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,
2022 and 2021 and our results of operations for
the years ended December 31, 2022 and 2021. 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 a loan production office in Phenix
City,
Alabama.
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51
Summary of Results of Operations
Year ended December 31
(Dollars in thousands, except per share data)
2022
2021
Net interest income (a)
$
27,622
$
24,460
Less: tax-equivalent adjustment
456
470
Net interest income (GAAP)
27,166
23,990
Noninterest income
6,506
4,288
Total revenue
33,672
28,278
Provision for loan losses
1,000
(600)
Noninterest expense
19,823
19,433
Income tax expense
2,503
1,406
Net earnings
$
10,346
$
8,039
Basic and diluted net earnings per share
$
2.95
$
2.27
(a) Tax-equivalent.
See "Table 1 - Explanation of Non-GAAP Financial Measures".
Financial Summary
The Company’s net earnings were $10.3
million for the full year 2022, compared to $8.0 million for the full year 2021.
Basic and diluted net earnings per share were $2.95 per share for the full year 2022,
compared to $2.27 per share for the full
year 2021.
Net interest income (tax-equivalent) was $27.6 million in 2022, a
13% increase compared to $24.5 million in 2021. This
increase was primarily due to improvements in the Company’s
net interest margin.
The Company’s net interest margin
(tax-equivalent) was 2.81% in 2022, compared to 2.55% in 2021.
This increase was primarily due to changes in our asset
mix and higher market interest rates on interest earning assets,
while our cost of funds decreased 4 basis points to 0.35%.
At December 31, 2022, the Company’s allowance
for loan losses was $5.8 million, or 1.14% of total loans, compared to
$4.9 million, or 1.08% of total loans, at December 31, 2021.
At December 31, 2022, the Company’s recorded
investment
in loans considered impaired was $2.6 million with a corresponding valuation allowance
(included in the allowance for loan
losses) of $0.5 million, compared to a recorded investment in loans considered impaired
of $0.2 million with no
corresponding valuation allowance at December 31, 2021.
The Company recorded a charge to provision for loan losses of
$1.0 million in 2022 compared to a negative provision for loan losses of $0.6
million during 2021.
The provision for loan
losses in 2022 was primarily related to loan growth and the downgrade of one borrowing
relationship.
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 charge-offs as a percent of average loans were 0.04%
in 2022 compared to
0.02% in 2021.
Noninterest income was $6.5 million in 2022 compared to $4.3
million in 2021.
The increase was primarily related to a
$3.2 million gain on the sale of land adjacent to the Company’s
headquarters.
Excluding the impact of this gain,
noninterest income was $3.3 million in 2022, a 24% decrease compared to 2021.
This decrease in noninterest income was
primarily due to a decrease in mortgage lending income
of $0.9 million as refinance activity slowed in our primary market
area related to higher market interest rates.
Noninterest expense was $19.8
million in 2022 compared to $19.4
million in 2021. Noninterest expense included a $1.6
million employee retention credit recognized in 2022.
Excluding the impact of this payroll tax credit, noninterest expense
was $21.4 million in 2022, a 10% increase compared to 2021.
The increase in noninterest expense was primarily due to
increases in net occupancy and equipment expense of $1.0 million related to the Company’s
new headquarters, which
opened in June 2022,
an increase in salaries and benefits expense of $0.6 million, and increases in other noninterest expense
of $0.4
million.
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52
Income tax expense was $2.5 million in 2022,
compared to $1.4 million in 2021.
The Company’s effective tax
rate for
2022 was 19.48%, compared to 14.89% in 2021.
This increase in tax expense was primarily due to increased pre-tax
earnings in 2022 and additional income tax expense of $0.2 million related to the Company’s
decision to surrender certain
bank-owned life insurance contracts in 2022.
The Company’s effective income
tax rate is principally impacted by tax-
exempt earnings from the Company’s investments
in municipal securities, bank-owned life insurance, and New Markets
Tax Credits.
The Company paid cash dividends of $1.06 per share in 2022, an increase of 2% from 2021.
At December 31, 2022, 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 16.25
%, a tier 1 leverage ratio of 10.01% and common equity
tier 1 (“CET1”) of 15.39%
at December 31, 2022.
COVID-19 Impact Assessment
The COVID-19 pandemic has occurred in waves of different
variants since the first quarter of 2020. Vaccines
to protect
against and/or reduce the severity of COVID-19 were widely introduced at the beginning
of 2021. At times, the pandemic
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, especially as vaccination levels increased, such
measures could be reestablished in cases of new
waves, especially a wave of a COVID-19 variant that is more resistant
to existing vaccines,
booster vaccines and newly
developed treatments.
COVID-19 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, especially
new variants of the virus, effective vaccines and drug treatments, 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.
We believe that the
direct economic effects of COVID-19 are diminishing, but that indirect effects
from the
pandemic and government economic and monetary stimuli to counter the pandemic,
continue.
These indirect effects
include a tight labor market, supply chain disruptions, consumer demand and the economic
effects of these stimulative
government fiscal and monetary policies in response to COVID-19 beginning in early
2020, which have led to inflation and
to the Federal Reserve tightening its monetary policies to fight inflation beginning March
2022.
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.
As permitted by state public health guidelines, on June 1, 2020, we re-
opened some of our branch lobbies. In 2021, we opened our remaining branch lobbies. We
continue to provide
services through our online and other electronic channels. In addition,
we maintain remote work access to help
employees stay at home while providing continuity of service during outbreaks of
COVID-19 variants.
Bank
employees, generally, are
working full time in the office although we have provided scheduling
flexibility to our
employees.
●
We serviced 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
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53
●
We
were an active PPP lender and made an aggregate of 677 PPP loans totaling approximately $56.7
million.
PPP
loans were 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 helped our customers and the communities
we serve.
As of December 31, 2022, we
had only one outstanding PPP loan since all but one such loan had been forgiven by the
SBA.
COVID-19 has also had various economic effects, generally.
These include supply chain disruptions and manufacturing
delays, shortages of certain goods and services, reduced consumer expenditure on
hospitality and travel, and migration from
larger urban centers to less populated areas and remote work. The
demand for single family housing has exceeded existing
supplies. When coupled with construction delays attributable to supply chain disruptions
and worker shortages, these
factors have caused housing prices and apartment rents to increase, generally.
Stimulative monetary and fiscal policies,
along with shortages of certain goods and services, and rising petroleum and food
prices, reflecting, among other things, the
war in the Ukraine, have led to the highest inflation in decades.
The Federal Reserve has begun rapidly increasing its target
federal funds rate from 0 – 0.25% at the beginning of March 2022 to 4.25 – 4.50%
at December 31, 2022, and 4.50 – 4.75%
at January 31, 2023.
The Federal Reserve also has been reducing its holdings of securities in its SOMA account
to reduce
market liquidity and counteract inflation.
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
%
We collected
approximately $1.5 million in fees from the SBA related to our PPP loans during 2020. Through
December
31, 2021, we had recognized all of these fees, net of related costs. As of December 31,
2021, we had received payments and
forgiveness on all PPP loans extended in 2020.
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 provided a second $900 billion stimulus package, including
$325 billion
in additional PPP loans. The Economic Aid Act also permits the collection of
a higher amount of PPP loan fees by
participating banks.
A summary of PPP loans extended during 2021 under the Economic Aid Act
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
12
5
6,494
32
Up to $350,000
242
95
13,757
68
Total
254
100
%
$
20,251
100
%
We collected
approximately $1.0 million in fees from the SBA related to PPP loans under the Economic
Aid Act. Through
December 31, 2022, we have recognized all of these fees, net of related costs.
As of December 31, 2022, we have received
payments and forgiveness on all but one PPP loan, in the amount of $0.1
million, under the Economic Aid Act.
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54
We believe that the COVID-19
pandemic stimuli and decreased economic activity increased customer liquidity and
tier
deposits at the Bank and decreased loan demand, while monetary stimulus reduced
interest rates and our costs of funds and
our interest earnings on loans.
As a result, our net interest margin was adversely affected.
A return to higher interest rates
appears underway, beginning in
March 2022, and has accelerated in recent months as a result of Federal Reserve efforts
to
curb inflation.
This has resulted in improved net interest margin, but at the same time
has reduced the market values of our
securities portfolio and resulted in unrealized securities losses.
As a result, we have had losses in our other comprehensive
income and our equity under generally accepted accounting principles has declined.
This has not adversely affected our
regulatory capital, however.
We continue to closely
monitor the pandemic’s effects,
and are working to continue our services and to address
developments as those occur. Our results of operations
for the year ended December 31, 2022, and our financial condition
at that date, which reflect only the continuing direct and indirect effects of the
pandemic, may not be indicative of future
results or financial conditions, including possible changes in 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, 2022,
all of our capital ratios were in excess of all regulatory requirements to be well capitalized.
Inflation and the shift from stimulative monetary policy in response to the COVID-19
pandemic to tightening monetary
policy beginning in March 2022 to fight inflation could result in adverse changes to
credit quality and our regulatory capital
ratios, and inflation will affect our costs, interest rates and the values of our assets and
liabilities, changes in customer
savings and payment behaviors and economic activity.
Continuing supply chain disruptions and tight labor markets also
adversely affect the levels and costs of economic activities.
We continue to closely
monitor these continuing effects of the
pandemic, and are working to anticipate and
address developments.
The CARES Act and the 2020 Consolidated Appropriations Act provide eligible
employers an employee retention credit
related to COVID-19.
After consultation with our tax advisors, we filed amended payroll tax returns
with the IRS, and
received an employee retention credit of approximately $1.6 million.
The direct health issues related to COVID-19 appear to be waning as a result of vaccinations,
new medications and
increased resistance to the virus as a result of prior infections, although new strains continue
to appear.
The economic
effects of the pandemic and government fiscal and monetary policy responses,
supply chain disruptions and inflation
continue, however.
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, changes in, and expectations regarding, market interest rates and inflation,
industry and peer bank loan loss rates
and other pertinent factors. 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.
In addition, our regulators, as an integral part of their examination process,
will periodically review the Company’s loans and
allowance for loan losses, and may require the Company to make
additional provisions to the allowance for loan losses based on their judgment about information available
to them at the
time of their examinations.
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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 the allowance for loan losses maintained is believed by
management, based on its processes and estimates, 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 and by
releases from the allowance when determined to be appropriate to the levels of loans and probable
loan losses in such loans.
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, 2022 and 2021, 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, 2022, the Company increased its look-back period to
55 quarters to continue to include losses
incurred by the Company beginning with the first quarter of 2009.
During 2021, the Company adjusted certain qualitative
and economic factors to reflect improvements in economic conditions in our primary
market area that had previously been
observed as a result of the COVID-19 pandemic.
No changes were made to qualitative and economic factors during 2022.
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56
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