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,
2023 and 2022 and our results of operations for
the years ended December 31, 2023 and 2022. 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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55
Summary of Results of Operations
Year ended December 31
(Dollars in thousands, except per share data)
2023
2022
Net interest income (a)
$
26,745
$
27,622
Less: tax-equivalent adjustment
417
456
Net interest income (GAAP)
26,328
27,166
Noninterest income
(2,981)
6,506
Total revenue
23,347
33,672
Provision for credit losses
135
1,000
Noninterest expense
22,594
19,823
Income tax (benefit) expense
(777)
2,503
Net earnings
$
1,395
$
10,346
Basic and diluted net earnings per share
$
0.40
$
2.95
(a) Tax-equivalent.
See "Table 1 - Explanation of Non-GAAP Financial Measures".
Financial Summary
The Company’s net earnings were $1.4
million for the full year 2023, compared to $10.3 million for the full year 2022.
Basic and diluted net earnings per share were $0.40 per share for the full year 2023,
compared to $2.95 per share for the full
year 2022.
Net earnings for 2023 included a loss on sale of securities, while 2022 net earnings included
a gain on sale of land and a
one-time payroll tax credit provided by the CARES Act.
The after-tax impact of the loss on securities reduced 2023
net
earnings by $4.7 million, while non-routine items in 2022 improved net earnings by $3.6
million.
Excluding non-routine
items, net earnings for the full year 2023 would have been $6.1 million, or $1.75
per share, compared to $6.7 million, or
$1.92 per share for the full year 2022.
Net interest income (tax-equivalent) was $26.7 million in 2023, a
3% decrease compared to $27.6 million in 2022. This
decrease was primarily due to a decline in interest earning assets, increased cost
of funds and changes in our deposit mix,
which was partially offset by a more favorable asset mix and higher
yields on interest
earnings assets.
The Company’s net
interest margin (tax-equivalent) was 2.89% in 2023,
compared to 2.81% in 2022.
Average loans for 2023 were $523.8
million, a 15% increase from 2022.
At December 31, 2023, the Company’s allowance
for credit losses was $6.9 million, or 1.23% of total loans, compared to
$5.8 million, or 1.14% of total loans, at December 31, 2022.
The implementation of CECL required pursuant to
Accounting Standards Codification (“ASC”) 326, which was effective
January 1, 2023, increased our allowance for credit
losses by $1.0 million, or 0.20% of total loans, as a day one transition adjustment.
For the full year 2023, increases in the
allowance for credit losses due to changes in the composition and balance of loans during 2023
were largely offset by
reductions in the allowance for credit losses due to the resolution of collateral dependent
nonperforming loans.
The Company recorded a provision for credit losses of $0.1 million in 2023 compared
to $1.0 million during 2022.
The
provision for credit losses under CECL is reflective of the Company’s
credit risk profile and the future economic outlook
and forecasts. Our CECL model is largely influenced by economic
factors including, most notably,
the anticipated
unemployment rate. The decrease in provision for credit losses was primarily related
to the downgrade of one borrowing
relationship in the fourth quarter of 2022, where one of these loans was repaid in full during the
second quarter of 2023.
Noninterest income was a loss of $3.0 million in 2023 compared to
income of $6.5 million in 2022.
Excluding the pre-tax
securities loss of $6.3 million related to the balance sheet repositioning strategy in 2023,
noninterest income would have
been $3.3 million for 2023,
compared to noninterest income of $3.3 million in 2022 after excluding the pre-tax gain of $3.2
million on the sale of land.
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56
Noninterest expense was $22.6 million in 2023 compared to $19.
8
million in 2022.
Excluding the impact of the one-
time payroll tax credit of $1.6 million, noninterest expense would have been $21.4
million in 2022. This increase in
noninterest expense reflects increases in net occupancy and equipment expenses of $0.2
million related to the Company’s
new headquarters, which opened in June 2022, professional fees expense of $0.
3
million, other real estate owned expense
of $0.1 million, FDIC and other regulatory assessments expenses of $0.2
million and other noninterest expense of $0.5
million, partially offset by decreases in salaries and benefits expense of
$0.2 million.
The provision for income taxes was a benefit of $0.8 million for an effective
tax rate of (125.73)% for 2023, compared to
tax expense of $2.5 million and an effective tax rate of 19.48% for 2022.
This decrease was primarily due to a decrease
in pre-tax earnings in 2023 resulting from the balance sheet repositioning. The
Company’s effective income
tax rate
otherwise is principally affected 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 $1.08 per share in 2023, an increase of 2% from 2022.
At December 31, 2023, 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 15.52%, a
tier 1 leverage ratio of 9.72% and common equity tier
1 (“CET1”) of 14.52%
at December 31, 2023.
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 credit losses, our
determination of credit losses for investment securities, 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.
On January 1, 2023, we adopted FASB
ASU 2016-13
Financial
Instruments - Credit Losses
(Topic
326) which significantly changes our methodology for determining our allowance
for
credit losses, and ASU 2022-02
, Financial Instruments – Credit Losses (Topic
326):
Troubled
Debt Restructurings and
Vintage Disclosures
which
eliminated the accounting guidance for TDRs, while enhancing disclosure
requirements for
certain loan refinancings and restructurings by creditors when a borrower is experiencing
financial difficulty.
Allowance for Credit Losses – Loans
The allowance for credit losses is a valuation account that is deducted from the loans' amortized
cost basis to present the net
amount expected to be collected on the loans. Loans are charged
off against the allowance when management believes the
uncollectability of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts
previously
charged-off and expected to be charged-off.
Accrued interest receivable is excluded from the estimate of credit losses.
The allowance for credit losses represents management’s
estimate of lifetime credit losses inherent in loans as of the
balance sheet date. The allowance for credit losses is estimated by management using relevant
available information, from
both internal and external sources, relating to past events, current conditions, and reasonable and
supportable forecasts.
The Company’s loan loss estimation process includes
procedures to appropriately consider the unique characteristics of
its
loan segments (commercial and industrial, construction and land development, commercial
real estate, multifamily,
residential real estate, and consumer loans).
These segments are further disaggregated into loan classes, the level at which
credit quality is monitored.
See Note 5, Loans and Allowance for Credit Losses, for additional information about our
loan
portfolio.
Credit loss assumptions are estimated using a discounted cash flow ("DCF") model
for each loan segment, except consumer
loans.
The weighted average remaining life method is used to estimate credit loss assumptions
for consumer loans.
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57
The DCF model calculates an expected life-of-loan loss percentage by considering the
forecasted probability that a
borrower will default (the “PD”), adjusted for relevant forecasted macroeconomic
factors, and LGD, which is the estimate
of the amount of net loss in the event of default.
This model utilizes historical correlations between default experience and
certain macroeconomic factors as determined through a statistical regression analysis.
The forecasted Alabama
unemployment rate is considered in the model for commercial and industrial, construction
and land development,
commercial real estate, multifamily,
and residential real estate loans.
In addition, forecasted changes in the Alabama home
price index is considered in the model for construction and land development and residential
real estate loans; forecasted
changes in the national commercial real estate (“CRE”) price index is considered
in the model for commercial real estate
and multifamily loans; and forecasted changes in the Alabama gross state product
is considered in the model for
multifamily loans.
Projections of these macroeconomic factors, obtained from an independent
third party, are utilized to
forecast quarterly rates of default based on the statistical PD models.
Expected credit losses are estimated over the contractual term of the loan, adjusted
for expected prepayments and principal
payments (“curtailments”) when appropriate. Management's determination of the
contract term excludes expected
extensions, renewals, and modifications unless the extension or
renewal option is included in the contract at the reporting
date and is not unconditionally cancellable by the Company.
To the extent the lives of the
loans in the portfolio extend
beyond the period for which a reasonable and supportable forecast can be
made (which is 4 quarters for the Company), the
Company reverts, on a straight-line basis back to the historical rates over an 8 quarter reversion
period.
The weighted average remaining life method was deemed most appropriate
for the consumer loan segment because
consumer loans contain many different payment structures,
payment streams and collateral.
The weighted average
remaining life method uses an annual charge-off rate over several vintages
to estimate credit losses.
The average annual
charge-off rate is applied to the contractual term adjusted for
prepayments.
Additionally, the allowance
for credit losses calculation includes subjective adjustments for
qualitative risk factors that are
believed likely to cause estimated credit losses to differ from historical experience.
These qualitative adjustments may
increase or reduce reserve levels and include adjustments for lending management experience
and risk tolerance, loan
review and audit results, asset quality and portfolio trends, loan portfolio growth, industry concentrations,
trends in
underlying collateral, external factors and economic conditions not
already captured.
Loans that do not share risk characteristics are evaluated on an individual basis. When
management determines that
foreclosure is probable and the borrower is experiencing financial difficulty,
the expected credit losses are based on the
estimated fair value of collateral held at the reporting date, adjusted for selling costs as appropriate.
Allowance for Credit Losses – Unfunded Commitments
Financial instruments include off-balance sheet credit instruments,
such as commitments to make loans and commercial
letters of credit issued to meet customer financing needs. The Company’s
exposure to credit loss in the event of
nonperformance by the other party to the financial instrument for off-balance sheet
loan commitments is represented by the
contractual amount of those instruments. Such financial instruments are
recorded when they are funded.
The Company records an allowance for credit losses on off-balance
sheet credit exposures, unless the commitments to
extend credit are unconditionally cancelable, through a charge to provision
for credit losses in the Company’s consolidated
statements of earnings. The allowance for credit losses on off-balance sheet credit
exposures is estimated by loan segment
at each balance sheet date under the current expected credit loss model using the same
methodologies as portfolio loans,
taking into consideration the likelihood that funding will occur as well as any third-party
guarantees. The allowance for
unfunded commitments is included in other liabilities on the Company’s
consolidated balance sheets.
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58
Assessment for Allowance for Credit Losses – Available
-for-Sale Securities
For any securities classified as available-for-sale that are in an unrealized
loss position at the balance sheet date, the
Company assesses whether or not it intends to sell the security,
or more likely than not will be required to sell the security,
before recovery of its amortized cost basis.
If either of these criteria are met, the security's amortized cost basis is written
down to fair value through net income.
If neither criterion is met, the Company evaluates whether any portion
of the
decline in fair value is the result of credit deterioration.
Such evaluations consider the extent to which the amortized cost of
the security exceeds its fair value, changes in credit ratings and any other known adverse
conditions related to the specific
security.
If the evaluation indicates that a credit loss exists, an allowance for credit losses is
recorded for the amount by
which the amortized cost basis of the security exceeds the present value of cash flows expected
to be collected, limited by
the amount by which the amortized cost exceeds fair value.
Any impairment not recognized in the allowance for credit
losses is recognized in other comprehensive income.
The Company is required to own certain stock as a condition of membership, such as the
FHLB-Atlanta and Federal
Reserve Bank of Atlanta (“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. Management 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 14, Fair Value,
of the unaudited 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.
Deferred Tax
Asset Valuation
A valuation allowance is recognized for a deferred tax asset if, based on the weight of available
evidence, it is more-likely-
than-not that some portion or the entire deferred tax asset will not be realized. The ultimate
realization of deferred tax assets
is dependent upon the generation of future taxable income during the periods
in which those temporary differences become
deductible. Management considers the scheduled reversal of deferred
tax liabilities, projected future taxable income and tax
planning strategies in making this assessment. At December 31,
2023 we had total deferred tax assets of $12.5 million
included as “other assets”, including $9.7 million resulting from unrealized losses in our securities
portfolio.
Based upon
the level of taxable income over the last three years and projections for future taxable
income over the periods in which the
deferred tax assets are deductible, management believes it is more likely than
not that we will realize the benefits of these
deductible differences at December 31, 2023.
The amount of the deferred tax assets considered realizable, however,
could
be reduced if estimates of future taxable income are reduced.
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59
Average Balance
Sheet and Interest Rates
Year ended December 31
2023
2022
Average
Yield/
Average
Yield/
(Dollars in thousands)
Balance
Rate
Balance
Rate
Loans and loans held for sale
$
523,838
4.76%
$
454,604
4.45%
Securities - taxable
335,366
2.15%
364,006
1.81%
Securities - tax-exempt (a)
52,122
3.81%
61,614
3.53%
Total securities
387,488
2.37%
425,620
2.06%
Federal funds sold
5,221
4.79%
43,766
1.00%
Interest bearing bank deposits
8,593
4.92%
58,141
0.99%
Total interest-earning assets
925,140
3.76%
982,131
3.05%
Deposits:
NOW
193,451
0.99%
197,177
0.19%
Savings and money market
289,235
0.74%
327,139
0.20%
Certificates of deposits
175,085
2.25%
154,273
0.84%
Total interest-bearing deposits
657,771
1.21%
678,589
0.34%
Short-term borrowings
3,255
2.21%
4,516
1.33%
Total interest-bearing liabilities
661,026
1.22%
683,105
0.35%
Net interest income and margin (a)
$
26,745
2.89%
$
27,622
2.81%
(a) Tax-equivalent.
See "Table 1 - Explanation of Non-GAAP
Financial Measures".
RESULTS
OF OPERATIONS
Net Interest Income and Margin
Net interest income (tax-equivalent) was $26.7 million in 2023, compared
to $27.6 million in 2022.
This decrease was
primarily due to a decline in interest earning assets and higher costs of funds partially offset
by improvements in the
Company’s yield on interest earning assets.
Net interest margin (tax-equivalent) increased
to 2.89% in 2023, compared to
2.81% in 2022.
This increase was
primarily due to a more favorable asset mix and higher yields on interest earning
assets.
These higher yields on interest earning assets were partially offset by
increased cost of funds.
During 2023, the cost of
funds increased to 122 basis points, compared to 35 basis points during 2022.
Since March of 2022, the Federal Reserve
increased the target federal funds range from 0 – 0.25% to 5.25
– 5.50%.
The tax-equivalent yield on total interest-earning assets increased by 71 basis points
to 3.76% in 2023 compared to 3.05%
in 2022.
This increase was primarily due to changes in our asset mix and higher market interest
rates on interest earning
assets.
The cost of total interest-bearing liabilities increased by 87 basis points to
1.22%
in 2023 compared to 0.35% in 2022.
Our
deposit costs may continue to increase if the Federal Reserve
maintains or increases its target federal funds rate, market
interest rates increase, and as customer behaviors change as a result of inflation and higher
market interest rates, and we
compete for deposits against other banks, money market mutual funds
,
Treasury securities and other interest bearing
alternative investments.
The Company continues to deploy various asset liability management strategies
to manage its risk from interest rate
fluctuations.
Deposit and loan pricing remains competitive in our markets.
We believe this
challenging rate environment
will continue in 2024.
Our ability to compete and manage our deposits costs until our interest-earning assets reprice
and we
generate new fixed rate loans with current market interest rates will be important to our
net interest margin during the
monetary tightening cycle that we believe will continue in 2024.
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60
Provision for Credit Losses
On January 1, 2023, we adopted ASC 326, which introduces the current expected
credit losses (CECL) methodology and
requires us to estimate all expected credit losses over the remaining life of our loans.
Accordingly, the provision for credit
losses represents a charge to earnings necessary to establish an allowance
for credit losses that, in management's evaluation,
is adequate to provide coverage for all expected credit losses.
The Company recorded a provision for credit losses of $0.1
million during 2023, compared to a provision for loan losses of $1.0 million for 2022.
Provision for credit losses expense is
affected by organic loan growth in our loan portfolio,
our internal assessment of the credit quality of the loan portfolio, our
expectations about future economic conditions and net charge-offs.
Our CECL model is largely influenced by economic
factors including, most notably,
the anticipated unemployment rate, which may be affected
by monetary policy.
The
provision for credit losses during 2023 was primarily related to an increase in the calculation
of current expected credit
losses due to loan growth during 2023.
This was largely offset by the resolution of a collateral dependent
nonperforming
loan, with a recorded investment of $1.3 million and a corresponding allowance of $0.5
million, that was collected in full
during the second quarter of 2023.
Our allowance for credit losses reflects an amount we believe appropriate,