10-Q 1 k80622e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 09/30/03 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 September 30, 2003, 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: (989) 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 by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange Act). YES NO X ------------ -------------- 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 November 3, 2003 ----- ------------------------------- Common Stock 3,860,282 No Par Value INDEX

COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS

See accompanying notes 3 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)

See accompanying notes 4 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Nine Months ended September 30, 2003 and September 30, 2002 (Unaudited)

See accompanying notes 5 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See accompanying notes 6 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1-Summary of Significant Accounting Policies Basic Presentation The accompanying unaudited 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 accounting principles generally accepted in the United States of America for complete presentation of financial statements. In management's opinion, 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 September 30, 2003 and December 31, 2002 and the results of its operations for the three and nine months ending September 30, 2003 and September 30, 2002. The results for the three and nine months ended September 30, 2003 are not necessarily indicative of the results expected for the full year. Principles of Consolidation The accompanying consolidated financial statements include the accounts of Commercial National Financial Corporation (CNFC), Commercial Bank (Bank), CNFC Financial Services, Inc. and CNFC Mortgage Corporation, both wholly owned subsidiaries of the Bank. All material intercompany accounts and transactions have been eliminated in consolidation. Nature of Operations, Industry Segments and Concentrations of Credit Risk CNFC is a one-bank holding company, which conducts limited business activities. The Bank performs the majority of business activities. The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. It maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit. While CNFC's chief decision-makers monitor the revenue stream of various products and services, operations are managed and financial performance is evaluated on a corporation-wide basis. Accordingly, management considers all of the CNFC's banking operations to be aggregated into one operating segment. The principal markets for the Bank's financial services are the Michigan communities in which the Bank is located and the areas surrounding these communities. The Bank serves these markets through nine offices located in Gratiot, Isabella and Montcalm Counties in Michigan. Use of Estimates To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, 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. The allowance for loan losses and fair values of securities and other financial instruments are particularly subject to change. STOCK COMPENSATION Employee compensation expense under stock options is reported using the intrinsic value method. No stock-based compensation cost is reflected in net income as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation Expense. 7 COMMERCIAL NATIONAL FINANCIAL CORPORATION

The pro forma effects are computed using option pricing models, using the following weighted-average assumptions as of the grant date.

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 maturity of 90 days or less and U.S. Treasury demand notes. Earnings and Dividends Per Share 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 diluted effect of any additional potential common shares. Earnings and dividends per common share are restated for all stock splits and stock dividends. Comprehensive Income Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes the change in unrealized appreciation and depreciation on securities available for sale, net of tax, which is also recognized as a separate component of shareholders' equity. Reclassifications Some items in the prior year financial statements have been reclassified to conform with the current year presentation. Newly Issued But Not Yet Effective Accounting Standards New accounting standards on asset retirement obligations, restructuring activities and exit costs, operating leases, and early extinguishment of debt were issued in 2002. The new accounting standards were adopted in 2003, and did not have a material impact on Commercial's financial position or results of operations. 8 COMMERCIAL NATIONAL FINANCIAL CORPORATION Note 2 - Earnings Per Share A reconciliation of the numerators and denominators of the basic earnings per share and diluted earnings per share computations for the periods ended is presented below. Stock options representing 73,984 and 162,438 shares of common stock were not considered in computing diluted earnings per share for the three and nine month periods in 2002 and 2003 because they were antidilutive.

9 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 2: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Summary Total assets decreased from $238.2 million at December 31, 2002 to $235.0 million at September 30, 2003. Management classifies the economic environment as having weak business loan demand offset by strong residential real estate activity. The interest rate environment provides few reasonably priced investment alternatives to place excess liquidity. Since December 31, 2002 management has been attempting to reduce the excess cash and fed funds position of the Bank through a combination of measures. These include: repayment of FHLB borrowings as they mature, holding fixed rate residential mortgage loans in situations where management believes the interest rate risk is acceptable and pricing other funding sources, such as network certificate of deposits, below prevailing market rates. At September 30, 2003 cash and cash equivalents was $9.2 million less than at December 31, 2002. At September 31, 2003 FHLB advances were $2.9 million less than at December 31, 2002. Loan totals increased by $3.8 million by a decision of management to retain a portion of purchase money and refinanced residential real estate loans. This increase occurred despite the $2.0 million in year to date loan charge-offs. 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, with minimal losses. Management believes 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 provides adequate short and medium term sources of liquidity. At a minimum the Bank has the following available to meet short-term liquidity needs: $10,508,000 in available FHLB advances based on available collateral and $9,000,000 in short term federal funds 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 At September 30, 2003 CNFC has identified $3,711,000 of loans as non-performing. This compares to $6,025,000 at December 31, 2002. The $3,711,000 in non-accrual loans represents four business relationships and their related entities. All non-accrual loans are considered impaired and the allowance for loan loss allocated to these loans is $1,229,000. During the quarter, management was able to dispose of $1.5 million in other real estate owned. 10 COMMERCIAL NATIONAL FINANCIAL CORPORATION

The allowance for loan losses was 1.44% of total loans at September 30, 2003 compared to 1.24% at June 30, 2003 and 1.51% at December 31, 2002. Management systematically evaluates the adequacy of the allowance such that the balance is commensurate with the performance of the loan portfolio. For purposes of evaluating the adequacy of the allowance, the performance of the loan portfolio is divided into four classifications: non-classified, watch, substandard-not impaired, and substandard-impaired. Management has subdivided the classifications of non-classified and watch into the following categories of loans: residential, consumer and business loans. Non-classified loans are loans that are viewed as homogeneous categories. These loans are generally current and performing as agreed. Commercial establishes a reserve on these categories of non-classified loans using the last three year historical charge-off experience. Watch credits are loans that management has identified as having some change that requires additional loan officer monitoring. These loans are generally paying as agreed, however, the ability to meet debt obligations, while adequate, has deteriorated. These loans are not considered impaired within the definition of FAS 114 and 118 and are viewed as homogeneous categories. 11 COMMERCIAL NATIONAL FINANCIAL CORPORATION Substandard-impaired and substandard-not impaired loans are business loans that management reviews for impairment under FAS 114 and 118. Management reviews these loans individually for impairment using either the present value of expected cash flow or the value of collateral. Loans not considered impaired are grouped as a homogenous category. A reserve is established on this category using historical loss experience. A specific reserve is calculated for each loan identified as impaired, however, the total allowance is available for any loan. Management believes the business loan portfolio contains the highest risk of loss of principal. The residential real estate loan portfolio has experienced net recoveries during the last three calendar years of $45,000. The consumer loan portfolio has experienced net recoveries of $8,000 during the last three calendar years. Despite a slowing economy, the consumer and residential real estate portfolios continue to perform at levels consistent with prior years. However, the business portfolio has not performed as well. During the quarter, management identified additional collateral deficiency for a loan relationship previously identified as impaired. This event, incorporated into management's allowance for loan loss methodology resulted in a $431,000 provision for loan loss during the quarter. Capital Resources CNFC's capital ratios continue to exceed regulatory guidelines for a "well capitalized" institution. It is management's intent to maintain capital ratios in excess of the minimum required to be well capitalized. A summary of CNFC's capital ratios follows:

RESULTS OF OPERATIONS Summary Net income for the quarter ended September 30, 2003 was $818,000, an increase of $75,000 or 10.2% compared to the same period in 2002. The primary factors that affected the increase in net income are: a $365,000 increase in net interest income, a $271,000 increase in non-interest income caused by continued strong level of sales of residential real estate loans to the secondary market and a $250,000 gain on sale of other real estate, offset by a $157,000 increase in the provision for loan loss acknowledging weakness in the business loan portfolio, and a $290,000 increase in non-interest expense caused by the additional overhead to support new facilities. Net Interest Income The following table illustrates the effect that changes in rates and balances of interest-earning assets and interest-bearing liabilities had on tax-equivalent net interest income for the three and nine months ending September 30, 2003 and 2002. 12 COMMERCIAL NATIONAL FINANCIAL CORPORATION

The change in status of a non-accrual loan returned to accrual status resulted in $180,000 of interest income recorded during the third quarter of 2003. Had the interest not been recovered, margin would have been 4.52%, an improvement over the 4.31% margin recorded during the same period of 2002. The improvement in margin compared to the third quarter of 2002 is due to the ability to reprice deposits and other liabilities down faster than the rates have declined on earning assets. Management has also been able to invest balances in low yielding fed funds sold into higher yielding loans. Though the yield on earning assets decreased when comparing the three months ending September 30, 2003 and September 30, 2002, management believes that the yield on earning assets would have decreased further had alternatives to fed funds not been found. The factors affecting the $545,000 increase in net interest income for the nine months ending September 30, 2003 are similar to those described above for the three months ending September 30, 2003. Noninterest Income Noninterest income for the three months ending September 30, 2003 was $772,000. This represents a $271,000 or 54.1% increase over the same period in 2002. Net gain on loan sales increased $42,000 or 21.2% compared to the same period in 2002. The Bank continued to experience significant refinancing activity in the early part of the third quarter of 2003, however, recent increases in mortgage loan interest rates has significantly reduced the volume of residential real estate loans being refinanced. We anticipate the gain on loan sales during the fourth quarter will be significantly lower than the gain recorded during the third quarter. During the third quarter management was able to dispose of a foreclosed property which resulted in a $250,000 gain on sale of other real estate owned. 13 COMMERCIAL NATIONAL FINANCIAL CORPORATION The factors affecting the $601,000 increase in noninterest income for the nine months ending September 30, 2003 are similar to those described above for the three months ending September 30, 2003. Noninterest Expense Noninterest expense for the three months ending September 30, 2003 totaled $1,800,000. This represents a $290,000 or 19.6% increase over the same period in 2002. Salary and benefit expense for the three months ending September 30, 2003 totaled $962,000 compared to $860,000 for the same period in 2002, an increase of $102,000 or 11.9%. Increased staffing for the new Greenville and Mt. Pleasant offices and the creation of a business loan processing department are the primary reasons for the increase. Full time equivalent employees increased from 75 at September 30, 2002 to 82 at September 30, 2003. Occupancy and equipment increased $90,200 or 44.6% compared to the same period in 2002. Costs associated with operating the new Greenville and Mt. Pleasant offices contributed to the increase expense. Professional fees for the quarter ending September 30, 2003 increased $26,000 or 29.0% compared to the same period in 2002. Search fees paid to hire the head of our Greenville, Michigan operation contributed to the increase. The factors affecting the $694,000 increase in noninterest expense for the nine months ending September 30, 2003 are similar to those described above for the three months ending September 30, 2003. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Commercial's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. Commercial's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Also, Commercial 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 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 threat to earnings and capital. Accordingly, effective risk management that maintains IRR at prudent levels is essential to Commercial's safety and soundness. Evaluating the quantitative level of IRR exposure requires the assessment of 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. Commercial's Asset/Liability Committee ("Committee") is responsible for managing this process. Commercial derives the majority of income from the excess of interest collected over interest paid. The rates of interest earned on its assets and owed on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, Commercial is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. Commercial is also subject to repayment risk when interest rates fall. For example, mortgage loans and other financial assets may be prepaid by a debtor so that the debtor may refinance their obligations at lower rates. Prepayment of assets carrying higher rates reduces interest income and overall asset yields. Fluctuating interest rates and prepayment risk provide a challenge in managing the net interest income of the Bank. For example: the Bank may fund a 15 year fixed rate residential real estate loan with a long term amortizing Federal Home Loan Bank Advance. In a stable interest rate environment, the Bank can reasonably predict the net interest income earned. However, if rates fall significantly, the residential mortgage customer may refinance their mortgage at a lower rate. The Bank continues to pay the higher rate on the Federal Home Loan Bank advance, thus eroding net interest income. In an alternative scenario, the Bank funds the same 15 year fixed rate residential real estate loan with 1 year certificates of deposits. If rates rise at the end of one year, the Bank will pay more interest to continue to fund the residential mortgage loan with 1 year certificates of deposit. The net interest income will be lower in year two than it was in the first year of the mortgage loan. 14 COMMERCIAL NATIONAL FINANCIAL CORPORATION An additional challenge management faces in managing net interest income is the fact that what would maximize net interest income to the Bank may be in conflict with the customers request for products and services. In the current low interest rate environment, management has greater concern that interest rates will rise significantly over time rather than fall. Management would prefer to offer variable rate loan products that would reprice upward as interest rates rise. However, our loan customers are generally requesting long term fixed rate loans. On the funding side, management would like to extend the maturities of its liabilities to match the loan customers request for longer term fixed rate loans. However, our deposit customers are reluctant to commit to long term certificate of deposits. Commercial's primary tool in measuring interest rate risk is to perform a simulation analysis. This analysis forecasts the effect of various interest rate changes on the balance sheet, economic value of equity, net interest income and net income. One common scenario performed by the Committee is to "shock" the balance sheet by assuming that Commercial has just experienced an immediate and parallel shift in the yield curve up or down 200 basis points. The model, using data and assumptions determined by management, reprice assets and liabilities at new market rates. The objective of this testing is to determine how the Bank's net interest income and the economic value of equity are affected by extreme changes in interest rates. These results are recorded and compared to previous results. Management performs this calculation quarterly. The limitation to this methodology is that the interest rate curve rarely shifts 200 basis points immediate and parallel. In addition, a downward 200 basis point shift in today's interest rate environment is not likely. Management is in the process of evaluating software that would allow for comparison of alternative interest rate scenarios, and provide management with better information to assess alternative funding and investing strategies. The Table below summarizes the effect a 200 basis point immediate and parallel shift of the yield curve has on net income. Net income may decrease in both a falling and rising interest rate environment. In a falling interest rate environment, management does not have the ability to lower deposit rates 200 basis points to offset a decrease in rates on earning assets. Therefore, if rates decreased 200 basis points, margin would likely compress resulting in lower net interest income. In a rising interest rate environment, the duration of earning assets would most likely extend and money currently invested in short term liabilities would benefit from the increase in rates. It is possible that in this scenario, net interest income would also decrease. Though the interest rate risk associated with a rising interest rate environment has increased, management believes the risk is still acceptable.

15 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures--Jeffrey S. Barker, the Corporation's Principal Executive Officer, and Patrick G. Duffy, the Corporation's Principal Financial Officer, have reviewed and evaluated the effectiveness of the Corporation's disclosure controls and procedures (as defined in Rules 240.13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act)) as of a date within ninety days before the filing date of this quarterly report. Based on their evaluation, they have concluded that the Corporation's disclosure controls and procedures are effective, providing them with material information relating to the Corporation as required to be disclosed in the reports the Corporation files or submits under the Exchange Act on a timely basis. (b) Changes in internal controls--There were no significant changes in the Corporation's internal controls or in other factors that could significantly affect the Corporation's disclosure controls and procedures subsequent to the date of the evaluation, nor were there any significant deficiencies or material weaknesses in the Corporation's internal controls. Forward Looking Statements This discussion and analysis of financial condition and results of operations, and other sections of this 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 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. 16 COMMERCIAL NATIONAL FINANCIAL CORPORATION PART II. OTHER INFORMATION Item 4 Submission of Matters to a Vote of Security Holders None ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 31.1 Certification of Chief Executive Officer 31.2 Certification of Chief Financial Officer 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Report on Form 8-K Current report on Form 8-K dated July 30, 2003 filed with the Security and Exchange Commission on July 31, 2003 announcing second quarter earnings. Current report on Form 8-K dated August 22, 2003 filed with the Security and Exchange Commission on September 4, 2003 announcing third quarter dividend. 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) /s/ Jeffrey S. Barker Date: November 14, 2003 ------------------------------------------ Jeffrey S. Barker President and Chief Executive Officer Date: November 14, 2003 /s/ Patrick G. Duffy ------------------------------------------ Patrick G. Duffy Executive Vice President and Chief Financial Officer 18 10-Q EXHIBIT INDEX EXHIBIT NO. DESCRIPTION EX-31.1 Certification of Chief Executive Officer EX-31.2 Certification of Chief Financial Officer EX-32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

COMMERCIAL NATIONAL FINANCIAL CORP /MI 10-Q