ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS
OF
OPERATIONS
The following is a discussion of our financial condition at December
31, 2020 and 2019 and our results of operations for
the years ended December 31, 2020 and 2019. The
purpose of this discussion is to provide information about our financial
condition and results of operations which is not otherwise apparent
from the consolidated financial statements. The
following discussion and analysis should be read along with
our consolidated financial statements and the related notes
included elsewhere herein. In addition, this discussion and analysis
contains forward-looking statements, so you should
refer to Item 1A, “Risk Factors” and “Special Cautionary Notice
Regarding Forward-Looking Statements”.
OVERVIEW
The Company was incorporated in 1990 under the laws of the State of
Delaware and became a bank holding company after
it acquired its Alabama predecessor,
which was a bank holding company established in 1984. The Bank,
the Company's
principal subsidiary, is an Alabama
state-chartered bank that is a member of the Federal Reserve System
and has operated
continuously since 1907. Both the Company and the Bank are
headquartered in Auburn, Alabama. The Bank conducts its
business primarily in East Alabama, including Lee County and
surrounding areas. The Bank operates full-service branches
in Auburn, Opelika, Notasulga and Valley,
Alabama.
The Bank also operates loan production offices
in Auburn and
Phenix City, Alabama.
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45
Summary of Results of Operations
Year ended December 31
(Dollars in thousands, except per share data)
2020
2019
Net interest income (a)
$
24,830
$
26,621
Less: tax-equivalent adjustment
492
557
Net interest income (GAAP)
24,338
26,064
Noninterest income
5,375
5,494
Total revenue
29,713
31,558
Provision for loan losses
1,100
(250)
Noninterest expense
19,554
19,697
Income tax expense
1,605
2,370
Net earnings
$
7,454
$
9,741
Basic and diluted net earnings per share
$
2.09
$
2.72
(a) Tax-equivalent.
See "Table 1 - Explanation of Non-GAAP Financial Measures".
Financial Summary
The Company’s net earnings were $7.5
million for the full year 2020, compared to $9.7 million for the full year
2019.
Basic and diluted net earnings per share were $2.09 per share
for the full year 2020, compared to $2.72 per share for the full
year 2019.
The decrease in full year 2020 net earnings was primarily driven
by the negative impact of the COVID-19
pandemic, which resulted in elevated provision for loan losses,
compared to 2019, in addition to a lower interest rate
environment.
Net interest income (tax-equivalent) was $24.8 million in 2020,
a 7% decrease compared to $26.6 million in 2019.
This
decrease was primarily due to net interest margin compression
resulting from the Federal Reserve’s
interest rate reductions
in response to COVID-19.
Net interest margin (tax-equivalent) decreased
to 2.92% in 2020, compared to 3.43% in 2019,
primarily due to the lower interest rate environment and changes
in our asset mix resulting from the significant increase in
customer deposits.
At December 31, 2020, the Company’s
allowance for loan losses was $5.6 million, or 1.22%
of total loans, compared to
$4.4 million, or 0.95% of total loans, at December 31, 2019.
Excluding Paycheck Protection Program (“PPP”) loans, the
Company’s allowance for loan
losses was 1.27% of total loans at December 31, 2020.
The Company recorded a provision
for loan losses of $1.1 million in 2020 compared to a
negative provision for loan losses of $0.3 million during 2019.
The
increase in the provision for loan losses was related to changes
in economic conditions and portfolio trends driven by the
impact of COVID-19 and resulting adverse economic conditions,
including higher unemployment in our primary market
area.
The provision for loan losses is based upon various estimates
and judgements, including the absolute level of loans,
loan growth, credit quality and the amount of net charge
-offs.
Net recoveries as a percent of average loans were 0.03% in
2020 compared to net charge-offs as a percent
of average loans of 0.03% in 2019.
Noninterest income was $5.4 million in 2020 compared to
$5.5 million in 2019.
Although total noninterest income was
largely unchanged in 2020, 2019 included a $1.7
million gain that resulted from the termination of a loan guarantee
program operated by the State of Alabama.
This decrease was partially offset by an increase
in mortgage lending income of
$1.5 million during 2020 compared to 2019, as lower interest
rates for mortgage loans increased refinancing activity and
pricing margins improved.
Noninterest expense was $19.6 million in 2020 compared to
$19.7 million in 2019.
The decrease was primarily due to a
reduction of $0.6 million in salaries and benefits expense which was offset
by an increase of $0.6 million in various
expenses related to the planned redevelopment of the Company’s
headquarters in downtown Auburn.
Income tax expense was $1.6 million in 2020 and $2.4
million in 2019 reflecting an effective tax rate of 17.72%
and
19.57%, respectively.
This change was primarily due to a decrease in the level of
earnings before taxes relative to tax-
exempt sources of income.
The Company’s effective
income tax rate is principally impacted by tax-exempt earnings
from
the Company’s investments in
municipal securities
and bank-owned life insurance.
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46
The Company paid cash dividends of $1.02 per share in 2020,
an increase of 2% from 2019. At December 31, 2020, the
Bank’s regulatory capital ratios
were well above the minimum amounts required to be “well capitalized”
under current
regulatory standards with a total risk-based capital ratio of
18.31%, a tier 1 leverage ratio of 10.32% and common equity
tier 1 (“CET1”) of 17.27% at December 31, 2020.
COVID-19 Impact Assessment
In December 2019, COVID-19 was first reported in China and
has since spread to a number of other countries, including
the United States. In March 2020, the World
Health Organization declared COVID-19 a global
pandemic and the United
States declared a National Public Health Emergency.
The COVID-19 pandemic has severely restricted the level
of
economic activity in our markets. In response to the COVID-19
pandemic, the State of Alabama, and most other states,
have taken preventative or protective actions to prevent the spread
of the virus, including imposing restrictions on travel
and business operations and a statewide mask mandate, advising or
requiring individuals to limit or forego their time
outside of their homes, limitations on gathering of people and
social distancing, and causing temporary closures of
businesses that have been deemed to be non-essential.
Though certain of these measures have been relaxed or
eliminated,
increases in reported cases could cause these measures to be
reestablished.
Auburn University, a major
source of economic
activity in Lee County, went to
remote instruction on March 16, 2020.
Auburn University announced its guidelines for the
remainder of the 2020/2021 school year,
which involves both remote and in person instruction as well as other social
distancing measures.
The economic effects of these measures are
not presently known.
COVID-19 has significantly affected local state, national
and global health and economic activity and its future effects
are
uncertain and will depend on various factors, including, among others,
the duration and scope of the pandemic, the
development and distribution of COVID-19 testing and contact
tracing, effective drug treatments and vaccines, together
with governmental, regulatory and private sector responses.
COVID-19 has had continuing significant effects on the
economy, financial markets and
our employees, customers and vendors. Our business, financial condition
and results of
operations generally rely upon the ability of our borrowers to
make deposits and repay their loans, the value of collateral
underlying our secured loans, market value, stability and liquidity and
demand for loans and other products and services we
offer, all of which are affected
by the pandemic.
See “Balance Sheet Analysis – Loans” for supplemental COVID
-19
disclosures.
We have implemented
a number of procedures in response to the pandemic to support
the safety and well-being of our
employees, customers and shareholders.
●
We believe our
business continuity plan has worked to provide essential banking
services to our communities and
customers, while protecting our employees’ health.
As part of our efforts to exercise social distancing in
accordance with the guidelines of the Centers for Disease Control
and the Governor of the State of Alabama,
starting March 23, 2020, we limited branch lobby service to appointment
only while continuing to operate our
branch drive-thru facilities and ATMs.
On June 1, 2020, we re-opened some of our branch lobbies as permitted
by
state public health guidelines.
We continue to provide
services through our online and other electronic channels.
In addition, we established remote work access to help employees
stay at home where job duties permit.
●
We are
focused on servicing the financial needs of our commercial and consumer
clients with extensions and
deferrals to loan customers effected by COVID-19,
provided such customers were not more than 30 days past
due
at the time of the request; and
●
We are
a participating lender in the PPP.
PPP loans are forgivable, in whole or in part, if the
proceeds are used for
payroll and other permitted purposes in accordance with the requirements
of the PPP.
These loans carry a fixed
rate of 1.00% and a term of two years (loans made before June 5,
2020) or five years (loans made on or after June
5, 2020), if not forgiven, in whole or in part.
Payments are deferred until either the date on which the Small
Business Administration (“SBA”) remits the amount of forgiveness
proceeds to the lender or the date that is 10
months after the last day of the covered period if the borrower
does not apply for forgiveness within that 10-month
period.
We believe these loans
and our participation in the program is good for our customers
and the
communities we serve.
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47
A summary of PPP loans extended during 2020 follows:
(Dollars in thousands)
# of SBA
Approved
Mix
$ of SBA
Approved
Mix
SBA Tier:
$2 million to $10 million
—
—
%
$
—
—
%
$350,000 to less than $2 million
23
5
14,691
40
Up to $350,000
400
95
21,784
60
Total
423
100
%
$
36,475
100
%
The Company extended $36.5 million in loans to 423 small businesses
under the PPP during 2020.
We collected
approximately $1.5 million in fees related to our PPP loans,
which are being recognized net of related costs, as a yield
adjustment over the life of the underlying PPP loans.
During 2020, we received payments and forgiveness on 158
loans
totaling
$17.5 million.
The outstanding balance for the remaining 265 loans as December
31, 2020 was approximately
$19.0 million.
On December 27, 2020, the Economic Aid to Hard-Hit Small
Businesses, Nonprofits, and Venues
Act (the “Economic Aid
Act”) was signed into law. The
Economic Aid Act provides a second $900 billion stimulus
package, including $325 billion
in additional PPP loans.
As of February 28, 2021, the Company has extended $17.4
million in loans to 169 small
businesses under the PPP provided by the Economic Aid Act.
We continue to closely
monitor this pandemic, and are working to continue our services
during the pandemic and to address
developments as those occur.
Our results of operations for the year ended December 31, 2020
,
and our financial condition
at that date reflect only the initial effects of the pandemic,
and may not be indicative of future results or financial
conditions, including possible additional monetary or fiscal stimulus,
and the possible effects of the expiration or extension
of temporary accounting and bank regulatory relief measures
in response to the COVID-19 pandemic.
As of December 31, 2020,
all of our capital ratios were in excess of all regulatory requirements to be
well capitalized.
The
effects of the COVID-19 pandemic on our borrowers
could result in adverse changes to credit quality and our regulatory
capital ratios.
We continue to closely
monitor this pandemic, and are working to continue our services during
the pandemic
and to address developments as those occur.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform
with U.S. generally accepted accounting
principles and with general practices within the banking industry.
In connection with the application of those principles, we
have made judgments and estimates which, in the case of the determination
of our allowance for loan losses, our
assessment of other-than-temporary impairment, recurring and non-recurring
fair value measurements, the valuation of
other real estate owned, and the valuation of deferred tax assets,
were critical to the determination of our financial position
and results of operations. Other policies also require subjective
judgment and assumptions and may accordingly impact our
financial position and results of operations.
Allowance for Loan Losses
The Company assesses the adequacy of its allowance for loan
losses prior to the end of each calendar quarter.
The level of
the allowance is based upon management’s
evaluation of the loan portfolio, past loan loss experience,
current asset quality
trends, known and inherent risks in the portfolio, adverse situations
that may affect a borrower’s ability to
repay (including
the timing of future payment), the estimated value of any underlying
collateral, composition of the loan portfolio, economic
conditions, industry and peer bank loan loss rates and other pertinent
factors, including regulatory recommendations. This
evaluation is inherently subjective as it requires material estimates including
the amounts and timing of future cash flows
expected to be received on impaired loans that may be susceptible
to significant change. Loans are charged off, in whole
or
in part, when management believes that the full collectability of the
loan is unlikely. A loan
may be partially charged-off
after a “confirming event” has occurred which serves to validate
that full repayment pursuant to the terms of the loan is
unlikely.
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48
The Company deems loans impaired when, based on current information
and events, it is probable that the Company will
be unable to collect all amounts due according to the contractual
terms of the loan agreement. Collection of all amounts due
according to the contractual terms means that both the interest
and principal payments of a loan will be collected as
scheduled in the loan agreement.
An impairment allowance is recognized if the fair value of the
loan is less than the recorded investment in the loan. The
impairment is recognized through the allowance. Loans that are
impaired are recorded at the present value of expected
future cash flows discounted at the loan’s
effective interest rate, or if the loan is collateral dependent,
impairment
measurement is based on the fair value of the collateral, less estimated
disposal costs.
The level of allowance maintained is believed by management to
be adequate to absorb probable losses inherent in the
portfolio at the balance sheet date. The allowance is increased
by provisions charged to expense and decreased by charge-
offs, net of recoveries of amounts previously charged
-off.
In assessing the adequacy of the allowance, the Company also
considers the results of its ongoing internal, independent
loan review process. The Company’s
loan review process assists in determining whether there are
loans in the portfolio
whose credit quality has weakened over time and evaluating the risk characteristics
of the entire loan portfolio. The
Company’s loan review process includes
the judgment of management, the input from our independent
loan reviewers, and
reviews that may have been conducted by bank regulatory agencies
as part of their examination process. The Company
incorporates loan review results in the determination of whether
or not it is probable that it will be able to collect all
amounts due according to the contractual terms of a loan.
As part of the Company’s quarterly assessment
of the allowance, management divides the loan portfolio
into five segments:
commercial and industrial, construction and land development, commercial
real estate, residential real estate, and consumer
installment loans. The Company analyzes each segment and
estimates an allowance allocation for each loan segment.
The allocation of the allowance for loan losses begins with a
process of estimating the probable losses inherent for these
types of loans. The estimates for these loans are established by category
and based on the Company’s internal
system of
credit risk ratings and historical loss data. The estimated loan loss allocation
rate for the Company’s internal system
of
credit risk grades is based on its experience with similarly graded
loans. For loan segments where the Company believes it
does not have sufficient historical loss data, the Company
may make adjustments based, in part, on loss rates of peer
bank
groups. At December 31, 2020 and 2019, and for the years then ended,
the Company adjusted its historical loss rates for the
commercial real estate portfolio segment based, in part, on loss rates of peer
bank groups.
The estimated loan loss allocation for all five loan portfolio segments
is then adjusted for management’s
estimate of
probable losses for several “qualitative and environmental” factors.
The allocation for qualitative and environmental
factors is particularly subjective and does not lend itself to exact mathematical
calculation.
This amount represents
estimated probable inherent credit losses which exist, but have not yet
been identified, as of the balance sheet date, and are
based upon quarterly trend assessments in delinquent and nonaccrual
loans, credit concentration changes, prevailing
economic conditions, changes in lending personnel experience,
changes in lending policies or procedures and other
influencing factors.
These qualitative and environmental factors are considered
for each of the five loan segments and the
allowance allocation, as determined by the processes noted
above, is increased or decreased based on the incremental
assessment of these factors.
The Company regularly re-evaluates its practices in determining the
allowance for loan losses. Since the fourth quarter of
2016, the Company has increased its look-back period each quarter
to incorporate the effects of at least one economic
downturn in its loss history. The
Company believes the extension
of its look-back period is appropriate due to the risks
inherent in the loan portfolio. Absent this extension, the early
cycle periods in which the Company experienced significant
losses would be excluded from the determination of the allowance for
loan losses and its balance would decrease. For the
year ended December 31, 2020, the Company increased its look
-back period to 47 quarters to continue to include losses
incurred by the Company beginning with the first quarter of 2009.
The Company will likely continue to increase its look-
back period to incorporate the effects of at least one
economic downturn in its loss history.
During 2020, the Company
adjusted certain qualitative and economic factors related to changes in
economic conditions driven by the impact of the
COVID-19 pandemic and resulting adverse economic conditions,
including higher unemployment in our primary market
area.
Further adjustments may be made in the future as a result of the ongoing COVID
-19 pandemic.
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49
Assessment for Other-Than-Temporary
Impairment of Securities
On a quarterly basis, management makes an assessment to determine
whether there have been events or economic
circumstances to indicate that a security on which there is an
unrealized loss is other-than-temporarily impaired.
For debt securities with an unrealized loss, an other-than
-temporary impairment write-down is triggered when (1)
the
Company has the intent to sell a debt security,
(2) it is more likely than not that the Company will be required
to sell the
debt security before recovery of its amortized cost basis, or
(3) the Company does not expect to recover the entire amortized
cost basis of the debt security.
If the Company has the intent to sell a debt security or if it is more
likely than not that it will
be required to sell the debt security before recovery,
the other-than-temporary write-down is equal to the entire
difference
between the debt security’s amortized
cost and its fair value.
If the Company does not intend to sell the security or it is not
more likely than not that it will be required to sell the security
before recovery, the other
-than-temporary impairment write-
down is separated into the amount that is credit related (credit loss component)
and the amount due to all other factors.
The
credit loss component is recognized in earnings and is the difference
between the security’s
amortized cost basis and the
present value of its expected future cash flows.
The remaining difference between the security’s
fair value and the present
value of future expected cash flows is due to factors that are not credit
related and is recognized in other comprehensive
income, net of applicable taxes.
The Company is required to own certain stock as a condition of
membership, such as Federal Home Loan Bank (“FHLB”)
and Federal Reserve Bank (“FRB”).
These non-marketable equity securities are accounted for at
cost which equals par or
redemption value.
These securities do not have a readily determinable fair value as their
ownership is restricted and there is
no market for these securities.
The Company records these non-marketable equity securities
as a component of other
assets, which are periodically evaluated for impairment. Ma
nagement considers these non-marketable equity securities to
be long-term investments. Accordingly,
when evaluating these securities for impairment, management considers
the
ultimate recoverability of the par value rather than by recognizing temporary
declines in value.
Fair Value
Determination
U.S. GAAP requires management to value and disclose certain of the
Company’s assets and liabilities
at fair value,
including investments classified as available-for-sale
and derivatives. ASC 820,
Fair Value
Measurements and Disclosures
,
which defines fair value, establishes a framework for measuring fair
value in accordance with U.S. GAAP and expands
disclosures about fair value measurements.
For more information regarding fair value measurements and disclosures,
please refer to Note 15, Fair Value,
of the consolidated financial statements that accompany this report.
Fair values are based on active market prices of identical assets or
liabilities when available.
Comparable assets or
liabilities or a composite of comparable assets in active markets are
used when identical assets or liabilities do not have
readily available active market pricing.
However, some of the Company’s
assets or liabilities lack an available or
comparable trading market characterized by frequent transactions between
willing buyers and sellers. In these cases, fair
value is estimated using pricing models that use discounted cash
flows and other pricing techniques. Pricing models and
their underlying assumptions are based upon management’s
best estimates for appropriate discount rates, default rates,
prepayments, market volatility and other factors, taking into
account current observable market data and experience.
These assumptions may have a significant effect on the reported
fair values of assets and liabilities and the related income
and expense. As such, the use of different models and
assumptions, as well as changes in market conditions, could
result in
materially different net earnings and retained earnings
results.