CHOICEONE FINANCIAL SERVICES INC - Quarter Report: 2021 March (Form 10-Q)

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements.

ChoiceOne Financial Services, Inc.
CONSOLIDATED BALANCE SHEETS

See accompanying notes to interim consolidated financial statements. 

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

See accompanying notes to interim consolidated financial statements. 

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

See accompanying notes to interim consolidated financial statements. 

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

For the three months ended March 31

(1) The amount shown represents the number of shares issued upon exercise of options, net of shares withheld for payment of certain taxes.  

See accompanying notes to interim consolidated financial statements. 

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

See accompanying notes to interim consolidated financial statements.

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

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Explanatory Note

On July 1, 2020, ChoiceOne Financial Services, Inc. (“ChoiceOne” or the “Company”) completed the merger of Community Shores Bank Corporation ("Community Shores") with and into ChoiceOne with ChoiceOne surviving the merger. Accordingly, the reported consolidated financial condition and operating results as of and for periods ending after July 1, 2020 include the impact of the merger.

For additional details regarding the merger with Community Shores and the merger of County Bank Corp. ("County") with and into ChoiceOne, see Note 8 (Business Combination) of the Notes to the Consolidated Financial Statements included in this report.

Principles of Consolidation

The consolidated financial statements include ChoiceOne Financial Services, Inc. ("ChoiceOne"), its wholly-owned subsidiary, ChoiceOne Bank (the "Bank"), and ChoiceOne Bank’s wholly-owned subsidiaries: ChoiceOne Insurance Agencies, Inc. (the "Insurance Agency"), Lakestone Financial Services, Inc. ("Lakestone Financial"), and Community Shores Financial Services, Inc. (“Community Shores Financial”). Intercompany transactions and balances have been eliminated in consolidation. 

ChoiceOne owns all of the common securities of Community Shores Capital Trust I (the “Capital Trust”).  Under U.S. generally accepted accounting principles ("GAAP"), the Capital Trust is not consolidated because it is a variable interest entity and ChoiceOne is not the primary beneficiary. 

The accompanying unaudited consolidated financial statements and notes thereto 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, 2021 and December 31, 2020, the Consolidated Statements of Income for the three-month periods ended March 31, 2021 and March 31, 2020, the Consolidated Statements of Comprehensive Income for the three-month periods ended March 31, 2021 and March 31, 2020, the Consolidated Statements of Changes in Shareholders’ Equity for the three-month periods ended March 31, 2021 and March 31, 2020, and the Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2021 and March 31, 2020. Operating results for the three months ended March 31, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in ChoiceOne’s Annual Report on Form 10-K for the year ended December 31, 2020.

Use of Estimates

To prepare financial statements in conformity with GAAP, 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; therefore, future results could differ. These estimates and assumptions are subject to many risks and uncertainties, including changes in interest rates and other general economic, business and political conditions, including the effects of the COVID-19 pandemic, and its potential effects on the economic environment, our customers and our operations, as well as any changes to federal, state and local government laws, regulations and orders in connection with the pandemic.  Actual results may differ from those estimates.

Loans to Other Financial Institutions 

ChoiceOne Bank entered into an agreement with another financial institution to fund mortgage loans. Loans to other financial institutions are purchased participating interests in individual advances made to mortgage bankers nation-wide from an unaffiliated originating bank. The originating bank services these loans and cash flows on the individual advances (principal, interest, and fees) which are allocated pro-rata based on ownership in the participating interest, less fees paid for the servicing activity. The underlying collateral is generally made up of 1-4 family first residential mortgages owned by the mortgage banker and held for sale in the secondary market and have been underwritten using secondary market underwriting standards prior to purchasing the participating interest. Once the mortgage banker delivers the loan to the secondary market, the advance is required to be paid off, including ChoiceOne Bank’s participating interest. If the advance (in which ChoiceOne Bank has a participating interest) is outstanding over 90 days, the originating bank has the right to request the participating interest be paid off by the mortgage banker. The participating interests are subject to concentration risk to 14 different mortgage banks, with the largest creditor outstanding representing 22% of the total at March 31, 2021.

Credit risk associated with the participating interest is measured as an allowance for loan losses when necessary. Losses are charged off against the allowance when incurred and recoveries of loan charge-offs are recorded when received. At least quarterly, ChoiceOne Bank reviews the portfolios of participating interests for potential losses including any participating interest that is outstanding over 90 days (even if the advance and participating interest is current). At March 31, 2021, 12 of the 114 participating interests with principal balances totaling $2.1 million had balances outstanding over 30 days. At December 31, 2020, 26 of the 222 participating interests with principal balances totaling $6.4 million had balances outstanding over 30 days.  During the first quarter of 2021, there were no losses or charge-offs of participating interests.  Loans to other financial institutions are excluded from note 3.  As of March 31, 2021 and 2020 none of the loans to other financial institutions were classified as impaired or nonaccrual.  

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 3 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 sheets as well as its net income.

Stock Transactions

A total of 4,732 shares of common stock were issued to ChoiceOne’s Board of Directors for a cash price of $ 146,000 under the terms of the Directors’ Stock Purchase Plan in the first quarter of 2021. A total of 1,201 shares for a cash price of $ 29,000 were issued under the Employee Stock Purchase Plan in the first quarter of 2021. 

Stock-Based Compensation

ChoiceOne grants restricted stock units to a select group of employees under the Stock Incentive Plan of 2012. All of the restricted stock units are initially unvested and vest three years after the grant date. Certain additional vesting provisions apply. Each unit, once vested, is settled by delivery of one share of ChoiceOne common stock.

Reclassifications 

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

Recent Accounting Pronouncements

The Financial Accounting Standards Board ("FASB") issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This ASU provides financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date by replacing the incurred loss impairment methodology in GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The new guidance attempts to reflect an entity’s current estimate of all expected credit losses and broadens the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually to include forecasted information, as well as past events and current conditions. There is no specified method for measuring expected credit losses, and an entity may apply methods that reasonably reflect its expectations of the credit loss estimate. Although an entity may still use its current systems and methods for recording the allowance for credit losses, under the new rules, the inputs used to record the allowance for credit losses generally will need to change to appropriately reflect an estimate of all expected credit losses and the use of reasonable and supportable forecasts. Additionally, credit losses on available-for-sale debt securities will have to be presented as an allowance rather than as a write-down. This ASU is effective for fiscal years beginning after December 15, 2022, and for interim periods within those years for companies considered a smaller reporting company with the Securities and Exchange Commission. ChoiceOne was classified as a smaller reporting company as of the determination date of November 15, 2019.  Management is currently evaluating the impact of this new ASU on its consolidated financial statements which may be significant.

Goodwill

Goodwill is not amortized but is evaluated annually for impairment and on an interim basis if events or changes in circumstances indicate that goodwill might be impaired. The goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount, and an impairment charge would be recognized for any amount by which the carrying amount exceeds the reporting unit's fair value.  Accounting pronouncements allow a company to first perform a qualitative assessment for goodwill prior to a quantitative assessment (Step 1 assessment). If the results of the qualitative assessment indicate that it is more likely than not that goodwill is impaired, then a quantitative assessment must be performed. If not, there is no further assessment required. The Company acquired Valley Ridge Financial Corp. in 2006, County in 2019, and Community Shores in 2020, which resulted in the recognition of goodwill of $13.7 million, $38.9 million and $7.3 million, respectively.  

As a result of the decline in economic conditions triggered by the COVID-19 pandemic, the market valuations, including ChoiceOne’s stock price, saw a significant decline in March 2020.  These events indicated that goodwill may be impaired and resulted in management performing a qualitative goodwill impairment assessment as of the end of the first quarter of 2020. As a result of the analysis, management concluded that it was more-likely-than-not that the fair value of the reporting unit could be greater than its carrying amount.  Based on the results of its qualitative analysis, management believed that a quantitative analysis was not necessary as of March 31, 2020.

Management performed its annual qualitative assessment of goodwill as of  June 30, 2020. In evaluating whether it is more likely than not that the fair value of ChoiceOne's operations was less than the carrying amount, management assessed the relevant events and circumstances such as the ones noted in ASC 350-20-35-3c. The analysis consisted of a review of ChoiceOne’s current and expected future financial performance, the potential impact of COVID-19 on the ability of ChoiceOne’s borrowers to comply with loan terms, and the impact that reductions in both short-term and long-term interest rates have had and  may continue to have on net interest margin and mortgage sales activity. The share price and book value of ChoiceOne’s stock were also compared to the prior year. Management also compared average deal values for recent closed bank transactions to ChoiceOne transactions.  Despite ChoiceOne's market capitalization declining slightly from  December 2019 to  June 2020, ChoiceOne's financial performance remained positive. This was evidenced by the strong financial indicators, solid credit quality ratios, as well as the strong capital position of ChoiceOne. In addition, second quarter 2020 revenue reflected significant and continuing growth in ChoiceOne's residential mortgage banking business, as well as net SBA fees related to Payroll Protection Program ("PPP") loans funded during the second quarter of 2020. In assessing the totality of the events and circumstances, management determined that it was more likely than not that the fair value of the Bank’s operations, from a qualitative perspective, exceeded the carrying value as of  June 30, 2020

Due to the potential impact of COVID-19 and any long term economic fallout that might occur, ChoiceOne engaged a third-party valuation firm to perform a quantitative analysis of goodwill as of November 30, 2020 ("the valuation date"). In deriving at the fair value of the reporting unit (ChoiceOne), the third-party firm assessed general economic conditions and outlook; industry and market considerations and outlook; the impact of recent events to financial performance; the market price of ChoiceOne’s common stock and other relevant events. In addition, the valuation relied on financial projections through 2025 and growth rates prepared by management. Based on the valuation prepared, it was determined that the ChoiceOne's estimated fair value of the reporting unit at the valuation date was greater than its book value and impairment of goodwill was not required.

Despite ChoiceOne's market capitalization declining slightly from December 2020 to March 2021, ChoiceOne's financial performance remained positive. This was evidenced by the strong financial indicators, solid credit quality ratios, as well as the strong capital position of ChoiceOne. In addition, first quarter 2021 revenue reflected significant and continuing growth driven by ChoiceOne' mortgage banking business, as well as net SBA fees related to Payroll Protection Program ("PPP") loans. 

Management concurred with the conclusion derived from the quantitative goodwill analysis performed as of the valuation date and determined that there were no material changes and that no triggering events have occurred that indicated impairment from the valuation date through March 31, 2021, and as a result that it is more likely than not that there was no goodwill impairment as of March 31, 2021.

During the first three months of 2021, management recorded two adjustment period entries to goodwill related to the merger with Community Shores.  The net effect of the adjustments decreased goodwill by $560,000.  

NOTE 2 – SECURITIES

The fair value of equity securities and the related gross unrealized gains (losses) recognized in noninterest income were as follows:

The fair value of securities available for sale and the related unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

ChoiceOne reviews its securities portfolio on a quarterly basis to determine whether unrealized losses are considered to be temporary or other-than-temporary. No other-than-temporary impairment charges were recorded in the three months ended March 31, 2021 or in the same period in 2020. ChoiceOne believes that unrealized losses on securities were temporary in nature and were due to changes in interest rates and reduced market liquidity and not as a result of credit quality issues.

Presented below is a schedule of maturities of securities as of March 31, 2021, the fair value of securities as of March 31, 2021 and December 31, 2020, and the weighted average yields of securities as of March 31, 2021:

Following is information regarding unrealized gains and losses on equity securities for the three-month periods ended March 31, 2021 and 2020:

NOTE 3 – LOANS AND ALLOWANCE FOR LOAN LOSSES

Activity in the allowance for loan losses and balances in the loan portfolio were as follows:

The provision for loan losses was $250,000 in the first quarter of 2021, compared to $775,000 in the same period in the prior year. The first quarter of 2021 provision was deemed prudent due to changes in the risk profile of ChoiceOne’s loan portfolio and the economic impact on ChoiceOne's local market areas and the national economy resulting from the COVID-19 pandemic upon ChoiceOne’s borrowers and their ability to repay loans. While it is difficult to predict the impact that COVID-19 will have in future quarters, ChoiceOne estimates these losses have been incurred as of March 31, 2021, and expects increased levels of past due loans, nonperforming loans and loan losses.

The process to monitor the credit quality of ChoiceOne’s loan portfolio includes tracking (1) the risk ratings of business loans, (2) the level of classified business loans, and (3) delinquent and nonperforming consumer loans. Business loans are risk rated on a scale of 1 to 9. A description of the characteristics of the ratings follows:

Risk Rating 1 through 5 or pass: These loans are considered pass credits. They exhibit acceptable credit risk and demonstrate the ability to repay the loan from normal business operations. 

Risk rating 6 or special mention:  Loans and other credit extensions bearing this grade are considered to be inadequately protected by the current sound worth and debt service capacity of the borrower or of any pledged collateral. These obligations, even if apparently protected by collateral value, have well-defined weaknesses related to adverse financial, managerial, economic, market, or political conditions that have clearly jeopardized repayment of principal and interest as originally intended. Furthermore, there is the possibility that ChoiceOne Bank will sustain some future loss if such weaknesses are not corrected. Clear loss potential, however, does not have to exist in any individual assets classified as substandard. Loans falling into this category should have clear action plans and timelines with benchmarks to determine which direction the relationship will move.

Risk rating 7 or substandard: Loans and other credit extensions graded “7” have all the weaknesses inherent in those graded “6”, with the added characteristic that the severity of the weaknesses makes collection or liquidation in full highly questionable or improbable based upon currently existing facts, conditions, and values. Loans in this classification should be evaluated for non-accrual status. All nonaccrual commercial and Retail loans must be at a minimum graded a risk code “7”.

Risk rating 8 or doubtful: Loans and other credit extensions bearing this grade have been determined to have the extreme probability of some loss, but because of certain important and reasonably specific factors, the amount of loss cannot be determined. Such pending factors could include merger or liquidation, additional capital injection, refinancing plans, or perfection of liens on additional collateral.

Risk rating 9 or loss: Loans in this classification are considered uncollectible and cannot be justified as a viable asset of ChoiceOne Bank. This classification does not mean the loan has absolutely no recovery value, but that it is neither practical nor desirable to defer writing off this loan even though partial recovery may be obtained in the future.

Information regarding ChoiceOne Bank's credit exposure was as follows:

Corporate Credit Exposure - Credit Risk Profile By Creditworthiness Category

Consumer Credit Exposure - Credit Risk Profile Based On Payment Activity

The following table provides information on loans that were considered troubled debt restructurings ("TDRs") that were modified during the three months ended March 31, 2021. There were no new TDRs in the three months ended March 31, 2020.

The following schedule provides information on TDRs as of March 31, 2021 where the borrower was past due with respect to principal and/or interest for 30 days or more during the three months ended March 31, 2021, which loans had been modified and classified as TDRs during the year prior to the default.  There were no TDRs as of March 31, 2020 where the borrower was past due with respect to principal and/or interest for 30 days or more during the three months ended March 31, 2020, which loans had been modified and classified as TDRs during the year prior to the default.  

In  March of 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed into law. Among other things, the CARES Act provides that certain loans subject to modifications related to the COVID-19 pandemic need not be classified as TDRs.   Further, the federal banking agencies issued an “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus” on March 22, 2020, followed by a revised statement on April 7, 2020, providing in part that short-term modifications to loans made on a good faith basis to borrowers who were current as of the implementation date of the statements are not considered TDRs. As a result of the pandemic, the Company provided a modification program to borrowers that included certain concessions such as interest only payments or payment deferrals. As of March 31, 2021, the Company had granted pandemic-related modifications on approximately 17 loans totaling $1.2 million which, in reliance on the statements of federal banking agencies and the CARES Act, are not reflected as TDRs in this report. A total of 17 deferments with loan balances totaling approximately $1.2 million remained active at March 31, 2021, with all other previous deferments resuming their payments in accordance with loan terms.    

Impaired loans by loan category follow: