<PAGE> 1
================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
X Quarterly Report Pursuant to Section 13 or 15(d) of the
--- Securities and Exchange Act of 1934
For the quarterly period ended June 30, 1998, or
Transition Report Pursuant to Section 13 or 15(d) of the
--- Securities Exchange Act of 1934
For the Transition Period from to
-------- ---------
Commission File No. 0-17000
COMMERCIAL NATIONAL FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Michigan 38-2799780
(State of Incorporation) (IRS Employer Identification No.)
101 North Pine River Street, Ithaca, Michigan 48847
(address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (517) 875-4144
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO
---------- ----------
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at August 3, 1998
----- -----------------------------
Common Stock 969,782
No Par Value
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<PAGE> 2
COMMERCIAL NATIONAL FINANCIAL CORPORATION
INDEX
<TABLE>
<S> <C> <C>
PART I FINANCIAL INFORMATION
- ------ ---------------------
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 1998 and December 31, 1997 (Page 3)
Consolidated Statements of Income for the three and six months ended June 30, 1998 and (Page 4)
June 30,1997
Consolidated Statements of Shareholders' Equity for the periods ended June 30, 1998 (Page 5)
and December 31, 1997
Consolidated Statements of Cash Flows for the six months ended June 30, 1998 and (Page 6)
June 30, 1997
Notes to Consolidated Financial Statements (Page 7-8)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 9-15)
PART II OTHER INFORMATION
- ------- -----------------
Item 6. Exhibits and Reports on Form 8-K
a) Exhibit 27-Financial Data Schedule (Page 18)
b) Reports on Form 8-K (Page 16)
SIGNATURES (Page 17)
</TABLE>
2
<PAGE> 3
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
June 30, 1998 (Unaudited) and December 31, 1997
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
---- ----
(Unaudited)
ASSETS
<S> <C> <C>
Cash and due from banks $ 5,541,127 $ 5,576,724
Federal funds sold 9,450,000 9,600,000
----------------- -----------------
Total cash and cash equivalents 14,991,127 15,176,724
Securities available for sale 14,514,883 8,436,349
Securities held to maturity (fair value $14,737,383 -
June 30, 1998; $20,847,000 - December 31, 1997) 14,310,068 20,383,446
Federal Home Loan Bank stock, at cost 1,391,300 1,391,300
Loans receivable, net of allowance for loan losses
$2,163,760 - June 30, 1998; $2,063,668 - December 31, 1997 124,895,749 122,457,789
Premises and equipment, net 2,941,485 3,188,743
Accrued interest receivable and other assets 1,585,993 1,370,472
----------------- -----------------
Total assets $ 174,630,605 $ 172,404,823
================= =================
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
Noninterest-bearing demand $ 15,392,409 $ 17,102,386
Interest-bearing demand 38,362,954 37,233,745
Savings 20,400,950 20,365,980
Time 59,698,451 59,244,780
----------------- -----------------
Total deposits 133,854,764 133,946,891
Securities sold under agreements to repurchase 7,243,920 4,151,844
U.S. Treasury demand notes 1,480,329 2,753,486
Federal Home Loan Bank advances 13,000,000 13,000,000
Accrued expenses and other liabilities 1,318,895 1,669,460
----------------- -----------------
Total liabilities 156,897,908 155,521,681
Shareholders' equity
Common stock, no par value: 1,750,000 shares
authorized; shares issued and outstanding
June 30, 1998 - 964,897 and December 31,
1997 - 954,322 - 954,322
Additional paid-in capital 16,537,782 15,277,539
Retained earnings 1,169,527 647,697
Net unrealized gain on securities available
for sale, net of tax 25,388 3,584
----------------- -----------------
Total shareholders' equity 17,732,697 16,883,142
----------------- -----------------
Total liabilities and shareholders' equity $ 174,630,605 $ 172,404,823
================= =================
</TABLE>
- --------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
3
<PAGE> 4
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Periods ended June 30, 1998 and 1997 (Unaudited)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the three months For the six months
ended June 30, ended June 30,
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Interest and dividend income
Loans receivable, including fees $ 2,844,008 $ 2,787,185 $ 5,592,628 $ 5,504,129
Taxable securities 228,060 162,355 481,805 330,205
Nontaxable securities 190,026 186,403 365,384 375,156
Federal funds sold 83,253 72,219 201,918 154,313
Federal Home Loan Bank stock dividends 27,750 21,344 55,195 49,131
------------ -------------- -------------- --------------
Total interest and dividend income 3,373,097 3,229,506 6,696,930 6,412,934
Interest expense
Deposits 1,209,903 1,145,206 2,432,326 2,303,042
Securities sold under agreements
to repurchase 76,625 92,688 144,409 171,799
Federal Home Loan Bank advances 217,475 149,997 421,636 292,120
Other 6,083 7,121 11,889 14,135
------------ -------------- -------------- --------------
Total interest expense 1,510,086 1,395,012 3,010,260 2,781,096
NET INTEREST INCOME 1,863,011 1,834,494 3,686,670 3,631,838
Provision for loan losses 90,000 155,000 180,000 215,000
------------ -------------- -------------- --------------
NET INTEREST INCOME AFTER PROVISION FOR
LOAN LOSSES 1,773,011 1,679,494 3,506,670 3,416,838
Noninterest income
Service charges and fees 125,693 115,921 235,524 189,306
Net gain on loan sales 99,871 10,404 200,922 50,794
Other 142,366 110,805 255,781 180,828
------------ -------------- -------------- --------------
Total noninterest income 367,930 237,130 692,227 420,928
Noninterest expense
Salaries and employee benefits 650,424 679,534 1,283,690 1,369,685
Occupancy and equipment 260,771 248,998 522,811 487,586
FDIC insurance 5,625 5,153 11,085 10,306
Printing, postage and supplies 66,806 115,843 113,044 170,617
Professional and outside services 65,317 61,013 117,796 110,278
Branch closing cost - 546,614 - 546,614
Other 265,406 268,148 521,896 608,712
------------ -------------- -------------- --------------
Total noninterest expense 1,314,349 1,925,303 2,570,322 3,303,798
------------ -------------- -------------- --------------
INCOME BEFORE INCOME TAX EXPENSE 826,592 (8,679) 1,628,575 533,968
Income tax expense 216,884 (58,903) 414,000 65,474
------------ --------------- -------------- --------------
NET INCOME $ 609,708 $ 50,224 $ 1,214,575 $ 468,494
============ ============== ============== ==============
Per share information
Basic earnings $ .63 $ .05 $1.26 $ .51
Diluted earnings $ .63 $ .05 $1.25 $ .50
Dividends declared $ .36 $ .31 $ .72 $ .60
</TABLE>
- --------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
4
<PAGE> 5
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Periods ended June 30, 1998 (Unaudited) and December 31, 1997
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Accumulated
Additional Other Total
Common Paid-in Retained Comprehensive Shareholders'
Stock Capital Earnings Income Equity
----- ------- -------- ------ ------
<S> <C> <C> <C> <C> <C>
BALANCE AT JANUARY 1, 1997 $ 872,982 $ 13,123,259 $ 1,499,422 $ 15,495,663
Net income 1,692,110 1,692,110
Other comprehensive income, net of tax:
Net change in unrealized gain on
securities available for sale $ 3,584 3,584
------------
Comprehensive income 1,695,694
------------
Cash dividends declared,
$1.24 per share (1,171,442) (1,171,442)
Stock issued in payment of 5%
stock dividend 45,246 1,323,423 (1,372,393) (3,724)
Stock issued under dividend
reinvestment program 14,839 375,900 390,739
Stock issued under stock option
plans 21,255 454,957 476,212
------------ ------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 1997 954,322 15,277,539 647,697 3,584 16,883,142
Net income 1,214,575 1,214,575
Other comprehensive income, net of tax:
Net change in unrealized gain on
securities available for sale 21,804 21,804
------------
Comprehensive income 1,236,379
------------
Transfer to additional paid in capital (963,846) 963,846
Cash dividends declared,
$0.72 per share (692,745) (692,745)
Stock issued under dividend
reinvestment program 8,555 247,597 256,152
Stock issued under stock option
plans 969 48,800 49,769
------------ ------------ ------------ ------------ ------------
BALANCE AT JUNE 30, 1998 $ - $ 16,537,782 $ 1,169,527 $ 25,388 $ 17,732,697
============ ============ ============ ============ ============
</TABLE>
- --------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
5
<PAGE> 6
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Periods ended June 30, 1998 and 1997 (Unaudited)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the six months ended
June 30,
1998 1997
---- ----
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 1,214,575 $ 468,494
Adjustments to reconcile net income to net
cash from operating activities
Provision for loan losses 180,000 215,000
Net gains on loan sales (200,922) (43,259)
Originations of loans held for sale (7,742,735) (3,213,393)
Proceeds from sales of loans held for sale 8,606,220 3,241,652
Depreciation, amortization and accretion 334,383 273,829
Write-off of assets associated with branch closing - 486,614
Net change in accrued interest receivable
and other assets (185,195) (436,594)
Net change in accrued expenses and
other liabilities (350,565) 187,796
--------------- ----------------
Net cash from operating activities 1,855,761 1,180,139
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available for sale (13,054,725) (1,994,375)
Proceeds from maturities of securities
available for sale 7,000,000 -
Proceeds from maturities of
securities held to maturity 6,100,000 5,110,055
Purchases of securities held to maturity - (2,497,978)
Net change in loans (3,357,219) (3,579,467)
Purchases of premises and equipment, net (69,382) (145,276)
--------------- ----------------
Net cash from investing activities (3,381,326) (3,107,041)
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in deposits (92,127) (6,714,535)
Net change in securities sold
under agreements to repurchase 3,092,076 3,384,631
Net change in U.S. Treasury demand notes (1,273,157) 160,371
Proceeds from Federal Home Loan Bank
advances - 2,000,000
Repayment of Federal Home Loan Bank
advances - (2,000,000)
Dividends paid and fractional shares (692,745) (558,192)
Proceeds from sale of common stock 305,921 389,809
--------------- ----------------
Net cash from financing activities 1,339,968 (3,337,916)
--------------- ----------------
Net change in cash and cash equivalents (185,597) (5,264,818)
Cash and cash equivalents, at beginning of year 15,176,724 13,150,844
--------------- ----------------
CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 14,991,127 $ 7,886,026
=============== ================
Cash paid during the period for
Interest $ 3,022,626 $ 2,941,638
Federal income taxes $ 510,000 $ 52,216
</TABLE>
- --------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
6
<PAGE> 7
Notes to Consolidated Financial Statements (Unaudited)
Note 1-Summary of Significant Accounting Policies
Basic Presentation
The accompanying unaudited condensed consolidated financial statements were
prepared in accordance with Rule 10-01 of regulation S-X and the instructions
for Form 10-Q and, therefore, do not include all disclosures required by
generally accepted accounting principles for complete presentation of financial
statements. In the opinion of management, the condensed consolidated financial
statements contain all adjustments (consisting of normal recurring accruals)
necessary to present fairly the financial condition of Commercial National
Financial Corporation as of June 30, 1998 and December 31, 1997, and the results
of its operations for the three and six months ending June 30, 1998 and June 30,
1997. The results for the three and six months ended June 30, 1998 are not
necessarily indicative of the results expected for the full year.
Principals of Consolidation
The accompanying consolidated financial statements include the accounts of
Commercial National Financial Corporation (CNFC) and its wholly owned
subsidiary, Commercial Bank (Bank). All material intercompany accounts and
transactions have been eliminated in consolidation.
Use of Estimates
To prepare financial statements in conformity with generally accepted
accounting principles, management makes estimates and assumptions based on
available information. These estimates and assumptions affect the amounts
reported in the financial statements and the disclosures provided, and future
results could differ. The allowance for loan losses and fair values of
securities and other financial instruments are particularly subject to change.
Cash Flow Reporting
Cash and cash equivalents include cash on hand, demand deposits with other
financial institutions and federal funds sold. Cash flows are reported, net, for
customer loan and deposit transactions, securities sold under agreements to
repurchase with original maturities of 90 days or less and U.S. Treasury demand
notes.
Securities
Securities are classified as held to maturity and carried at amortized cost
when management has the positive intent and ability to hold them to maturity.
Securities are classified as available for sale when they might be sold before
maturity. Securities available for sale are carried at fair value, with net
unrealized holding gains and losses reported separately in shareholders' equity,
net of tax. Trading securities are bought principally for sale in the near term,
and are reported at fair value with unrealized gains and losses included in
earnings. Securities are written down to fair value when a decline in fair value
is not temporary. CNFC did not classify securities for trading at any time
during 1998 or 1997.
Gains and losses on sales are determined using the amortized cost of the
specific security sold. Interest and dividend income, adjusted by amortization
of purchase premiums and discounts, is included in earnings.
Income Taxes
Income tax expense is the sum of the current year income tax due or
refundable and the change in deferred tax assets and liabilities. Deferred tax
assets and liabilities are the expected future tax consequences of temporary
differences between the carrying amounts and tax bases of assets and
liabilities, computed using enacted tax rates. A valuation allowance, if needed,
reduces deferred tax assets to the amount expected to be realized.
7
<PAGE> 8
Earnings and Dividends Per Share
Basic and diluted earnings per common share are computed under a new
accounting standard, SFAS No. 128, effective beginning with the quarter ended
December 31, 1997. All prior earnings per common share amounts have been
restated to be comparable. Basic earnings per common share is based on net
income divided by the weighted average number of common shares outstanding
during the period. Diluted earnings per common share shows the dilutive effect
of any additional potential common shares. Earnings and dividends per common
share are restated for all stock splits and stock dividends. The average number
of shares used to calculate basic earnings per share for the periods ending June
30, 1998 and June 30, 1997 were 963,198 and 927,609 respectively. The average
number of shares used to calculate diluted earnings per share for the periods
ending June 30, 1998 and June 30, 1997 were 968,298 and 930,040 respectively.
Stock Dividends
Dividends issued in stock are reported by transferring the market value of
the stock issued from retained earnings to common stock and additional paid-in
capital. Fractional shares are paid in cash for all stock dividends.
Comprehensive Income
Under a new accounting standard, comprehensive income is now reported for
all periods. Comprehensive income includes both net income and other
comprehensive income. Other comprehensive income includes the change in
unrealized gains and losses on securities for sale, foreign currency translation
adjustments, and additional minimum pension liability.
Reclassifications
Some items in the prior year financial statements have been reclassified to
conform with the current year presentation.
8
<PAGE> 9
ITEM 2: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FINANCIAL CONDITION
Total assets for the quarter ending June 30, 1998 increased slightly to
$174,631,000 from the $172,405,000 at the quarter ending December 31, 1997.
Total loans were $127,060,000 as of June 30, 1998. This is a $2,539,000 or 2.0%
increase from December 31, 1997 balance of $124,521,000. The increase was
primarily a result of demand for business and home mortgage loans.
During the second quarter, the Corporation sold its credit card portfolio. The
selling of the portfolio allows management to focus on its core competencies of
commercial loans and home mortgages. The book value of the portfolio was
$656,000. No gain or loss was recorded.
Investment securities totaled $28,825,000 at June 30, 1998, compared to
$28,820,000 at December 31, 1997. The current flat Treasury yield curve, and
relatively low interest rates have reduced the desirability of investments. All
security purchases are classified as available for sale.
Deposits remained virtually unchanged during the period. Total deposits at June
30, 1998 were $133,855,000 compared to $133,947,000 at December 31, 1997.
Federal Home Loan Bank (FHLB) advances remained unchanged at $13,000,000.
LIQUIDITY
Management defines liquidity as the ability to fund appropriate levels of
credit worthy loans, meet the immediate cash withdrawal requirements of
depositors, and maintain access to sufficient resources to meet unexpected
contingencies at a reasonable cost and or with minimum losses.
While modest loan growth continues, the Bank's deposit base has not
increased at the same rate. The loan to deposit ratio based on ending balances
was 94.9% at June 30, 1998 compared to 93.0% at December 31, 1997. Management is
confident that the combination of available FHLB advances, Federal funds lines
of credit, the available for sale investment portfolio, and our ability to sell
mortgage loans and the government guaranteed portion of commercial loans
provides adequate short and medium term sources of liquidity. At a minimum the
Bank has the following available to meet short term liquidity needs: $9,450,000
in Fed funds sold, $8,000,000 in available FHLB advances and $6,000,000 in short
term lines of credit with correspondent banks.
CNFC also needs cash to pay dividends to its shareholders. The primary
source of cash is the dividends paid to CNFC by the Bank. Management believes
that cash from operations is sufficient to supply the cash needed to continue
paying a reasonable dividend.
ASSET QUALITY AND THE ALLOWANCE FOR LOAN LOSS
The allowance for loan losses was 1.70% of total loans at June 30, 1998
compared to 1.66% at December 31, 1997. Loans past due greater than 30 days
totaled $329,000 or .3% of total loans. Loan quality remains at acceptable
levels compared to long term historical trends.
Net year to date charge-offs totaled $82,000 compared to $93,000 for the
six months ending June 30, 1997. During the quarter the Bank expensed a
provision of $90,000 to the allowance compared to $155,000 during the same
period in 1997. During the second quarter of 1997, management elected to fund an
additional provision to the allowance to account for some weakness in the
indirect automobile portfolio. Management continues to systematically evaluate
the adequacy of the allowance such that the balance is commensurate with the
performance of the loan portfolio, general market conditions and other relevant
factors.
9
<PAGE> 10
CAPITAL RESOURCES
CNFC's capital ratios continue to exceed regulatory guidelines for a "well
capitalized" institution. A summary of CNFC's capital ratios follows:
<TABLE>
<CAPTION>
June 30, December 31, June 30, December 31, Minimum Required to be Well
1998 1997 1997 1996 Capitalized Under Prompt
Corrective Action Regulations
<S> <C> <C> <C> <C> <C>
Total capital to risk 15.1% 14.7% 14.4% 14.3% 10.0%
weighted assets ===== ===== ===== ===== =====
Tier 1 capital to 13.9% 13.5% 13.2% 13.0% 6.0%
risk weighted assets ===== ===== ===== ===== ====
Tier 1 capital to 10.3% 10.3% 9.5% 9.4% 5.0%
average assets ===== ===== ==== ==== ====
</TABLE>
RESULTS OF OPERATIONS
Net income for the quarter ended June 30, 1998 was $610,000, an increase of
$560,000 compared to the same period in 1997. During the second quarter of 1997,
the Corporation recorded a $547,000 non recurring charge to close two
supermarket branches. The second quarter of 1998 benefited from strong mortgage
loan activity resulting in $100,000 in gains on loan sales during the quarter.
Year to date net income totaled $1,215,000 compared to $468,000 for the same
period of 1997.
Return on average shareholders' equity for the three months ended June 30,
1998 and 1997 was 13.8% and 1.2% respectively. Return on average assets for the
three months ending June 30, 1998 and 1997 was 1.4% and .1% respectively. Year
to date return on average equity was 14.8% and 5.9% for 1998 and 1997
respectively. Year to date return on average assets was 1.4% and .6% for 1998
and 1997 respectively.
Net Interest Income
The following table illustrates the effect that changes in rates and
volumes of interest-earning assets and interest-bearing liabilities had on net
interest income for the three and six months ending June 30, 1998 and 1997.
<TABLE>
<CAPTION>
Three Months Ending June 30, Six Months Ending June 30,
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Interest Income(tax equivalent) $3,490,000 $3,353,000 $6,930,000 $6,646,000
Interest Expense 1,510,000 1,395,000 3,010,000 2,781,000
---------- ---------- ---------- ----------
Net Interest Income $1,980,000 $1,958,000 $3,920,000 $3,865,000
========== ========== ========== ==========
Average Volume
Interest-earning Assets $164,161,000 $154,777,000 $164,437,000 $154,902,000
Interest-bearing Liabilities 139,191,000 131,520,000 139,538,000 132,170,000
------------ ------------ ------------ ------------
Net differential $ 24,970,000 $ 23,257,000 $ 24,899,000 $ 22,732,000
============ ============ ============ ============
Average Yields/Rates
Yield on Earning Assets 8.53% 8.69% 8.50% 8.65%
Rate Paid on Liabilities 4.35% 4.25% 4.35% 4.24%
----- ----- ----- -----
Interest Spread 4.18% 4.44% 4.15% 4.41%
===== ===== ===== =====
Net Interest Margin 4.84% 5.07% 4.81% 5.03%
===== ===== ===== =====
</TABLE>
10
<PAGE> 11
The change in net interest income is attributable to the following:
<TABLE>
<CAPTION>
Three Months Ending June 30, 1998 Six Months Ending June 30, 1998
Volume Rate Inc/(Dec) Volume Rate Inc/(Dec)
<S> <C> <C> <C> <C> <C> <C>
Interest Earning $711,000 $(574,000) $ 137,000 $664,000 $(380,000) $ 284,000
Assets
Interest Bearing 465,000 (350,000) 115,000 420,000 (191,000) 229,000
-------- --------- --------- -------- --------- ---------
Liabilities
Net Interest $246,000 $(224,000) $ 22,000 $244,000 $(189,000) $ 55,000
Income ======== ========== ========= ======== ========== =========
</TABLE>
The increase in net interest income is due to an increase in earning
assets. Net interest margin for the three months ending June 30, 1998 decreased
to 4.84% compared to 5.07% for the three months ending June 30, 1997. Several
factors have lead to the decrease in margin. A drop in long term interest rates
has resulted in a general trend to refinancing of home mortgage loans at lower
rates, the drop in interest rates has also made it difficult to replace maturing
investments and business loans with assets earning comparable yields. Market
pressures have made it more difficult to reduce deposit rates quickly enough to
offset the decrease in yield on earning assets. In the short term, the Bank's
earning assets are more sensitive to shifts in interest rates than are the
interest bearing liabilities.
Non-interest Income
Non-interest income for the three months ending June 30, 1998 was $368,000.
This represents a $131,000 or 55.3% increase over the same period in 1997. Year
to date 1998 non interest income was $692,000 compared to $421,000 during the
same period in 1997.
The non interest income for first six months of 1998, benefits from a
number of service charges and new products implemented in the second and third
quarters of 1997. These included several new deposit service charges, improved
pricing of mortgage loans sold to the secondary market compared to the first
quarter of 1997, introduction of an ATM surcharge, and the introduction of a
receivable factoring program.
The low interest rates during 1998 have resulted in a significant increase
in mortgage loan refinances. A majority of the 15 and 30 year fixed rates loans
were sold to the secondary market. This resulted in a significant increase in
gains on mortgage loan sales.
Non-interest Expense
Non-interest expense for the three months ending June 30, 1998 totaled
$1,314,000. This represents a $611,000 or 31.7% decrease over the same period in
1997. However, the June 30, 1997 results reflect a non-recurring charge to close
to supermarket branches. Without this one time charge, non interest expense
would have been $1,379,000. Comparing June 30, 1998 results with June 30, 1997
results adjusted for the one time charge, non-interest expense decreased $65,000
or 4.7%.
Year to date non-interest expense totaled $2,570,000 compared to $3,304,000
for the same period in 1997. Comparing the June 30, 1998 year to date results
with June 30, 1997 results adjusted for the $547,000 non-recurring charge, non
interest expense decreased $187,000 or 6.8%.
In general, overhead expenses were lower due to management's continued
emphasis on controlling overhead. CNFC's ratio of non-interest expense to
average assets for the quarter ending June 30, 1998 decreased to 3.0% from 4.8%
for the quarter ending June 30, 1997. Adjusted for the non-recurring charge, the
overhead ratio would have been 3.4% for the three months ending June 30, 1997.
Year to date overhead ratio decreased to 3.0% in 1998 from 4.1% in 1997.
Adjusted for the non-recurring charge in 1997, the overhead ratio would have
been 3.4% for the six months ending June 30, 1997.
11
<PAGE> 12
Salary and benefit expense for the three months ending June 30, 1998
totaled $650,000 compared to $680,000 a reduction of $30,000 or 4.4%. This
savings was created largely by two events: closure of two supermarket branches
in the second quarter of 1997 and the related reduction in full time
equivalents, and a general reduction in full time equivalents. Management
continues to focus on the optimal use of our employees and associated control of
overhead costs.
Occupancy and equipment expense for the three months ending June 30, 1998
increased $12,000 or 4.8% compared to same period of 1997. Increased
depreciation expense related to changes in the estimated useful life of various
technology related assets is the primary cause for this increase.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Commercial's primary market risk exposure is interest rate risk and, to a
lesser extent, liquidity risk. All of the Corporation's transactions are
denominated in U.S. dollars with no specific foreign exchange exposure. The
Corporation has a limited exposure to commodity prices related to agricultural
loans. Any impacts that changes in foreign exchange rate and commodity prices
would have on interest rates are assumed to be insignificant.
Interest rate risk ("IRR") is the exposure of a banking organization's
financial condition to adverse movements in interest rates. Accepting this risk
can be an important source of profitability and stockholder value, however,
excessive levels of IRR could pose a significant threat to the Corporation's
earnings and capital base. Accordingly, effective risk management that maintains
IRR at prudent levels is essential to the Corporation's safety and soundness.
Evaluating a financial institution's exposure to changes in interest rates
includes assessing both the adequacy of the management process used to control
IRR and the organization's quantitative level of exposure. When assessing the
IRR management process, the Corporation seeks to ensure that appropriate
policies, procedures, management information systems and internal controls are
in place to maintain IRR at prudent levels with consistency and continuity.
Evaluating the quantitative level of IRR exposure requires the Corporation to
assess the existing and potential future effects of changes in interest rates on
its consolidated financial condition, including capital adequacy, earnings,
liquidity, and, where appropriate, asset quality.
The Federal Reserve Board, together with the Office of the Comptroller of
the Currency and the Federal Deposit Insurance Corporation, adopted a Joint
Agency Policy Statement on IRR effective June 26, 1996. The policy statement
provides guidance to examiners and bankers on sound practices for managing IRR,
which will form the basis for ongoing evaluation of the adequacy of IRR
management at supervised institutions. The policy statement also outlines
fundamental elements of sound management that have been identified in prior
Federal Reserve guidance and discusses the importance of these elements in the
context of managing IRR. Specifically, the guidance emphasizes the need for
active board of directors and senior management oversight and a comprehensive
risk management process that effectively identifies, measures, and controls IRR.
Financial institutions derive their income primarily from the excess of
interest collected over interest paid. The rates of interest an institution
earns on its assets and owes on its liabilities generally are established
contractually for a period of time. Since market interest rates change over
time, an institution is exposed to lower profit margins (or losses) if it cannot
adapt to interest rate changes. For example, assume that an institution's assets
carry intermediate -or long term fixed rates and that those assets are funded
with short-term liabilities. If market interest rates rise by the time the
short-term liabilities must be refinanced, the increase in the institution's
interest expense on its liabilities may not be sufficiently offset if assets
continue to earn at the long-term fixed rates. Accordingly, an institution's
profits could decrease on existing assets because the institution will either
have lower net interest income or, possibly, net interest expense. Similar risks
exist when assets are subject to contractual interest rate ceilings, or rate
sensitive assets are funded by longer-term, fixed-rate liabilities in a
decreasing rate environment.
12
<PAGE> 13
Various techniques might be used by an institution to minimize IRR. One
approach used by the Corporation is to periodically analyze its assets and
liabilities and make future financing and investment decisions based on payment
streams, interest rates, contractual maturities, and estimated sensitivity to
actual or potential changes in market interest rates. Such activities fall under
the broad definition of asset/liability management. The Corporation's primary
asset/liability management technique is the measurement of its asset/liability
gap. That is, the difference between the cash flow amounts of interest-sensitive
assets and liabilities that will be refinanced or repriced during a given
period. For example, if the asset amount to be priced exceeds the corresponding
liability amount for a certain day, month, year, or longer period, the
institution is in an asset-sensitive gap position. In this situation, net
interest income would increase if market interest rates rose or decrease if
market interest rates fell. If, alternatively, more liabilities than assets will
reprice, the institution is in a liability-sensitive position. Accordingly, net
income would decline when rates rose and increase when rates fell. Also, these
examples assume that interest rate changes for assets and liabilities are of the
same magnitude, whereas actual rate changes generally differ in magnitude for
assets and liabilities.
Several ways an institution can manage IRR include: selling existing assets
or repaying certain liabilities; matching repricing periods for new assets and
liabilities for example, by shortening terms of new loans or investments; and
hedging existing assets, liabilities, or anticipated transactions. An
institution might also invest in more complex financial instruments intended to
hedge or otherwise change IRR. Interest rate swaps, futures contracts, options
on futures, and other such derivative financial instruments often are used for
this purpose. Because these instruments are sensitive to interest rate changes,
they require management expertise to be effective. The Corporation has not
purchased derivative financial instruments in the past and does not presently
intend to purchase such instruments.
Financial institutions are also subject to prepayment risk in falling rate
environments. For example, mortgage loans and other financial assets may be
prepaid by a debtor so that the debtor may refund its obligations at new, lower
rates. Prepayments of assets carrying higher rates reduce the Corporation's
interest income and overall asset yields. Certain portions of an institution's
liabilities may be short-term or due on demand, while most of its assets may be
invested in long-term loans or investments. Accordingly, the Corporation seeks
to have in place sources of cash to meet short-term demands. These funds can be
obtained by increasing deposits, borrowing, or selling assets. Also, Federal
Home Loan Bank advances and short-term borrowings provide additional sources of
liquidity for the Corporation.
The following table provides information about the Corporation's financial
instruments that are sensitive to changes in interest rates as of June 30, 1998.
The Corporation had no derivative financial instruments, or trading portfolio,
as of that date. The expected maturity date values for loans receivable,
mortgage-backed securities, and investment securities were calculated without
adjusting the instrument's contractual maturity date for expectations of
prepayments. Expected maturity date values for interest-bearing core deposits
were not based upon estimates of the period over which the deposits would be
outstanding, but rather the opportunity for repricing.
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<PAGE> 14
Principal/Notional Amount Maturing in:
<TABLE>
<CAPTION>
1998 1999 2000 2001 2002 Thereafter Total Fair Value
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Rate Sensitive Assets
Fixed interest rate loans $ 5,590 $ 6,815 $11,250 $15,147 $10,299 $23,581 $72,682 $78,306
Average interest rate 10.29% 9.84% 9.54% 8.54% 8.59% 7.98% 8.79%
Variable interest rate loans 11,357 6,455 3,337 4,904 5,341 22,984 54,378 51,707
Average interest rate 9.82% 9.78% 9.68% 9.56% 9.43% 8.49% 9.18%
Fixed interest rate securities 2,110 5,080 4,945 4,485 2,460 9,505 28,585 29,252
Average interest rate 8.10% 6.50% 6.45% 6.18% 6.67% 7.01% 6.74%
FHLB stock 1,391 1,391 1,391
Average interest rate
Federal funds sold 9,450 9,450 9,450
Average interest rate 5.60% 5.60%
Rate Sensitive Liabilities:
Non-interest bearing demand 15,238 15,238 15,238
Interest bearing demand 38,363 38,363 38,363
Average interest rate 2.80% 2.80%
Savings 20,401 20,401 20,401
Average interest rate 2.41% 2.41%
Time deposits 27,372 22,585 4,577 2,460 1,624 1,080 59,698 59,807
Average interest rate 5.00% 4.95% 5.17% 5.21% 4.67% 5.08% 5.00%
Repurchase agreements 7,244 7,244 7,244
Average interest rate 5.34% 5.34%
U.S. Treasury demand notes 1,480 1,480 1,480
Average interest rate 4.92% 4.92%
Fixed rate FHLB advances 3,000 3,000 5,000 1,000 1,000 13,000 12,966
Average interest rate 6.24% 6.11% 6.05% 6.50% 5.68% 5.71%
</TABLE>
YEAR 2,000 ISSUES
CNFC is aware of the issues associated with the programming code in
existing computer systems as the year 2000 approaches. The "Year 2000" will
affect virtually every computer operation in some way by the rollover of the two
digit value used to represent the year to 00. The issue is whether computer
software will properly recognize the date-sensitive information when the year
changes to 2000. Systems that do not properly recognize such information could
generate erroneous data or cause a system failure.
CNFC recognizes the need to ensure its operation will not be adversely
impacted by Year 2000 software failures. CNFC has established a process for
evaluating and managing risks associated with this issue. This process includes
the formation of a Technology Committee comprised of management and independent
members of the board of directors to ensure that progress is made in identifying
non-compliant systems and developing appropriate responses to correct the
deficiencies. Management is in the process of obtaining software and hardware
vendor representation that their computer systems are Year 2000 compliant and is
planning to test for compliance. We anticipate that all major computer systems
will be compliant by December 31, 1998. The financial impact to CNFC as of June,
1998 should not be material.
FORWARD LOOKING STATEMENTS
This discussion and analysis of financial condition and results of
operations, and other sections of this annual report contain forward looking
statements that are based on management's beliefs, assumptions, current
expectations, estimates and projections about the financial services industry,
the economy, and
14
<PAGE> 15
about the Corporation itself. Words such as "anticipates", "believes",
"estimates", "expects" "forecasts" "intends", "is likely", "plans", "product",
"projects", variations of such words and similar expressions are intended to
identify such forward-looking statements. These statements are not guarantees of
future performance and involve certain risks, uncertainties, and assumptions
("Future Factors") that are difficult to predict with regard to timing, extent,
likelihood and degree of occurrence. Therefore, actual results and outcomes may
materially differ from what may be expressed or forecasted in such forward
looking statements. Furthermore, CNFC undertakes no obligation to update, amend
or clarify forward-looking statements, whether as a result of new information,
future events, or otherwise.
Future Factors include changes in interest rates and interest rate
relationships; demand for products and services; the degree of competition by
traditional and non-traditional competitors; changes in banking regulations and
tax laws; changes in prices, levies, and assessments; the impact of technology,
governmental and regulatory policy changes; the outcome of pending and future
litigation and contingencies; trends in customer behavior including their
ability to repay loans; and vicissitudes of the national and local economies.
These are representative of the Future Factors that could cause a difference
between an actual outcome and a forward-looking statement.
15
<PAGE> 16
COMMERCIAL NATIONAL FINANCIAL CORPORATION
PART II. OTHER INFORMATION
Item 6 (a) Exhibit 27 Financial Data
Item 6 (b) Reports on Form 8-K
None
16
<PAGE> 17
COMMERCIAL NATIONAL FINANCIAL CORPORATION
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Commercial National Financial Corporation
(Registrant)
Date: August 8,1998
/s/ Jeffrey S. Barker
Jeffrey S. Barker
President and Chief Executive Officer
/s/ Patrick G. Duffy
Patrick G. Duffy
Vice President and Chief Financial
Officer
17
<PAGE> 18
INDEX TO EXHIBITS
EXHIBIT NO. DESCRIPTION
- ----------- -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> JUN-30-1998
<CASH> 5,541
<INT-BEARING-DEPOSITS> 0
<FED-FUNDS-SOLD> 9,450
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 14,515
<INVESTMENTS-CARRYING> 29,250
<INVESTMENTS-MARKET> 29,288
<LOANS> 127,060
<ALLOWANCE> 2,164
<TOTAL-ASSETS> 174,631
<DEPOSITS> 133,855
<SHORT-TERM> 8,724
<LIABILITIES-OTHER> 1,319
<LONG-TERM> 13,000
0
0
<COMMON> 0
<OTHER-SE> 16,538
<TOTAL-LIABILITIES-AND-EQUITY> 174,631
<INTEREST-LOAN> 5,593
<INTEREST-INVEST> 902
<INTEREST-OTHER> 202
<INTEREST-TOTAL> 6,697
<INTEREST-DEPOSIT> 2,432
<INTEREST-EXPENSE> 3,010
<INTEREST-INCOME-NET> 3,687
<LOAN-LOSSES> 180
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 2,570
<INCOME-PRETAX> 1,629
<INCOME-PRE-EXTRAORDINARY> 1,629
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,215
<EPS-PRIMARY> 1.26
<EPS-DILUTED> 1.25
<YIELD-ACTUAL> 4.84
<LOANS-NON> 0
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 2,064
<CHARGE-OFFS> 120
<RECOVERIES> 40
<ALLOWANCE-CLOSE> 2,164
<ALLOWANCE-DOMESTIC> 1,142
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 1,022
</TABLE>
