10-Q 1 k86704e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 06/30/04 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934 For the quarterly period ended June 30, 2004, 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 July 28, 2004 ----- ---------------------------- Common Stock No Par Value 4,081,157 -------------------------------------------------------------------------------- INDEX PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003 (Page 3) Consolidated Statements of Income and Other Comprehensive Income (unaudited) for the three and six months ended June 30, 2004 and June 30, 2003 (Page 4) Consolidated Statements of Changes in Shareholders' Equity (unaudited) for the six months ended June 30, 2004 and June 30, 2003 (Page 5) Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2004 and June 30, 2003 (Page 6) Notes to Consolidated Financial Statements (unaudited) (Page 7-9) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 10-13) Item 3. Quantitative and Qualitative Disclosures about Market Risk (Page 13-15) Item 4. Controls and Procedures (Page 15) PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (Page 16-17) SIGNATURES (Page 16)

COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 1: FINANCIAL STATEMENTS 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 STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY Six Months Ended June 30, 2004 and June 30, 2003 (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 Basis of 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 consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial condition of Commercial National Financial Corporation as of June 30, 2004 and December 31, 2003 and the results of its operations for the three and six months ending June 30, 2004 and June 30, 2003. The results for the three and six months ended June 30, 2004 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. There were no grants for the period ending June 30, 2004. 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. There were no grants for the period ending June 30, 2004.

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. 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 48,792 and 99,248 shares of common stock were not considered in computing diluted earnings per share for the three and six month periods in 2003 and 2004 because they were antidilutive. 8 COMMERCIAL NATIONAL FINANCIAL CORPORATION

9 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION Summary Total assets ended the quarter at $243.2 million compared to $239.8 million at December 31, 2003. Management classifies the economic environment as having weak business loan demand offset by an active residential real estate market. The residential real estate refinancing activity has been significantly reduced as interest rates moved higher. Loan totals increased $5.8 million as a result of growth in the residential real estate loan portfolio. The business loan portfolio has decreased $3.6 million since December 31, 2003 while the residential real estate portfolio has increased $8.9 million. During the first six months of 2003, CNFC charged-off $1,945,000 of loan balances to the allowance for loan losses compared to $104,000 during the same period in 2004. Loan quality has improved, however, CNFC continues to work with several business loan customers, representing $2.9 million in loan balances, experiencing financial difficulties. 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: $17 million in available FHLB advances based on available collateral and $9 million in short term federal funds lines of credit with correspondent banks and the Federal Reserve. In addition, CNFC has secured a $5 million line of credit with a correspondent bank. The stock of Commercial Bank secures the line of credit. The interest rate on the line of credit is equal to the prime interest rate at June 30, 2004 of 4.00%. 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 June 30, 2004 CNFC has identified $2.9 million of loans as non-performing. This compares to $825,000 at December 31, 2003. All non-accrual loans are considered impaired. The specific allowance for loan loss allocated to these loans is $335,000 at June 30, 2004 and $189,000 at December 31, 2003. The balance in repossessed assets and other real estate at June 30, 2004 represents two residential real estate properties which management believes will not result in material loss. 10 COMMERCIAL NATIONAL FINANCIAL CORPORATION

Allowance for Loan Loss Summary of Activity

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. 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 11 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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 assets identified as non-performing and/or non-accrual are considered impaired. The impaired loans are secured by real estate and supported by appraisals, however, in a weak economy the ability to ultimately collected the full amount represented by the appraisal is not certain. Management is aware of recent completed sales involving similar types of real estate and believes that there is sufficient value to limit Commercial's exposure to $335,000. However, no assurance can be given that the ultimate exposure is significantly higher than this amount. 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 June 30, 2004 was $674,000, an increase of $672,000 compared to the same period in 2003. The primary factor that affected the decrease in net income is: a $1,140,000 decrease in the provision for loan loss. 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 six months ending June 30, 2004 and 2003.

12 COMMERCIAL NATIONAL FINANCIAL CORPORATION The following table quantifies the effect on net interest income of changes in the volume of assets and liabilities and the change in yields and cost of funds for the three and six months ended June 30, 2004

In general, interest rates have trended upward during the first and second quarters of 2004, as economic data supported a strengthening economy. In the short run, this has had little effect on CNFC's margin. Margin has remained stable at 4.45% compared to 4.47% for the same period of 2003. The factors affecting the $50,000 increase in tax equivalent net interest income for the six months ending June 30, 2004 are similar to those described above for the three months ending June 30, 2004. Noninterest Income Noninterest income for the three months ending June 30, 2004 was $420,000. This represents a $16,000 or 3.7% decrease over the same period in 2003. The decrease in the net gain on loan sales of $209,000 or 80.4% compared to the same period in 2003 was the primary reason for the overall decrease. Rising interest rates eliminated the incentive for residential real estate customers to refinance existing loans. We do not anticipate a resumption of the refinancing activity. Offsetting the decrease in net gain on loan sales was a $192,000 or 1200.0% increase in other noninterest income. As rates have increased, the average life of the residential real estate mortgage loan portfolio has extended. This has resulted in an increase in the value of mortgage servicing rights. During the second quarter of 2004, CNFC recorded a recovery of $132,000 in the value of mortgage servicing rights previously expensed to a valuation allowance. The factors affecting the $263,000 decrease in noninterest income for the six months ending June 30, 2004 are similar to those described above for the three months ending June 30, 2004. Noninterest Expense Noninterest expense for the three months ending June 30, 2004 totaled $1,791,000. This represents a $91,000 or 5.4% increase over the same period in 2003. Salary and benefit expense for the three months ending June 30, 2004 totaled $989,000 compared to $930,000 for the same period in 2003, an increase of $59,000 or 6.3%. The increase represents normal merit increases in salary, and normal increases in related benefit expense. Professional fees for the quarter ending June 30, 2004 totaled $88,000 compared to $105,000 for the same period in 2003. This represents a $17,000 or 16.2% decrease. Included in the 2003 totals was $18,000 in employment search fees. The search fees for 2004 are $0. The factors affecting the $219,000 increase in noninterest expense for the six months ending June 30, 2004 are similar to those described above for the three months ending June 30, 2004. 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 13 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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. 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 certificates 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 cash flows associated with CNFC's assets and liabilities. 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 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 monthly. 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 implemented a new interest rate risk model during the first quarter of 2004. In addition to the 200 basis point immediate and parallel shift in interest rates, management performs additional projections using other interest rate environments, asset growth assumptions and funding strategies. The results listed below for December 31, 2003 were obtained using the Bank's prior model. The Table below summarizes the effect a 200 basis point immediate and parallel shift of the yield curve has on net income. In a falling interest rate environment, management does not have the ability to lower 14 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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 and potentially lower net income. In an environment where interest rates increased 200 basis points in an immediate and parallel shift in the yield curve, management projects that net income will increase during the next 12 months. The difference in June 30, 2004 projected net income compared to December 31, 2003 is primarily due to the change in the interest rate risk model used by management. Management believes that the new model more accurately predicts the repricing opportunities and cash flows comprising the balance sheet at June 30, 2004. Projected Percentage Change in Net Income

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 the end of the period covered by this Form 10-Q quarterly report. Based on their evaluation, they have concluded that the Corporation's disclosure controls and procedures were effective as of June 30, 2004. (b) Changes in internal controls-The Corporation also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter ended June 30, 2004, that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter that ended June 30, 2004. 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. 15 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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. PART II. OTHER INFORMATION ITEM 2 CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES The following table shows information relating to the repurchase of shares of Commercial National Financial Corporation common stock for the three months ended June 30, 2004:

------------ (1) A stock repurchase program was established during 1998. The board of directors of Commercial National Financial Corporation has authorized the repurchase of up to 383,340 shares. The repurchase program has no expiration date. ITEM 4 SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS Commercial National Financial Corporation held its annual meeting of shareholders on April 27, 2004. A total of 3,440,613 shares were represented in person or by proxy, or more than 84.39% of the total shares outstanding. Proposal: Shareholders elected 10 Director nominees named in the Proxy Statement.

ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: Exhibit 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). Exhibit 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 16 COMMERCIAL NATIONAL FINANCIAL CORPORATION Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. (b) Reports on Form 8-K Current report on Form 8-K dated May 27, 2004 filed with the Securities and Exchange Commission on May 27, 2004, under Item 5, announcing the 2004 second quarter dividend. Current report on Form 8-K dated May 6, 2004 filed with the Securities and Exchange Commission on May 10, 2004, under Item 9, announcing first quarter 2004 earnings. Current report on Form 8-K dated May 19, 2004 filed with the Securities and Exchange Commission on May 25, 2004, under Item 5, announcing the election of Robert S. Elmore to the board of directors of Commercial National Financial Corporation. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Commercial National Financial Corporation (Registrant) Date: July 31, 2004 /s/ Jeffrey S. Barker --------------------------------------------- Jeffrey S. Barker President and Chief Executive Officer Date: July 31, 2004 /s/ Patrick G. Duffy --------------------------------------------- Patrick G. Duffy Executive Vice President and Chief Financial Officer 17 10-Q EXHIBIT INDEX

COMMERCIAL NATIONAL FINANCIAL CORP /MI 10-Q