CHOICEONE FINANCIAL SERVICES INC - Quarter Report: 2010 March (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

Commission File Number: 000-19202

ChoiceOne Financial Services, Inc.
(Exact Name of Registrant as Specified in its Charter)

Indicate by checkmark 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 has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes                 No        

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes         No   X     

As of April 30, 2010, the Registrant had outstanding 3,270,288 shares of common stock.

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)

See accompanying notes to consolidated financial statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

See accompanying notes to consolidated financial statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See accompanying notes to consolidated financial statements.

ChoiceOne Financial Services, Inc.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
The consolidated financial statements include ChoiceOne Financial Services, Inc. (the "Registrant") and its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and the Bank's wholly-owned subsidiary ChoiceOne Insurance Agencies, Inc. Intercompany transactions and balances have been eliminated in consolidation.

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information, prevailing practices within the banking industry and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

The accompanying consolidated financial statements reflect all adjustments ordinary in nature which are, in the opinion of management, necessary for a fair presentation of the Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009, the Consolidated Statements of Income for the three-month periods ended March 31, 2010 and March 31, 2009, the Consolidated Statements of Changes in Shareholders' Equity for the three-month periods ended March 31, 2010 and March 31, 2009, and the Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2010 and March 31, 2009. Operating results for the three months ended March 31, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 2009.

Allowance for Loan Losses
The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management's evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios. See Note 2 to the interim consolidated financial statements for additional information.

Management believes the accounting estimate related to the allowance for loan losses is a "critical accounting estimate" because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on ChoiceOne's assets reported on the balance sheet as well as its net income.

Stock Transactions
A total of 1,234 shares of common stock were issued to the Registrant's Board of Directors for a cash price of $10,000 under the terms of the Directors' Stock Purchase Plan in the first quarter of 2010. A total of 2,155 shares were issued to employees for a cash price of $15,000 under the Employee Stock Purchase Plan for the quarter ended March 31, 2010.

Reclassifications
Certain amounts presented in prior periods have been reclassified to conform to the current presentation.

ChoiceOne Financial Services, Inc.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE 2 - ALLOWANCE FOR LOAN LOSSES

An analysis of changes in the allowance for loan losses follows:

Information regarding impaired loans follows:

NOTE 3 - EARNINGS PER SHARE

Earnings per share are based on the weighted average number of shares outstanding during the period. A computation of basic earnings per share and diluted earnings per share follows:

As of March 31, 2010 and 2009, there were 48,732 stock options that are considered to be anti-dilutive to earnings per share for the three-month periods ended March 31, 2010 and 2009. These stock options have been excluded from the calculation above.

NOTE 4 - FINANCIAL INSTRUMENTS

Financial instruments as of the dates indicated were as follows:

The estimated fair values approximate the carrying amounts for all assets and liabilities except those described later in this paragraph. The methodology for determining the estimated fair value for securities available for sale is described in Note 5. The estimated fair value for loans is based on the rates charged at March 31, 2010 for new loans with similar maturities, applied until the loan is assumed to reprice or be paid. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. The estimated fair values for time deposits and Federal Home Loan Bank advances are based on the rates paid at March 31, 2010 for new deposits or FHLB advances, applied until maturity. The estimated fair values for other financial instruments and off-balance sheet loan commitments are considered nominal.

NOTE 5 - FAIR VALUE MEASUREMENTS

The following tables present information about the Bank's assets and liabilities measured at fair value on a recurring basis and the valuation techniques used by the Bank to determine those fair values.

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Bank's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.

There were no liabilities measured at fair value as of March 31, 2010 or December 31, 2009. Disclosures concerning assets measured at fair value are as follows:

Assets Measured at Fair Value on a Recurring Basis
(Dollars in Thousands)

Of the Level 3 assets that were held by the Bank at March 31, 2010, the net unrealized gain for the three months ended March 31, 2010 was $2,000, which is recognized in other comprehensive income in the consolidated balance sheet. There were no sales or purchases of Level 3 securities in the first quarter of 2010.

Both observable and unobservable inputs may be used to determine the fair value of positions classified as Level 3 assets and liabilities. As a result, the unrealized gains and losses for these assets and liabilities presented in the tables above may include changes in fair value that were attributable to both observable and unobservable inputs.

Available-for-sale investment securities categorized as Level 3 assets primarily consist of bonds issued by local municipalities. The Bank estimates the fair value of these bonds based on the present value of expected future cash flows using management's best estimate of key assumptions, including forecasted interest yield and payment rates, credit quality and a discount rate commensurate with the current market and other risks involved.

The Bank also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are not normally measured at fair value, but can be subject to fair value adjustments in certain circumstances, such as impairment. Disclosures concerning assets measured at fair value on a non-recurring basis are as follows:

Assets Measured at Fair Value on a Non-recurring Basis
(Dollars in Thousands)

Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Bank estimates the fair value of the loans based on the present value of expected future cash flows using management's best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals). The changes in fair value consisted of charge-downs of impaired loans that were posted to the allowance for loan losses and write-downs of other real estate that were posted to a valuation account.

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. ("ChoiceOne" or the "Registrant") and its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and the Bank's wholly-owned subsidiary, ChoiceOne Insurance Agencies, Inc. This discussion should be read in conjunction with the consolidated financial statements and related notes.

FORWARD-LOOKING STATEMENTS

This discussion 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 the Registrant itself. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "plans," "predicts," "projects," variations of such words and similar expressions are intended to identify such forward-looking statements. Management's determination of the provision and allowance for loan losses and the fair value of investment securities involve judgments that are inherently forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions ("risk 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, implied or forecasted in such forward-looking statements. Furthermore, the Registrant undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2009; 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 laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit availability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

RESULTS OF OPERATIONS

Summary
Net income for the first quarter of 2010 was $644,000, which represented a decrease of $97,000 or13% compared to the same period in 2009. Growth in net interest income and noninterest income and a reduction in noninterest expense was offset by a higher provision for loan losses in the first quarter of 2010 compared to the same period in the prior year. Basic and diluted earnings per common share were $0.20 for the first quarter of 2010, compared to $0.23 for the same quarter in 2009. The return on average assets and return on average shareholders' equity percentages were .56% and 4.84%, respectively, for the first quarter of 2010, compared to .65% and 5.62%, respectively, for the same period in 2009.

Dividends
Cash dividends of $393,000 or $0.12 per share were declared in the first quarter of 2010, compared to $390,000 or $0.12 per share in the first quarter of 2009. The cash dividend payout percentage was 61% for the first three months of 2010, compared to 53% in the same period a year ago.

Interest Income and Expense
Tables 1 and 2 on the following pages provide information regarding interest income and expense for the three-month periods ended March 31, 2010 and 2009, respectively. Table 1 documents ChoiceOne's average balances and interest income and expense, as well as the average rates earned or paid on assets and liabilities. Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. These tables are referred to in the discussion of interest income, interest expense and net interest income.

Table 1 - Average Balances and Tax-Equivalent Interest Rates

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Table 2 - Changes in Tax-Equivalent Net Interest Income

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Net Interest Income
The presentation of net interest income on a tax-equivalent basis is not in accordance with generally accepted accounting principles ("GAAP"), but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine net interest income on a tax-equivalent basis were $192,000 and $241,000 for the three months ended March 31, 2010 and 2009, respectively. These adjustments were computed using a 34% federal income tax rate.

As shown in Tables 1 and 2, tax-equivalent net interest income increased $113,000 in the first three months of 2010 compared to the same period in 2009. The relationship between growth in average interest-earning assets and a small decrease in average interest-bearing liabilities caused net interest income to increase $550,000 in the first quarter of 2010 compared to the same quarter in the prior year. Although the net interest spread grew 13 basis points in the first quarter of 2010 compared to the first quarter in 2009, the impact of the larger interest-earning assets balance compared to interest-bearing liabilities resulted in a $437,000 decrease in net interest income.

The average balance of loans decreased $608,000 in the first quarter of 2010 compared to the same period in 2009. Average commercial and industrial and commercial real estate loans were $4.7 million higher in the first quarter of 2010 than in the same quarter of 2009. This was offset by a $5.5 million decrease in the average balance of residential real estate mortgage loans. The decrease in the average loans balance combined with a 42 basis point decrease in the average rate earned caused tax-equivalent interest income from loans to decline $342,000 in the first quarter of 2010 compared to the same period in the prior year. The average balance of total securities grew $1.8 million in the first three months of 2010 compared to the same period in 2009. Additional securities were purchased in the first quarter of 2010 due to the declining balance in loans. The growth in securities was offset by lower interest rates earned which caused interest income to decline $182,000 in the first quarter of 2010 compared to the same quarter in 2009. Interest income from other interest-earning assets was unchanged in the first quarter of 2010 as growth in average assets was offset by a 22 basis point decline in the average rate earned.

The average balance of interest-bearing demand deposits increased $21.3 million in the first three months of 2010 compared to the same period in 2009. The effect of the higher average balance, offset by a 9 basis point decline in the average rate paid, caused interest expense to increase $11,000 in the first quarter of 2010 compared to the same quarter in 2009. The average balance of savings deposits increased $3.9 million in the first quarter of 2010 compared to the same quarter in the prior year. The impact of the savings deposit growth was offset by an 8 basis point drop in the average rate paid, which caused interest expense to decrease $4,000 in the first three months of 2010 compared to the same period in 2009. The average balance of certificates of deposit was down $12.3 million in the first quarter of 2010 compared to the same period in 2009. The average balance of local certificates was $303,000 higher while the average balance of nonlocal certificates was $18.9 million lower in 2010 than in 2009. The decline in certificates of deposit plus a 105 basis point reduction in the average rate paid on certificates caused interest expense to fall $524,000 in the first quarter of 2010 compared to the same period in 2009. The average balance of advances from the Federal Home Loan Bank ("FHLB") was $11.8 million lower in the first three months of 2010 than in the same period of the prior year. The average rate paid on FHLB advances was 39 basis points higher in the first quarter of 2010 than the same quarter of 2009 due to low-rate floating rate advances comprising a smaller portion of total advances in 2010 than they did in 2009. The combination of the decline in FHLB advances and the increase in the average rate paid caused interest expense to decrease $106,000 in the first three months of 2010 compared to the same period in 2009. A small decrease in the average balance of other interest-bearing liabilities in the first quarter of 2010 compared to the first quarter of 2009 plus a 16 basis point drop in the average rate paid and caused a $14,000 decrease in interest expense.

ChoiceOne's net interest income spread was 3.93% in the first quarter of 2010, compared to 3.80% for the first quarter of 2009. The growth in the interest spread was due to a 74 basis point decrease in the average rate paid on interest-bearing liabilities in the first quarter of 2010 compared to the same quarter of 2009, which was partially offset by a drop in the average rate earned on interest-earning assets of 61 basis points. The reduction in the rate paid on liabilities was due in part to aggressive repricing of local deposits as general market interest rates fell during 2009 and the first quarter of 2010. The decline in general market interest rates over the last twelve months also impacted the rates earned on interest-earning assets as the rates earned on new assets were less than the maturing assets that they replaced.

Provision and Allowance for Loan Losses
The allowance for loan losses grew $365,000 from December 31, 2009 to March 31, 2010. The allowance growth occurred in spite of a decline in total loans of $6.1 million since the end of 2009. The provision for loan losses was $1,050,000 in the first quarter of 2010, compared to $600,000 in the same period in 2009. The allowance increase resulted from the provision for loan losses exceeding net charge-offs in the first quarter of 2010 and was believed necessary due to continued concerns over the Michigan economy. While nonperforming loans decreased in the first quarter of 2010 from $14.0 million to $13.0 million, loans whose payments were past due 30 to 89 days and still accruing interest increased from $4.6 million to $7.5 million. The allowance for loan losses was 1.48% of total loans at March 31, 2010, compared to 1.34% at December 31, 2009 and 1.27% at March 31, 2009.

Charge-offs and recoveries for respective loan categories for the three months ended March 31 were as follows:

Net charge-offs in the first quarter of 2010 were $685,000, compared to $141,000 in the first quarter of 2009. Net charge-offs on an annualized basis as a percentage of average loans were .86% in the first three months of 2010 compared to .18% for the same period in the prior year. The charge-offs in the first quarter of 2010 included $428,000 of allowance that had been specifically allocated as of December 31, 2009. Management is aware that the economic climate in Michigan will continue to affect business and personal borrowers and may cause charge-offs to remain at heightened levels in future quarters. Management has worked and intends to continue to work with delinquent borrowers in an attempt to lessen the negative impact to ChoiceOne. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur throughout 2010, the provision and allowance for loan losses will be reviewed by the Bank's management and adjusted as necessary.

Noninterest Income
Total noninterest income increased $131,000 or 10% in the first quarter of 2010 compared to the same period in 2009. A significant increase in gains on sales of securities was partially offset by lower levels of insurance and investment commissions and gains on sales of loans. Approximately $386,000 of securities gains were recognized in the first quarter of 2010 from sales of preferred stock that represented a recovery of losses recognized on money market preferred securities in the fourth quarter of 2008. The decrease in insurance and investment commissions was primarily due to lower mutual fund and annuity sales. The reduction in gains on sales of loans resulted from a lower level of refinancing activity in the first quarter of 2010 than occurred in the same quarter in 2009.

Noninterest Expense
Total noninterest expense decreased $99,000 or 3% in the first quarter of 2010 compared to the same period in 2009. Salaries and benefits expense was down $94,000 due to lower wages, commissions, and health care costs. Data processing expense grew $50,000 due to increased numbers of accounts and volume. Supplies and postage expense was $26,000 lower due to less purchases of supplies. Other noninterest expense was $36,000 lower in the first quarter of 2010 than the same quarter in 2009 due to lower levels of directors' fees, foreclosed asset expense, and loan collection expense.

Income Tax Expense
Income tax expense was $175,000 in the first quarter of 2010 compared to $136,000 for the same quarter in 2009. The effective tax rate was 21.4% for 2010 and 15.5% for 2009. The increase in the effective tax rate was caused by lower nontaxable income from municipal securities and $95,000 of nondeductible losses on sales of preferred stock in 2010 compared to 2009.

FINANCIAL CONDITION

Securities
The securities available for sale portfolio increased $4.0 million from December 31, 2009 to March 31, 2010. Various securities totaling $12.1 million were purchased in the first three months of 2010 to replace maturities, principal repayments, and calls within the securities portfolio. Approximately $4.8 million in various securities were called or matured since the end of 2009. Principal repayments on securities totaled $1.8 million in the first three months of 2010. Approximately $2.1 million of securities were sold in the first quarter of 2010 for a net gain of $389,000.

A book gain of $386,000 and a tax loss of $95,000 were recognized from the sale of preferred stock in the first quarter of 2010. The difference was caused by losses recorded for book purposes but not tax purposes in the fourth quarter of 2008 when preferred stock was received from the unwinding of money market preferred securities.

Loans
The loan portfolio (excluding loans held for sale) declined $6.1 million from December 31, 2009 to March 31, 2010. Loan demand in the first quarter of 2010 has been sluggish due to the lackluster Michigan economy and reduced real estate values. Balances in all but commercial and industrial loans were reduced since the end of 2009, with a decrease of $2.7 million in commercial real estate loans and $1.9 million in agricultural loans contributing most of the decline.

Information regarding impaired loans can be found in Note 2 to the consolidated financial statements included in this report. The total balance of loans classified as impaired decreased from $9.7 million as of December 31, 2009 to $8.9 million as of March 31, 2010. The decrease in the first quarter of 2010 resulted from payments received on loans and charge-offs of loans, which was partially offset by loans moved to impaired status. The balance of loans with no allowance allocated decreased $117,000 in the first quarter of 2010 while the balance of loans with an allowance allocated decreased $727,000 in the same quarter. The decrease in impaired loans was due to payments received and charge-offs of loan balances in the first quarter.

As part of its review of the loan portfolio, management also monitors the various nonperforming loans. Nonperforming loans are comprised of: (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or loans past due 90 days or more, which are considered troubled debt restructurings.

The balances of these nonperforming loans were as follows:

At March 31, 2010, nonaccrual loans included $5.9 million in commercial industrial and commercial real estate loans and $4.3 million in residential real estate loans. At December 31, 2009, nonaccrual loans included $7.8 million in commercial industrial and commercial real estate loans and $4.1 million in residential real estate loans. The decrease in nonaccrual loans was due to payments received and charge-offs of loan balances in the first quarter. The increase in loans considered troubled debt restructurings was caused by additional commercial loans and residential mortgage loans that had their terms modified. Management believes the specific reserves allocated to its nonperforming loans are sufficient at March 31, 2010; however, management believes future credit deterioration is possible given the status of the Michigan economy.