

Accrued expenses

 

(25,110

)

(2,654

)

Taxes payable

 

37,273

 

18,721

 

Net cash provided by operating activities

 

46,923

 

72,617

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Proceeds from maturities of investment securities held-to-maturity

 

1,658

 

71

 

Proceeds from maturities of investment securities available-for-sale

 

297,156

 

245,816

 

Proceeds from sales of investment securities  available-for-sale

 

8

 

107,995

 

Purchases of investment securities held-to-maturity

 

(4,765

)

(598

)

Purchases of investment securities available-for-sale

 

(244,497

)

(414,155

)

Net increase in customer loans

 

(163,394

)

(135,778

)

Proceeds from sales of other real estate owned

 

75

 

268

 

Capital expenditures

 

(702

)

(4,603

)

Proceeds from sales of buildings

 

1,169

 

205

 

Business acquisitions

 

 

(24,211

)

Other investing activity

 

(183

)

(810

)

Net cash used in investing activities

 

(113,475

)

(225,800

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net increase in noninterest-bearing deposits

 

18,468

 

34,699

 

Net increase in checking plus interest and savings accounts

 

268,332

 

41,788

 

Net (decrease) increase in certificates of deposit

 

(5,766

)

158,056

 

Net increase (decrease) in short-term borrowings

 

95,306

 

(54,909

)

Repayment of long-term debt

 

(12

)

 

Proceeds from issuance of shares

 

3,986

 

1,892

 

Repurchase of common shares

 

 

(212

)

Dividends paid

 

(26,335

)

(20,637

)

Net cash provided by financing activities

 

353,979

 

160,677

 

Net increase in cash and cash equivalents

 

287,427

 

7,494

 

Cash and cash equivalents at beginning of period

 

362,701

 

545,781

 

Cash and cash equivalents at end of period

 

$

650,128

 

$

553,275

 

SUPPLEMENTAL INFORMATION

 

 

 

 

 

Cash payments for interest

 

$

21,389

 

$

25,847

 

Cash payments for income taxes

 

2,579

 

8,271

 

 

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 performance.  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. Business Combinations

 

The following provides information concerning acquisitions; These acquisitions were accounted for as purchases. The results of operations of these acquisitions subsequent to the acquisition dates are included in Bankshares’ Statements of Consolidated Income. Individually, the results of operations of these acquisitions prior to the acquisition dates were not material to Bankshares’ results of operations.

 

 In March and April 2003, Bankshares acquired in separate transactions, Boyd Watterson Asset Management LLC (“BW”), an investment management firm, and Peremel & Company, Inc. (“Peremel”), a directed and discount brokerage company.  In the aggregate, the companies were purchased for approximately $29 million in cash.  The BW acquisition has a potential additional contingent payment of up to $8.6 million which, if paid, will be recorded as goodwill.  The contingent payment will be recorded assuming certain metrics are met 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 three to eight years.  Goodwill recorded on these transactions totaled approximately $18.0 million at March 31, 2004.

 

 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 paid to F&M shareholders in connection with the acquisition was $124.1 million in cash and 10.4 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 of March 31, 2004, Bankshares had recorded $400.3 million of goodwill, $36.0 million of core deposit intangible, $5.8 million of mostly client relationship intangibles (relating to the two insurance subsidiaries) and $1.1 million in a trademark intangible. The weighted average amortization period for the newly-acquired core deposit intangible is nine years, and the client-relationship identified intangible ranges from three to fifteen years. 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.

 

6



 

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 basic EPS and diluted EPS for the quarter ended March 31, 2004 and 2003, respectively.

 

 

 

For the 3 Months Ended March 31, 2004

 

2004 (In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

55,697

 

79,725

 

$

0.70

 

Dilutive effect of stock options and restricted stock awards

 

 

 

533

 

 

 

Diluted EPS

 

$

55,697

 

80,258

 

$

0.69

 

 

 

 

For the 3 Months Ended March 31, 2003

 

2003 (In thousands, except per share data)

 

Net
Income

 

Weighted Average
Common Shares

 

EPS

 

Basic EPS

 

$

48,986

 

68,769

 

$

0.71

 

Dilutive effect of stock options and restricted stock awards

 

 

 

421

 

 

 

Diluted EPS

 

$

48,986

 

69,190

 

$

0.71

 

 

Antidilutive options and awards excluded from the computation of diluted earnings per share were 298,319 and 265,505 for the three months ended March 31, 2004 and 2003, respectively.

 

4. Investment Securities

 

The amortized cost and fair value of investment securities at March 31, 2004, December 31, 2003 and March 31, 2003 are shown below:

 

 

 

March 31, 2004

 

December 31, 2003

 

March 31, 2003

 

(Dollars in thousands)

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Amortized
Cost

 

Fair
Value

 

Securities available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

745,330

 

$

767,902

 

$

823,356

 

$

845,754

 

$

1,076,879

 

$

1,117,943

 

U.S. Government agencies

 

792,237

 

809,771

 

778,916

 

793,611

 

665,629

 

693,685

 

Mortgage-backed securities

 

1,292,191

 

1,303,352

 

1,288,109

 

1,283,630

 

732,123

 

741,955

 

States and political subdivisions

 

74,665

 

76,931

 

77,897

 

79,870

 

549

 

576

 

Other investments

 

130,080

 

132,133

 

118,948

 

120,649

 

83,199

 

87,817

 

Total

 

$

3,034,503

 

$

3,090,089

 

$

3,087,226

 

$

3,123,514

 

$

2,558,379

 

$

2,641,976

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Securities held-to-maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

$

26,555

 

$

28,436

 

$

28,213

 

$

30,115

 

$

38,231

 

$

41,040

 

Other investments

 

25,969

 

25,969

 

21,204

 

21,204

 

15,687

 

15,687

 

Total

 

$

52,524

 

$

54,405

 

$

49,417

 

$

51,319

 

$

53,918

 

$

56,727

 

 

5. Impaired Loans

 

When scheduled principal or interest payments are past due 90 days or more at quarter-end on any loan, the accrual of interest income is discontinued and subsequent receipts on these loans are recorded as a reduction of principal, and interest income is recorded only once principal recovery is reasonably assured. Previously accrued but uncollected interest on these loans is charged against interest income. Generally a loan may be restored to accruing status when all past due principal, interest and late charges have been paid and the bank expects repayment of the remaining contractual principal and interest.

 

7



 

Under Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-an amendment of FASB Statements No. 5 and 15,” 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. 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 the 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. 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 March 31, 2004, December 31, 2003, and March 31, 2003 are shown below.  See Form 10-K for more detail.

 

(Dollars in thousands)

 

March 31,
2004

 

December 31,
2003

 

March 31,
2003

 

Impaired loans with a specific valuation allowance

 

$

25,971

 

$

26,715

 

$

8,189

 

All other impaired loans

 

16,508

 

18,692

 

15,865

 

Total impaired loans

 

$

42,479

 

$

45,407

 

$

24,054

 

 

 

 

 

 

 

 

 

Specific allowance for loan losses applicable to impaired loans

 

$

14,094

 

$

14,925

 

$

4,857

 

General allowance for loan losses applicable to other than impaired loans

 

142,541

 

140,412

 

135,570

 

Total allowance for loan losses

 

$

156,635

 

$

155,337

 

$

140,427

 

 

 

 

 

 

 

 

 

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

 

$

103

 

$

443

 

$

97

 

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

 

$

42,479

 

$

31,241

 

$

24,054

 

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

 

$

103

 

$

223

 

$

97

 

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

 

$

42,479

 

$

37,382

 

$

24,054

 

 

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

 

Bankshares is a party to financial instruments that are not reflected in the balance sheet, which include commitments to extend credit and standby letters of credit. Various commitments to extend credit (lines of credit) are made in the normal course of banking business. Letters of credit are issued for the benefit of customers by affiliated banks. These commitments are subject to loan underwriting standards and geographic boundaries consistent with Bankshares’ loans outstanding. Bankshares’ lending activities are concentrated in Maryland, Delaware and Virginia.

 

 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Total commitments to extend credit were $3.6 billion at March 31, 2004 and December 31, 2003,  and $3.0 billion at March 31, 2003.

 

 Standby letters of credit are commitments issued to guarantee the performance of a customer to a third party. Outstanding letters of credit were $303.3 million at March 31, 2004, $281.4 million at December 31, 2003 and $243.5 million at March 31, 2003.  Fees received for issuing letters of credit are deferred and amortized over the life of the commitment.  The fees on letters of credit at March 31, 2004 and December 31, 2003 had a carrying value of $1.1 million and $1.0 million, respectively, representing unamortized fees.

 

 Bankshares’ mortgage banking subsidiary is a Fannie Mae Delegated Underwriting and Servicing lender, and 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 $148.6 million and $149.4 million at March 31, 2004 and December 31, 2003, respectively.  No allowance has been established for possible losses on loans originated and sold in the secondary market since there have been no losses recognized during the history of this arrangement and no losses were incurred at March 31, 2004.  The mortgage subsidiary also has originated and sold loans with recourse in the event of foreclosure on the underlying real estate.  The unamortized amount of principal balance of loans sold with recourse totaled $2.2 million and $2.3 million at March 31, 2004 and December 31, 2003, respectively.  These mortgages are generally in good standing, are well-collateralized and no loss has ensued and no future loss is expected.

 

 Bankshares has committed to invest funds in third-party private equity investments. At March 31, 2004, December 31, 2003 and March 31, 2003, $20.9 million, $16.1 million and $18.0 million, respectively, remained unfunded.

 

8



 

7. Other Intangible Assets

 

The following table discloses the gross carrying amount and accumulated amortization of intangible assets subject to amortization at March 31, 2004 and December 31, 2003:

 

 

 

March 31, 2004

 

December 31, 2003

 

(Dollars in thousands)

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Gross carrying
amount

 

Accumulated
amortization

 

Net
amount

 

Deposit intangibles

 

$

49,881

 

$

(10,913

)

$

38,968

 

$

49,881

 

$

(9,546

)

$

40,335

 

Mortgage servicing rights

 

2,086

 

(1,577

)

509

 

2,351

 

(1,790

)

561

 

Customer lists and others

 

17,010

 

(2,264

)

14,746

 

17,010

 

(1,683

)

15,327

 

Total

 

$

68,977

 

$

(14,754

)

$

54,223

 

$

69,242

 

$

(13,019

)

$

56,223

 

 

The projections of amortization expense shown for mortgage servicing rights are based on asset balances and the interest rate environment as of March 31, 2004. 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 estimated lives of up to nine years. Bankshares recorded $36.0 million of core deposit intangibles in conjunction with the F&M acquisition. Management reviews other intangible assets for impairment yearly 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.

 

(Dollars in thousands)

 

Core
deposit
intangibles

 

Mortgage
servicing
intangibles

 

Customer lists
and other
intangibles

 

Total

 

Three months ended March 31, 2004 (actual)

 

$

1,367

 

$

79

 

$

586

 

$

2,032

 

Nine months ended December 31, 2004 (estimated)

 

4,100

 

238

 

1,744

 

6,082

 

Twelve months ended December 31, 2004 (estimated)

 

5,467

 

317

 

2,330

 

8,114

 

 

 

 

 

 

 

 

 

 

 

Estimate for year ended December 31,

2005

 

5,467

 

192

 

2,326

 

7,985

 

 

2006

 

5,467

 

 

 

2,083

 

7,550

 

 

2007

 

5,321

 

 

 

1,890

 

7,211

 

 

2008

 

4,605

 

 

 

1,708

 

6,313

 

 

2009

 

4,004

 

 

 

985

 

4,989

 

 

9



 

8. Comprehensive Income

 

The following table summarizes the related tax effect of unrealized gains (losses) on securities available-for-sale for the three months ended March 31, 2004 and 2003.  The net amount is included in accumulated other comprehensive income (loss) in the Statement of Changes in Consolidated Shareholders’ Equity.

 

 

 

For the 3 Months Ended March 31,

 

 

 

2004

 

2003

 

(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

 

$

19,243

 

$

(7,020

)

$

12,223

 

$

(5,073

)

$

1,988

 

$

(3,085

)

Reclassification adjustment for (gains)

 

 

 

 

 

 

 

 

 

 

 

 

 

Losses included in net income

 

55

 

(22

)

33

 

(815

)

322

 

(493

)

Total

 

$

19,298

 

$

(7,042

)

$

12,256

 

$

(5,888

)

$

2,310

 

$

(3,578

)

 

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 March 31, 2004, Bankshares and all of its bank affiliates exceeded all capital adequacy requirements to be considered well capitalized.

 

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 March 31, 2004 and December 31, 2003.

 

 

 

March 31, 2004

 

December 31, 2003

 

(Dollars in thousands)

 

Bankshares

 

MSD&T

 

Bankshares

 

MSD&T

 

 

 

 

 

 

 

 

 

 

 

Tier I capital

 

$

1,283,922

 

$

402,057

 

$

1,248,492

 

$

396,186

 

Total risk-based capital

 

1,709,187

 

447,399

 

1,666,064

 

440,479

 

Net risk-weighted assets

 

10,336,236

 

3,612,085

 

10,020,487

 

3,529,223

 

Adjusted average total assets

 

12,960,988

 

4,307,838

 

13,011,399

 

4,353,713

 

 

 

 

 

 

 

 

 

 

 

Tier I capital ratio

 

12.42

%

11.13

%

12.46

%

11.23

%

Total capital ratio

 

16.54

%

12.39

%

16.63

%

12.48

%

Leverage ratio

 

9.91

%

9.33

%

9.60

%

9.10

%

 

Bankshares has an ongoing share repurchase program.  As of March 31, 2004 there remain 1,476,327 shares of the 2,000,000 shares previously authorized by the Board of Directors on December 11, 2001.  For the three months ended March 31, 2004 and the twelve months ended December 31, 2003, -0- and 5,500 shares, respectively, were repurchased by Bankshares in open market transactions.   In April 2004, management resumed the repurchase of shares by entering into a privately negotiated agreement for the accelerated purchase of one million shares.

 

10



 

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 – its 19 Community Banks, MSD&T Banking and Investment and Wealth Management  (IWM).

 

The following tables present selected segment information for the three months ended March 31, 2004 and 2003.  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 Banking” whereas BW and Peremel are included in the column “IWM”.

 

 

 

 

For the 3 Months Ended March 31, 2004

 

 

 

Banking

 

 

 

 

 

 

 

(Dollars in thousands)

 

Community

 

MSD&T

 

Total (1)

 

IWM

 

Other

 

Total

 

Net interest income

 

$

95,762

 

$

34,843

 

$

130,605

 

$

 

$

3,069

 

$

133,674

 

Provision for loan losses

 

(159

)

(2,267

)

(2,426

)

 

 

(2,426

)

Noninterest income

 

20,817

 

11,059

 

26,835

 

22,382

 

668

 

49,885

 

Noninterest expenses

 

(55,785

)

(24,783

)

(75,527

)

(17,379

)

(480

)

(93,386

)

Adjustments

 

(1,898

)

5,129

 

3,231

 

(796

)

(2,435

)

 

Income (loss) before income taxes

 

58,737

 

23,981

 

82,718

 

4,207

 

822

 

87,747

 

Income tax (expense) benefit

 

(20,395

)

(8,651

)

(29,046

)

(1,683

)

(1,321

)

(32,050

)

Net income (loss)

 

$

38,342

 

$

15,330

 

$

53,672

 

$

2,524

 

$

(499

)

$

55,697

 

Average loans

 

$

6,370,303

 

$

2,967,933

 

$

9,338,236

 

 

$

197

 

$

9,338,433

 

Average earning assets

 

8,706,230

 

4,003,020

 

12,370,034

 

 

105,817

 

12,475,851

 

Average assets

 

9,168,590

 

4,350,122

 

13,069,701

 

 

548,492

 

13,618,193

 

Average deposits

 

7,238,415

 

3,022,107

 

10,138,846

 

 

(72,201

)

10,066,645

 

Average equity

 

930,920

 

442,227

 

1,373,147

 

 

475,314

 

1,848,461

 

 

 

 

For the 3 Months Ended March 31, 2003

 

 

 

Banking

 

 

 

 

 

 

 

(Dollars in thousands)

 

Community

 

MSD&T

 

Total (1)

 

IWM

 

Other

 

Total

 

Net interest income

 

$

76,252

 

$

35,185

 

$

111,437

 

$

 

$

(311

)

$

111,126

 

Provision for loan losses

 

(1,612

)

(1,404

)

(3,016

)

 

 

(3,016

)

Noninterest income

 

13,296

 

10,444

 

20,230

 

17,359

 

264

 

37,853

 

Noninterest expenses

 

(38,384

)

(21,677

)

(56,551

)

(13,953

)

723

 

(69,781

)

Adjustments

 

(1,611

)

3,760

 

2,149

 

(808

)

(1,341

)

 

Income (loss) before income taxes

 

47,941

 

26,308

 

74,249

 

2,598

 

(665

)

76,182

 

Income tax (expense) benefit

 

(16,599

)

(9,476

)

(26,075

)

(1,039

)

(82

)

(27,196

)

Net income (loss)

 

$

31,342

 

$

16,832

 

$

48,174

 

$

1,559

 

$

(747

)

$

48,986

 

Average loans

 

$

4,462,827

 

$

2,896,537

 

$

7,359,364

 

 

$

281

 

$

7,359,645

 

Average earning assets

 

6,225,782

 

3,867,355

 

9,908,894

 

 

84,339

 

9,993,233

 

Average assets

 

6,539,154

 

4,145,799

 

10,405,827

 

 

118,382

 

10,524,209

 

Average deposits

 

5,275,024

 

2,947,659

 

8,111,078

 

 

(41,740

)

8,069,338

 

Average equity

 

834,837

 

451,004

 

1,285,841

 

 

9,499

 

1,295,340

 

 


(1)  Amounts do not necessarily add due to eliminations.

 

11



 

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 to convert its nonprepayable fixed-rate debt to floating-rate debt.

 

The fair value of derivative instruments recorded in other assets was $12.9 million (notional $250.0 million) and $6.6 million (notional $203.1 million) at March 31, 2004 and December 31, 2003, respectively.  The fair value of derivative instruments recorded in other liabilities was $4.3 million (notional $103.1 million) and $8.0 million (notional $150.0 million) at March 31, 2004 and December 31, 2003, respectively.  For the three months ended March 31, 2004, Bankshares recognized a net gain of $6 thousand, which represented the ineffective portion of the fair-value hedge of fixed-rate loans made to borrowers.  For the year ended December 31, 2003, Bankshares recognized a net gain of $70 thousand.  The impact of the hedge decreased interest income $42 thousand in the first three months of 2004 and $167 thousand in 2003.  The fair-value hedges of nonprepayable fixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interest expense $2.8 million in the first three months of 2004 and $8.5 million in 2003.

 

The following tables summarize the gross position of derivatives at March 31, 2004 and December 31, 2003:

 

 

 

 

 

 

 

Weighted Average

 

 

 

March 31, 2004 (Dollars in thousands)

 

Number
of Contracts

 

Notional
Amount

 

Years to
Maturity

 

Fixed Rate

 

Variable Rate

 

Fair
Value

 

Gross Position Summary:

 

 

 

 

 

 

 

 

 

 

 

 

 

Pay Fixed/Receive Variable Interest Rate Swaps (1)

 

1

 

$

3,091

 

0.12

 

9.38

%

4.00

%

$

(18

)

Receive Fixed/Pay Variable Interest Rate Swaps (2)

 

3

 

350,000

 

8.24

 

5.21

%

1.93

%

8,609

 

Total

 

4

 

$

353,091

 

8.17

 

 

 

 

 

$

8,591

 

 

 

 

 

 

 

 

Weighted Average

 

 

 

 

 

Number

 

Notional

 

Years to

 

 

 

 

 

Fair

 

December 31, 2003 (Dollars in thousands)

 

of Contracts

 

Amount

 

Maturity

 

Fixed Rate

 

Variable Rate

 

Value

 

Gross Position Summary:

 

 

 

 

 

 

 

 

 

 

 

 

 

Pay Fixed/Receive Variable Interest Rate Swaps (1)

 

1

 

$

3,108

 

0.33

 

9.38

%

4.00

%

$

(64

)

Receive Fixed/Pay Variable Interest Rate Swaps (2)

 

3

 

350,000

 

8.44

 

5.21

%

1.98

%

(1,366

)

Total

 

4

 

$

353,108

 

8.37

 

 

 

 

 

$

(1,430

)

 


(1)  Hedges fixed-rate commercial loan.

(2)  Hedges fixed-rate long-term debt.

 

Mortgage loans held-for-sale have inherent forward contract (agreements to sell or purchase loans at a specific rate or yield) characteristics. Risk may arise from the corresponding parties’ inability to meet the term of their contracts and from movement in interest rates. Bankshares had forward commitments to sell and fund individual fixed-rate and variable-rate mortgage loans that are reported at fair value. The fair value adjustment were not material at March 31, 2004 and December 31, 2003.

 

12



 

12. Stock-based Compensation Expense

 

Bankshares has several stock-based compensation programs for its directors, management and employees. Compensation costs for stock options and restricted stock awards are included in salary expense.  Another form of stock-based compensation is phantom stock, which is used for Bankshares’ Directors’ Deferred Compensation Plan.  The compensation cost for the phantom stock, which fluctuates with changes in Bankshares’ stock price, is included in other expenses.  Stock-based compensation amounts for the three months ended March 31, 2004 and 2003 are summarized in the following table:

 

 

 

For the 3 Months Ended
March 31,

 

(Dollars in thousands)

 

2004

 

2003

 

Stock options expense

 

$

406

 

$

459

 

Restricted stock awards expense

 

487

 

318

 

Subtotal included in salaries expense

 

893

 

777

 

Phantom stock expense

 

(378

)

(675

)

Total stock-based compensation expense

 

$

515

 

$

102

 

 

13.         Pension & Other Postretirement Benefit Plans

 

Bankshares sponsors qualified and nonqualified pension plans and other postretirement benefit plans for its employees.  The following table summarizes the components of the net periodic benefit cost for the pension plans for the three months ended March 31, 2004 and 2003.

 

 

 

For the 3 months ended March 31, 2004

 

For the 3 months ended March 31, 2003

 

 

 

Qualified

 

Nonqualified

 

Total

 

Qualified

 

Nonqualified

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Service cost

 

$

1,572

 

$

141

 

$

1,713

 

$

1,280

 

$

115

 

$

1,395

 

Interest cost

 

2,549

 

101

 

2,650

 

2,498

 

78

 

2,576

 

Expected return on plan assets

 

(3,845

)

 

(3,845

)

(3,099

)

 

(3,099

)

Amortization of prior service cost

 

195

 

6

 

201

 

195

 

6

 

201

 

Recognized net actuarial (gain) loss

 

153

 

29

 

182

 

605

 

8

 

613

 

Amortization of transition asset

 

 

24

 

24

 

 

25

 

25

 

Net periodic benefit cost

 

$

624

 

$

301

 

$

925

 

$

1,479

 

$

232

 

$

1,711

 

 

The following table summarizes the components of the net periodic benefit cost for the other postretirement benefit plans for the three months ended March 31, 2004 and 2003.

 

 

 

For the 3 months ended March 31,

 

 

 

2004

 

2003

 

 

 

 

 

 

 

Service cost

 

$

65

 

$

29

 

Interest cost

 

214

 

121

 

Expected return on plan assets

 

 

 

Amortization of prior service cost

 

 

 

Recognized net actuarial (gain) loss

 

38

 

21

 

Amortization of transition asset

 

 

 

Net periodic benefit cost

 

$

317

 

$

171

 

 

As previously disclosed in its financial statements for the year ended December 31, 2003, Bankshares generally makes cash contributions to the pension plan in amounts equal to the maximum permitted by Employee Retirement Income Securities Act guidelines.  Under those guidelines, Bankshares could contribute up to approximately $20 million to the pension plan during 2004. As of March 31, 2004, no contributions had been made.

 

13



 

14.         Recent Accounting Standards

 

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer,” which addresses the accounting for differences between contractual cash flows and expected cash flows for loans acquired in a transfer when those differences are attributable at least in part to credit quality.  It includes such loans acquired in purchase business combinations where there is evidence of deterioration in credit quality since origination. This SOP requires the difference between expected cash flows and the purchase price to be accreted as an adjustment to yield over the life of the acquired loans; the difference between contractual cash flows and expected cash flows is not subject to accretion. This SOP would represent a change from current practice where the allowance for loan losses is carried over in purchase accounting. The SOP is effective for loans acquired beginning after December 15, 2004. Bankshares is currently evaluating the impact it will have on operations and financial statements.

 

In March 2004, the Emerging Issues Task Force published Issue No. 03-6 (“EITF 03-6”) “Participating Securities and the Two-Class Method under FASB Statement No. 128, ‘Earnings Per Share’.” Statement No. 128 indicates that participating securities should be included in basic earnings per share (“EPS”), if the effect is dilutive, using either the two-class method or the if-converted method. The issue clarifies how to determine whether a security (other than common stock) should be considered a “participating security” for purposes of computing EPS and how earnings should be allocated to a participating security when using the two-class method for computing basic EPS. This issue does not have an impact on Bankshares’ financial statements.

 

In March 2004, the SEC amended Staff Accounting Bulletin: No. 105 (“SAB 105”) “Application of Accounting Principles to Loan Commitments”. SAB 105 adds Section DD to Topic 5 which summarizes the views of the staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB 105 provides guidance on mortgage loan commitments that are entered into with customers at a specified rate and are intended to be sold after they are funded. Bankshares is currently evaluating the impact this bulletin will have on the financial statements.

 

15.         Subsequent Event

 

On April 30, 2004, Bankshares announced that it has initiated a significant reorganization within its Community Banking network.  In a move designed to create banks of sufficient size and depth to compete more effectively today and in the future, Bankshares will combine 11 affiliate banks to create four new organizations, all with a more prominent Mercantile identity. This reorganization will enable Bankshares to operate more effectively and efficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks will better leverage our branch network, reduce administrative and operational redundancies and increase the breadth and depth of expertise among our associates. All banks being combined are geographically contiguous, share increasingly common market dynamics and offer the opportunity to create scale efficiencies. Pending regulatory approval, the banks are anticipated to be combined in July.

 

The banks currently range in asset size from $110 million to $850 million and are located in the southern and eastern portions of Bankshares’ market.  The four resulting banks will range in asset size from $580 million to $1.5 billion. The resulting banks will consist of:

 

                  Mercantile Peninsula Bank, with 39 branches and proforma assets of $1.5 billion, loans of $1.2 billion and deposits of $1.2 billion at March 31, 2004, will be formed by combining Baltimore Trust Company, headquartered in Selbyville, Del.; Farmers & Merchants Bank-Eastern Shore, headquartered in Onley, Va.; and Peninsula Bank, headquartered in Princess Anne, Md.

 

                  Mercantile Southern Maryland Bank, with 17 branches and proforma assets of $930 million, loans of $530 million and deposits of $790 million at March 31, 2004, will be formed by combining Bank of Southern Maryland, headquartered in LaPlata, Md.; Calvert Bank and Trust Company, headquartered in Prince Frederick, Md.; and The First National Bank of St. Mary’s, headquartered in Leonardtown, Md.

 

                  Mercantile County Bank, with 17 branches and proforma assets of $790 million, loans of $620 million and deposits of $640 million at March 31, 2004, will be formed by combining County Banking & Trust Company, headquartered in Elkton, Md., and The Forest Hill State Bank, headquartered in Bel Air, Md.

 

                  Mercantile Eastern Shore Bank, with 19 branches and proforma assets of $580 million, loans of $500 million and deposits of $440 million at March 31, 2004, will be formed by combining The Chestertown Bank of Maryland, headquartered in Chestertown, Md.; The Peoples Bank of Maryland, headquartered in Denton, Md.; and St. Michaels Bank, headquartered in St. Michaels, Md.

 

14



 

Upon completion of legal consolidation, Bankshares will have a total of 13 banking affiliates including the lead bank, MSD&T.  Management anticipates the operational conversions to the four new banks will occur late in the third quarter and early in the fourth quarter of 2004.

 

In tandem with the Community Banking initiative, Bankshares previously announced a more unified, regional approach to the Washington, D.C. market and that most all of the MSD&T Banking resources currently operating in that region, including the K Street branch, would be combined into Potomac Valley Bank.  In light of the regional strategy, the expanded Potomac affiliate will be renamed Mercantile Potomac Bank.  We anticipate that the name change will be completed by the end of summer.

 

 

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 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. (See Footnote No. 2 to the Consolidated Financial Statements included in this report.)

 

Net income for the quarter ended March 31, 2004 was $55.7 million, a 14% increase from net income of $49.0 million for the same period in 2003 and a 10% increase over the $50.6 million reported for the fourth quarter of 2003.  For the quarter ended March 31, 2004, diluted net income per share was $.69, a decrease of 3% from the $.71 reported for the first quarter of last year and an increase of 10% over the $.63 reported for the fourth quarter last year.  Adjusted weighted average shares outstanding increased from 69.2 million for the quarter ended March 31, 2003, to 80.3 million for the quarter ended March 31, 2004 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 first quarter included: $0.2 million of after-tax expenses related to the merger of F&M compared to $2.8 million in the fourth quarter of 2003 and continued compression of the net interest margin to 4.37% in the first quarter of 2004 from 4.57% in the first quarter of 2003.

 

Bankshares also reports cash 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 (such as those associated with integrating acquired entities’ operations into Bankshares).  Cash operating earnings totaled $56.8 million for the first quarter of 2004, an increase of 16% over the $48.8 million for the same period for 2003 and an increase of 4% over the $54.5 million for the fourth quarter of 2003.  Diluted cash operating earnings per share for the first quarter of 2004 and 2003 were $.71, and $.70, respectively, and $.69 per share for the fourth quarter of 2003.  A reconciliation of net income (GAAP basis) to cash operating earnings can be found on pages 30 and 31 of this filing.

 

Management believes that reporting several key measures based on cash operating earnings and tangible equity (equity less intangible assets and their related amortization expense) is important, as this is the basis for measuring the adequacy of capital for regulatory purposes.  For the three months ended March 31, 2004, return on average tangible assets was 1.76%, return on average tangible equity was 18.01% and average tangible equity to average tangible assets was 9.75%.  Comparable ratios for the three months ended March 31, 2003 were 1.92%, 16.99% and 11.31%, respectively.  A reconciliation of these ratios from their respective GAAP basis ratios can be found on pages 30 and 31 of this filing.

 

15



 

Segment Reporting

 

As noted in Footnote No. 10 “Segment Reporting”, Bankshares has historically reported on three distinct business segments for which financial information is segregated for use in assessing performance and allocating resources when reporting to the Board of Directors. Segment financial information is subjective and, unlike financial accounting, is not necessarily based on GAAP. As a result, the financial information of the reporting segments is not necessarily comparable with similar information reported by others and may not be comparable with Bankshares’ consolidated results.

 

BANKING

 

On a combined basis, Community Banks and MSD&T continue to be the primary contributors to Bankshares’ earnings, accounting for 96% of Bankshares’ net income. Historically, Bankshares has distinguished between two operating units, Community and MSD&T, with the former focused on small business and retail banking and the latter on commercial and specialty lending. With the F&M acquisition and the announced plan to consolidate 11 affiliate banks into 4 banks (see Footnote No. 15 “Subsequent Event” for more information), this distinction is becoming less apparent. Increased house lending authority at the Community Banks has resulted in additional loan growth within their footprint and less referral and overline business to MSD&T.

 

Community Banking

 

Net income for the quarter ended March 31, 2004, was $38.3 million. This represented a $7.0 million, or 22% increase over the same quarter last year. Community Banking was the primary beneficiary of the F&M acquisition. For the first quarter of 2004 compared to the same period last year, net interest income increased by $19.5 million, or 26%, to $95.8 million. Growth in average earning assets of $2.5 billion, largely attributable to the F&M acquisition, more than offset the effect of a 55 bp reduction in the net interest margin. Contributing to the net interest margin compression was the capital restructuring of the Community Banks during the third quarter last year. $300 million of subordinated debt issued by Bankshares in April 2003 was invested in a like amount of subordinated debt issued by the Community Banks. Excess equity capital was paid to Bankshares in the form of a special cash dividend. The $3.1 million in interest expense incurred during the first quarter of 2004 related to this subordinated debt reduced the Community Banks’ net interest margin by 14 bp. The Community Banks had a modest provision for loan losses compared to the first quarter of 2003 as credit quality remained stable. Net income for the fourth quarter of 2003 was $40.1 million. During the fourth quarter of last year the Community Banks reversed $5.0 million of their allowance for loan losses, reflective of the improving economy and credit quality. The net interest margin decreased 1 bp for the current quarter compared to the 4.48% level of the fourth quarter of 2003.

 

The year-over-year increases in noninterest income and noninterest expenses for the first quarter of 2004 compared to the same period of 2003, are attributable to the F&M acquisition and branch / market expansion programs at several Community Banks. Noninterest income increased year-over-year by $7.5 million; with deposit service charges increasing $2.0 million, and insurance fees increasing $3.7 million, accounting for the largest gains. Noninterest expenses increased by $17.4 million in the first quarter of 2004 compared to the first quarter of 2003. Over 50% of this increase is related to salaries and benefits, which grew by $8.9 million. Occupancy expense increased by $1.7 million and furniture and equipment expenses increased by $0.7 million. At the close of this quarter, the integration of F&M had been substantially completed. Management expects to complete the sale of one branch to a third party and the consolidation of the mortgage banking operations during the second quarter. Noninterest income increased $0.4 million while noninterest expenses decreased $2.5 million from the fourth quarter of 2003.

 

MSD&T

 

The net income contribution from MSD&T declined by $1.5 million from the first quarter of 2003 to $15.3 million for the current quarter, compared to the same period last year. Contributing to the decline were reduced net interest income, a higher provision for loan losses and increased noninterest expenses. Partially offsetting these items was an increase in noninterest income. Net income for the fourth quarter of 2004 was $11.1 million.

 

The decline in net interest income in the first quarter of 2004 compared to the same period in 2003 was attributable to a 20 basis point (“bp”) decline in the net interest margin from 3.75% to 3.55%. This decline is consistent with the overall decline experienced by Bankshares. Partially offsetting the reduction in the net interest margin was 4% growth in average earning assets. The provision for loan losses increased by more than 60% to $2.3 million. The increased provision is reflective of the level of nonperforming loans at MSD&T. For additional information, see discussion of nonperforming assets under “Nonperforming Assets” below. The net interest margin increased 1 bp in the first quarter of 2004 compared to the 3.54% level of the fourth quarter of 2003.

 

The increase in noninterest income was spread across numerous categories. Noninterest income increased $0.6 million in the first quarter of 2004 compared to the first quarter of 2003, and increased $1.1 million over the fourth quarter of 2003. Noninterest expense increased by $3.1 million from the first quarter of 2003 to $24.8 million. This represents a 14% increase over the prior year. Increased personnel costs accounted for approximately $2.6 million of the increase. Staffing levels increased from 844 full time equivalent to 908 full time equivalent year-over-year. Expansion of banking services, including one branch acquired from F&M, added 32 to the

 

16



 

staff levels, corporate support (primarily compliance, loan review, treasury and accounting support) increased staff levels by 28, and technology and operations added 5 to the staff levels. Certain of these costs are allocated to IWM and Community Banking as reflected in the “adjustments” line. Noninterest expense decreased $0.9 million, or 3% from the fourth quarter of 2003.

 

INVESTMENT & WEALTH MANAGEMENT

 

Net income increased nearly $1.0 million or 62% to $2.5 million for the quarter ended March 31, 2004 as compared to the $1.6 million reported in the same period last year. IWM reported net income of $2.0 million for the quarter ended December 31, 2003.

 

Revenues for the first quarter of 2004 increased $5.0 million, or 29%, over the prior year’s first quarter, with $2.2 million of the increase related to the BW and Peremel acquisitions. Total assets under administration increased from $39.1 billion at March 31, 2003 to $46.8 billion at March 31, 2004 with assets under management increasing from $19.0 billion to $22.5 billion.  Revenues increased $1.3 million from $21.0 million in the fourth quarter of 2003 due to rising equity markets and increased new sales.

 

Noninterest expenses increased by $3.4 million or 25% to $17.4 million for the first quarter of 2004 from $14.0 million for the prior year first quarter. The previously referenced acquisitions accounted for $2.1 million of the increase. Noninterest expenses increased $0.8 million or 5% from the fourth quarter of 2003. Full time equivalent staff levels have increased from 267 at March 31, 2003 to 301 at March 31, 2004. Expansion of the BW operations coupled with the Peremel acquisition and the assumption of F&M’s brokerage operation accounted for 25 of the full time equivalent increase. During the first quarter of 2004, Bankshares entered into a 7 year service contract with SunGard Wealth Management Services to provide a new core accounting system and assume management of IWM’s back-office operations. Post conversion, which is expected late in 2004, Bankshares expects to achieve net savings in excess of $1.0 million in 2005. Management expects to incur conversion and exit costs in the range of $1.5 million to $2.0 million in the second half of 2004.

 

17



 

CONSOLIDATED RESULTS

Net Interest Income and Net Interest Margin

 

Analysis of Interest Rates and Interest Differentials

The following table presents the distribution of the average consolidated balance sheet, interest income/expense and annualized yields earned and rates paid through the three months ended March 31, 2004 and 2003.

 

 

 

2004

 

2003

 

(Dollars in thousands)

 

Average
Balance

 

Income*/
Expense

 

Yield*/
Rate

 

Average
Balance

 

Income*/
Expense

 

Yield*/
Rate

 

Earning assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans:**

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

$

5,401,384

 

$

74,280

 

5.53

%

$

4,449,636

 

$

66,059

 

6.02

%

Construction

 

1,103,901

 

14,209

 

5.18

 

823,547

 

11,386

 

5.61

 

Residential real estate

 

1,358,975

 

20,488

 

6.06

 

1,077,721

 

18,313

 

6.89

 

Consumer

 

1,474,173

 

21,229

 

5.79

 

1,008,741

 

16,449

 

6.61

 

Total loans

 

9,338,433

 

130,206

 

5.61

 

7,359,645

 

112,207

 

6.18

 

Federal funds sold, et al

 

47,791

 

175

 

1.47

 

56,500

 

723

 

5.19

 

Securities:***

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

798,980

 

7,786

 

3.92

 

1,241,058

 

13,027

 

4.26

 

U.S. Agency securities

 

761,720

 

7,308

 

3.86

 

686,987

 

8,168

 

4.82

 

Mortgage-backed securities

 

1,277,802

 

12,307

 

3.87

 

511,513

 

5,989

 

4.75

 

Other stocks & bonds

 

146,592

 

3,607

 

9.90

 

98,378

 

821

 

3.38

 

Tax-exempt securities

 

 

 

 

 

 

 

 

 

 

 

 

 

States & political subdivisions

 

104,375

 

1,451

 

5.59

 

38,794

 

772

 

8.07

 

Total securities

 

3,089,469

 

32,459

 

4.23

 

2,576,730

 

28,777

 

4.53

 

Interest-bearing deposits in other banks

 

158

 

 

1.09

 

358

 

3

 

3.89

 

Total earning assets

 

12,475,851

 

162,840

 

5.25

 

9,993,233

 

141,710

 

5.75

 

Cash and due from banks

 

285,524

 

 

 

 

 

225,975

 

 

 

 

 

Bank premises and equipment, net

 

141,632

 

 

 

 

 

103,706

 

 

 

 

 

Other assets

 

871,583

 

 

 

 

 

341,538

 

 

 

 

 

Less: allowance for loan losses

 

(156,397

)

 

 

 

 

(140,243

)

 

 

 

 

Total assets

 

$

13,618,193

 

 

 

 

 

$

10,524,209

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings

 

$

1,364,181

 

984

 

0.29

 

$

1,029,033

 

1,370

 

0.54

 

Checking plus interest accounts

 

1,236,552

 

461

 

0.15

 

953,243

 

558

 

0.24

 

Money market

 

1,590,460

 

2,362

 

0.60

 

1,185,071

 

2,637

 

0.90

 

Time deposits $100,000 and over

 

1,287,695

 

6,379

 

1.99

 

1,223,688

 

7,968

 

2.64

 

Other time deposits

 

1,979,433

 

10,581

 

2.15

 

1,716,941

 

12,596

 

2.98

 

Total interest-bearing deposits

 

7,458,321

 

20,767

 

1.12

 

6,107,976

 

25,129

 

1.67

 

Short-term borrowings

 

919,388

 

1,419

 

0.62

 

779,200

 

1,545

 

0.80

 

Long-term debt

 

649,058

 

5,255

 

3.26

 

275,838

 

2,362

 

3.47

 

Total interest-bearing funds

 

9,026,767

 

27,441

 

1.22

 

7,163,014

 

29,036

 

1.64

 

Noninterest-bearing deposits

 

2,608,324

 

 

 

 

 

1,961,362

 

 

 

 

 

Other liabilities and accrued expenses

 

134,641

 

 

 

 

 

104,493

 

 

 

 

 

Total liabilities

 

11,769,732

 

 

 

 

 

9,228,869

 

 

 

 

 

Shareholders’ equity

 

1,848,461

 

 

 

 

 

1,295,340

 

 

 

 

 

Total liabilities & shareholders’ equity

 

$

13,618,193

 

 

 

 

 

$

10,524,209

 

 

 

 

 

Net interest rate spread

 

 

 

$

135,399

 

4.03

%

 

 

$

112,674

 

4.11

%

Effects of noninterest-bearing funds

 

 

 

 

 

0.34

 

 

 

 

 

0.46

 

Net interest margin on earning assets

 

 

 

 

 

4.37

%

 

 

 

 

4.57

%

Taxable-equivalent adjustment included in:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan income

 

 

 

$

1,146

 

 

 

 

 

$

1,215

 

 

 

Investment securities income

 

 

 

579

 

 

 

 

 

333

 

 

 

Total

 

 

 

$

1,725

 

 

 

 

 

$

1,548

 

 

 

 


* Presented on a tax-equivalent basis using the statutory federal corporate income tax rate of 35% (see reconciliation of non-GAAP measures on pages 30 and 31)

** Nonaccrual loans are included in average loans

*** Balances reported at amortized cost; excludes pretax unrealized gains (losses) on securities available-for-sale

 

18



 

Rate / Volume Analysis

A rate/volume analysis, which demonstrates changes in interest income and expense for significant assets and liabilities, appears below:

 

 

 

For the three months ended March 31,
2004 vs. 2003

 

 

 

Due to variances in

 

(Dollars in thousands)

 

Rates

 

Volumes (4)

 

Total

 

Interest earned on:

 

 

 

 

 

 

 

Loans:

 

 

 

 

 

 

 

Commercial (1)

 

$

(5,909

)

$

14,130

 

$

8,221

 

Construction (2)

 

(1,053

)

3,876

 

2,823

 

Residential real estate

 

(2,604

)

4,779

 

2,175

 

Consumer

 

(2,810

)

7,590

 

4,780

 

Total loans

 

(12,376

)

30,375

 

17,999

 

Taxable securities (3)

 

(1,931

)

4,934

 

3,003

 

Tax-exempt securities (3)

 

(626

)

1,305

 

679

 

Federal funds sold, et al

 

(437

)

(111

)

(548

)

Interest-bearing deposits in other banks

 

(1

)

(2

)