MIDDLEFIELD BANC CORP - Quarter Report: 2005 March (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended March 31, 2005

For the transition period from                      to

Commission File Number 33-23094

Middlefield Banc Corp.

15985 East High Street, Middlefield, Ohio 44062-9263
(Address of principal executive offices)

(440) 632-1666
(Registrant’s telephone number, including area code)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or 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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12-b2
of the Act). Yes o No x

State the number of shares outstanding of each of the issuer’s classes of common equity as of the latest practicable date:

Class: Common Stock, without par value
Outstanding at May 10, 2005: 1,360,270

MIDDLEFIELD BANC CORP.
INDEX

MIDDLEFIELD BANC CORP.
CONSOLIDATED BALANCE SHEET
(Unaudited)

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF INCOME
(Unaudited)

     See accompanying unaudited notes to the consolidated financial statements.

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
(Unaudited)

     See accompanying unaudited notes to the consolidated financial statements.

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)

     See accompanying notes to unaudited consolidated financial statements.

MIDDLEFIELD BANC CORP.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — BASIS OF PRESENTATION

The consolidated financial statements of Middlefield Banc Corp. (“Middlefield”) includes its wholly owned subsidiary, The Middlefield Banking Company (the “Bank”). All significant inter-company items have been eliminated.

The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the instructions for Form 10-Q and Article 10 of Regulation S-X. In Management’s opinion, the financial statements include all adjustments, consisting of normal recurring adjustments, that Middlefield considers necessary to fairly state Middlefield’s financial position and the results of operations and cash flows. The balance sheet at December 31, 2004, has been derived from the audited financial statements at that date but does not include all of the necessary informational disclosures and footnotes as required by U. S. generally accepted accounting principles. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included with Middlefield’s Form 10-K (File No. 33-23094). The results of Middlefield’s operations for any interim period are not necessarily indicative of the results of Middlefield’s operations for any other interim period or for a full fiscal year.

NOTE 2 – STOCK-BASED COMPENSATION

The Company maintains a stock option plan for key officers, employees, and non-employee directors. Had compensation expense for the stock option plans been recognized in accordance with the fair value accounting provisions of FAS No. 123, Accounting for Stock-Based Compensation, net income applicable to common stock, basic, and diluted net income per common share would have been as follows:

NOTE 3 — EARNINGS PER SHARE

Middlefield provides dual presentation of Basic and Diluted earnings per share. Basic earnings per share utilizes net income as reported as the numerator and the actual average shares outstanding as the denominator. Diluted earnings per share includes any dilutive effects of options, warrants, and convertible securities.

There are no convertible securities that would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income (Unaudited) will be used as the numerator. The following tables set forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation.

NOTE 4 – COMPREHENSIVE INCOME

The components of comprehensive income consist exclusively of unrealized gains and losses on available for sale securities. For the three months ended March 31, 2005, this activity is shown under the heading Comprehensive Income as presented in the Consolidated Statement of Changes in Stockholders’ Equity (Unaudited). For the three months ended March 31, 2004, comprehensive income totaled $978,002.

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

The following discussion and analysis provides further detail to the financial condition and results of operations of the Company. The MD&A should be read in conjunction with the notes and financial statements presented in this report.

CHANGES IN FINANCIAL CONDITION

General. The Company’s total assets increased by $7.3 million or 2.5% from December 31, 2004 to $298.6 million at March 31, 2005. Cash and cash equivalents, loans receivable, accrued interest and other assets, and bank owned life insurance increased $3.7 million, $2.8 million, $611,000 and $50,000, respectively. The increase in total assets reflects a corresponding increase in total liabilities of $7.1 million or 2.67% and an increase in stockholders’ equity of $236,000 or .9%. The increase in total liabilities was primarily the result of an increases in deposits of $9.6 million, partially offset by decreases to short-term borrowing, other borrowing and accrued interest and other liabilities of $618,000, $1.7 million, and $101,000, respectively. The increase in stockholders’ equity was the result of increases in additional paid in capital and retained earnings of $195,000 and $436,000, respectively, as well as a increases in comprehensive loss of $395,000.

Cash on hand, due from banks and Federal funds sold. Cash on hand, due from banks and federal funds sold represent cash equivalents. Cash equivalents increased a combined $3.7 million or 70.6% to $9.1 million at March 31, 2005 from $5.3 million at December 31, 2004. Deposits from customers into savings and checking accounts, loan and security repayments and proceeds from borrowed funds typically increase these accounts. Decreases result from customer withdrawals, new loan originations, security purchases and repayments of borrowed funds. The increase for the quarter ended March 31, 2005 can principally be attributed to increases in deposits.

Securities. The Company’s securities portfolio increased by $185,000 or 0.3% to $57.6 million at March 31, 2005 from $57.4 million at December 31, 2004. During the quarter ended March 31, 2005 the Company recorded purchases of available for sale securities of $2.9 million, consisting of purchases of government agencies and municipal bonds. Offsetting the purchases of securities were repayments and maturities of securities of $2.0 million during the three months ended March 31, 2005. In addition, the securities portfolio decreased approximately $600,000

due to decreases in the market value. These fair value adjustments represent temporary fluctuations resulting from changes in market rates in relation to average yields in the available for sale portfolio. If securities are held to their respective maturity dates, no fair value gain or loss is realized.

Loans receivable. The loans receivable category consists primarily of single family mortgage loans used to purchase or refinance personal residences located within the Company’s market area and commercial real estate loans used to finance properties that are used in the borrowers businesses or to finance investor-owned rental properties, and to a lesser extent commercial and consumer loans. Net loans receivable increased $2.8 million or 1.3% to $215.8 million at March 31, 2005 from $213 million at December 31, 2004. Included in this increase were increases in commercial loans of $5.6 million or 9.5% and home equity loans of $1.2 million or 5.8%, as well as decreases in mortgage loans of $4.4 million during the three months ended March 31, 2005. The reduction to the loan repayments between the periods is a reflection of the recent retraction of interest rates from the 50-year lows experienced in 2004.

Non-performing loans. Non-performing loans included non-accrual loans, renegotiated loans, loans 90 days or more past due, other real estate loans, and repossessed assets. A loan is classified as non-accrual when, in the opinion of management, there are serious doubts about collectibility of interest and principal. At the time the accrual of interest is discontinued, future income is recognized only when cash is received. Renegotiated loans are those loans which terms have been renegotiated to provide a reduction or deferral of principal or interest as a result of the deterioration of the borrower. Non-performing loans amounted to $2.1 million or 0.96% and $1.5 million or 0.68% of total loans at March 31, 2005 and December 31, 2004, respectively. The increase for the quarter was due in part to a loan secured by commercial real estate with minimal loss anticipated

Deposits. The Company considers various sources when evaluating funding needs, including but not limited to deposits, which are a significant source of funds totaling $249.4 million or 91.5% of the Company’s total funding sources at March 31, 2005. Total deposits increased $9.6 million or 4.0% to $249.4 million at March 31, 2005 from $239.9 million at December 31, 2004. The increase in deposits is primarily related to the growth of certificates of deposits that totaled $113.3 million at March 31, 2005 an increase of $9.5 million or 9.2% for the year. Money Market accounts increased $1.4 million, or 9.1%, while noninterest-bearing demand deposit accounts and saving deposits decreased $729,000, or 2.0%, and $741,000, or .98, respectively, during the three months ended March 31, 2005.

Borrowed funds. The Company utilizes short and long-term borrowings as another source of funding used for asset growth and liquidity needs. These borrowings primarily include FHLB advances and repurchase agreements. Borrowed funds decreased $2.3 million or 9.2% to $23.2 million at March 31, 2005 from $25.6 million at December 31, 2004. FHLB advances decreased $1.7 million or 7.3% while short-term borrowings decreased $618,000 or 33.0%. The decrease in FHLB advances is a result of the increase in the Company’s deposits.

Stockholders’ equity. Stockholders’ equity increased $236,000 or .9% to $25.1 million at March 31, 2005 from $24.8 million at December 31, 2004. The increase in stockholders’ equity was the result of increases in additional paid in capital and retained earnings of $195,000 and $436,000, respectively, as well as, an increase in accumulated other comprehensive loss of $395,000. The increase of accumulated other comprehensive loss was the result of a decrease in the mark to market of the Company’s securities available for sale portfolio.

RESULTS OF OPERATIONS

General. The Company recorded net income of $714,000 for the three months ended March 31, 2005, as compared to net income of $685,000 for the same period in the prior year. The $29,000 or 4.2% increase in net income for the three months ended March 31, 2005, as compared to the three months ended March 31, 2004, was primarily attributable to an increase in net interest income and non-interest income of $152,000 and $84,000, respectively, and a decrease in provisions for income taxes of $54,000. These items were partially offset by increases in non-interest expense of $232,000 and a net change in the provision for loan losses of $30,000.

Net interest income. Net interest income, the primary source of revenue growth for the Company, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Net interest income comprises 62.4% of total revenues for the three months ended March 31, 2005. The level of interest rates and changes in the amount and composition of interest earning assets and liabilities affect the Company’s net interest income. Net interest income increased $152,000 or 6.3% to $2.6 million for the three months ended March 31, 2005, compared to $2.4 million for the same period in the prior year. This increase in net interest income can be attributed to an increase in interest income of $317,000 partially offset by an increase in interest expense 165,000. The net interest margin declined during the first quarter of 2005 due to an increase in interest rates from their recent lows. This change in interest rates resulted in a growth in the cost of funds of 5 basis points to 2.67% for the quarter ended March 31, 2005, compared to 2.62% for the same period in the prior year. This increase in the cost of funds negatively impacted net interest income along with the decline in the yield on interest earning assets of 9 basis points to 6.16% for the quarter ended March 31, 2005, compared to 6.25% for the same period in the prior year.

Interest income. Interest income increased $317,000 or 8.3% to $4.1 million for the three months ended March 31, 2005, compared to $3.8 million for the same period in the prior year. This increase can be attributed to increases in interest earned on loans receivable, securities, and federal funds sold of $245,000, $64,000 and $4,000 respectively.

Interest earned on loans receivable increased $245,000 or 7.4% to $3.5 million for the quarter ended March 31, 2005, compared to $3.3 million for the same period in the prior year. This increase was primarily attributable to a increase in the average balance of loans receivable of $21.2 million or 10.8% to $216.9 million for the three months ended March 31, 2005, as compared to $195.7 million for the same period in the prior year.

Interest earned on securities increased $64,000 or 13.3% to $547,000 for the three months ended March 31, 2005, compared to $483,000 for the same period in the prior year. This increase in earnings was a direct result of an increase in the average balance by $6.4 million to $57.5 million for the three months ended March 31, 2005 as compared to $51.1 million for the same period in the prior year.

Interest expense. Interest expense increased $165,000 or 11.9% to $1.6 million for the three months ended March 31, 2005, compared to $1.4 million for the same period in the prior year. This increase in interest expense can be primarily attributed to increases in interest incurred on deposits and borrowed funds of $107,000 and $57,000 million, respectively.

Interest incurred on deposits increased $107,000 or 9.1% to $1.3 million for the three months ended March 31, 2005, compared to $1.2 million for the same period in the prior year. This increase was primarily attributable to an increase in the average balance of deposits of $15.5 million to $207.9 million for the three months ended March 31, 2005 from $192.4 million for the same period in the prior year.

Interest incurred on borrowed funds increased $57,000 or 29.3% to $252,000 for the three months ended March 31, 2005, compared to $195,000 million for the same period in the prior year. This increase was primarily attributable to an increase in the average balance of borrowed funds of $6.2 million or 33.4% to $249,000 for the three months ended March 31, 2005, compared to $195,000 for the same period in the prior year.

Provision for loan losses. The provision for loan losses for the quarter ended March 31, 2005 is the result of normal operations for the quarter. In determining the appropriate level of allowance for loan losses, management considers historical loss experience, the financial condition of borrowers, economic conditions (particularly as they relate to markets where the Company originates loans), the status of non-performing assets, the estimated underlying value of the collateral and other factors related to the collectability of the loan portfolio. The Company’s total allowance for losses on loans at March 31, 2005 and December 31, 2004 amounted to $2.7 million or 1.23% and $2.6 million or 1.22%, respectively, of the Company’s total loan portfolio. The Company’s allowance for losses on loans as a percentage of non-performing loans was 127.7% and 334.4% at March 31, 2005 and December 31, 2004, respectively.

Non-interest income. Non-interest income increased $84,000 or 21.3% to $481,000 for the three months ended March 31, 2005, compared to $397,000 for the same period in the prior year. This increase can be attributed primarily to increases in fees and service charges and other income of $72,000 and $29,000, respectively. Partially offsetting these increases was a decrease to earnings on bank-owned life insurance (BOLI) of $17,000.

Fees and service charges increased $72,000 or 25.6% to $353,000 for the three months ended March 31, 2005, compared to $281,000 for the same period in the prior year. The increase to fees generated from checking accounts is a result of the Company introducing a new overdraft service in the second quarter of 2004. Partially offsetting the increases was a decline in earnings from BOLI due to the lower fixed rates for the period.

Non-interest expense. Non-interest expense increased $232,000 or 13.0% to $2.0 million for the three months ended March 31, 2005, from $1.8 million for the same period in the prior year. This increase was the result of increases in compensation and employee benefits, equipment expense and data processing of $96,000, $14,000 and $20,000, respectively. The increase to compensation and employee benefits is primarily related to increases in health care costs and retirement plans as well as normal salary increases between the periods. The change in equipment cost was due to the added depreciation on new check and document imaging equipment purchase in the 4^th quarter of 2004.

Provision for income taxes. The Company recognized $262,000 in income tax expense, which reflected an effective tax rate of 26.8% for the three months, ended March 31, 2005, as compared to $316,000 with an effective tax rate of 31.6% for the respective 2004 period.

CRITICAL ACCOUNTING ESTIMATES

The Company’s critical accounting estimates involving the more significant judgments and assumptions used in the preparation of the consolidated financial statements as of March 31, 2005, have remained unchanged from December 31, 2004.

Average Balance Sheet and Yield/Rate Analysis. The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average

interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include non-accrual loans and exclude the allowance for loan losses, and interest income includes accretion of net deferred loan fees. Interest and yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax equivalent basis utilizing a federal tax rate of 34%. Yields and rates have been calculated on an annualized basis utilizing monthly interest amounts.

Analysis of Changes in Net Interest Income. The following table analyzes the changes in interest income and interest expense, between the quarters ended March 31, 2005 and 2004, in terms of: (1) changes in volume of interest-earning assets and interest-bearing liabilities and (2) changes in yields and rates. The table reflects the extent to which changes in the Company’s interest income and interest expense are attributable to changes in rate (change in rate multiplied by prior period volume), changes in volume (changes in volume multiplied by prior period rate) and changes attributable to the combined impact of volume/rate (change in rate multiplied by change in volume). The changes attributable to the combined impact of volume/rate are allocated on a consistent basis between the volume and rate variances. Changes in interest income on securities reflects the changes in interest income on a fully tax equivalent basis.

LIQUIDITY

Management’s objective in managing liquidity is maintaining the ability to continue meeting the cash flow needs of its customers, such as borrowings or deposit withdrawals, as well as its own financial commitments. The principal sources of liquidity are net income, loan payments, maturing and principal reductions on securities and sales of securities available for sale, federal funds sold and cash and deposits with banks. Along with its liquid assets, the Company has additional sources of liquidity available to ensure that adequate funds are available as needed. These include, but are not limited to, the purchase of federal funds, and the ability to borrow funds under line of credit agreements with correspondent banks and a borrowing agreement with the Federal Home Loan Bank of Cincinnati, Ohio and the adjustment of interest rates to obtain depositors. Management feels that it has the capital adequacy, profitability and reputation to meet the current and projected needs of its customers.

For the three months ended March 31, 2005, the adjustments to reconcile net income to net cash from operating activities consisted mainly of depreciation and amortization of premises and equipment, the provision for loan losses, net amortization of securities and net changes in other assets and liabilities. Cash and cash equivalents increased as a result of the purchasing of government agency securities. For a more detailed illustration of sources and uses of cash, refer to the condensed consolidated statements of cash flows.

INFLATION

Substantially all of the Company’s assets and liabilities relate to banking activities and are monetary in nature. The consolidated financial statements and related financial data are presented in accordance with GAAP in the United States of America (GAAP). GAAP currently requires the Company to measure the financial position and results of operations in terms of historical dollars, with the exception of securities available for sale, impaired loans and other real estate loans that are measured at fair value. Changes in the value of money due to rising inflation can cause purchasing power loss.

Management’s opinion is that movements in interest rates affect the financial condition and results of operations to a greater degree than changes in the rate of inflation. It should be noted that interest rates and inflation do effect each other, but do not always move in correlation with each other. The Company’s ability to match the interest sensitivity of its financial assets to the interest sensitivity of its liabilities in its asset/liability management may tend to minimize the effect of changes in interest rates on the Company’s performance.

REGULATORY MATTERS

The Company is subject to the regulatory requirements of The Federal Reserve System as a one-bank holding company. The affiliate bank is subject to regulations of the Federal Deposit Insurance Corporation (FDIC) and the State of Ohio, Division of Financial Institutions.

REGULATORY CAPITAL REQUIREMENTS

The Company is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the Banks’ operations.

The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion and plans for capital restoration are required.

The minimum requirements are:

     The following table illustrates the Company’s risk-weighted capital ratios at March 31, 2005:

Item 3. Quantitative and Qualitative Disclosures about Market Risk

ASSET AND LIABILITY MANAGEMENT

The primary objective of the Company’s asset and liability management function is to maximize the Company’s net interest income while simultaneously maintaining an acceptable level of interest rate risk given the Company’s operating environment, capital and liquidity requirements, performance objectives and overall business focus. The principal determinant of the exposure of the Company’s earnings to interest rate risk is the timing difference between the repricing and maturity of interest-earning assets and the repricing or maturity of its interest-bearing liabilities. The Company’s asset and liability management policies are designed to decrease interest rate sensitivity primarily by shortening the maturities of interest-earning assets while at the same time extending the maturities of interest-bearing liabilities. The Board of Directors of the Company continues to believe in strong asset/liability management in order to insulate the Company from material and prolonged increases in interest rates. As a result of this policy, the Company emphasizes a larger, more diversified portfolio of residential mortgage loans in the form of mortgage-backed securities. Mortgage-backed securities generally increase the quality of the Company’s assets by virtue of the insurance or guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Company.

The Company’s Board of Directors has established an Asset and Liability Management Committee consisting of four outside directors, the President and Chief Executive Officer, Executive/Vice President/ Chief Operating Officer, Senior Vice President/Chief Financial Officer and Senior Vice President/Commercial Lending. This committee, which meets quarterly, generally monitors various asset and liability management policies and strategies, which were implemented by the Company over the past few years. These strategies have included: (i) an emphasis on the investment in adjustable-rate and shorter duration mortgage-backed securities; (ii) an emphasis on the origination of single-family residential adjustable-rate mortgages (ARMs), residential construction loans and commercial real estate loans, which generally have adjustable or floating interest rates and/or shorter maturities than traditional single-family residential loans, and consumer loans, which generally have shorter terms and higher interest rates than mortgage loans; (iii) increase the duration of the liability base of the Company by extending the maturities of savings deposits, borrowed funds and repurchase agreements.

The Company has established the following guidelines for assessing interest rate risk:

Net interest income simulation. Given a 200 basis point parallel and gradual increase or decrease in market interest rates, net interest income may not change by more than 10% for a one-year period.

Portfolio equity simulation. Portfolio equity is the net present value of the Company’s existing assets and liabilities. Given a 200 basis point immediate and permanent increase or decrease in market interest rates, portfolio equity may not correspondingly decrease or increase by more than 20% of stockholders’ equity.

The following table presents the simulated impact of a 200 basis point upward and a 200 basis point downward shift of market interest rates on net interest income and the change in portfolio equity. This analysis was done assuming that the interest-earning asset and interest-bearing liability levels at March 31, 2005 remained constant. The impact of the market rate movements was developed by simulating the effects of rates changing gradually over a one-year period from the March 31, 2005 levels for net interest income. The impact of market rate movements was developed by simulating the effects of an immediate and permanent change in rates at March 31, 2005 for portfolio equity:

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. Based on their evaluation as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Registrant’s principal executive officer and principal financial officer have concluded that the Registrant’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by Middlefield in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in internal controls. There were no significant changes in the Registrant’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II — OTHER INFORMATION

     Item 1. Legal Proceedings

     None

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     None

Item 3. Defaults by the Company on its senior securities

     None

Item 4. Submission of matters to a vote of security holders

     None

Item 5. Other information

     None

Item 6. Exhibits

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned and hereunto duly authorized.