SOUTHERN MICHIGAN BANCORP INC - Quarter Report: 2004 September (Form 10-Q)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from to

Commission File Number 2-78178

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 o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES o NO x

The number of shares of the registrant's common stock, $2.50 par value, outstanding as of October 29, 2004 was 1,830,005 (including shares held by the ESOP).

PART I - FINANCIAL INFORMATION

ITEM 1.  Financial Statements.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

SOUTHERN MICHIGAN BANCORP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED)

SOUTHERN MICHIGAN BANCORP, INC.

See notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)

SOUTHERN MICHIGAN BANCORP, INC.

See notes to condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SOUTHERN MICHIGAN BANCORP, INC.

September 30, 2004

NOTE A -- BASIS OF PRESENTATION

The accompanying year-end balance sheet data was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. For further information, refer to the consolidated financial statements included in Southern Michigan Bancorp, Inc.'s (the "Company") annual report on Form 10-K for the year ended December 31, 2003.

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. ESOP shares are considered outstanding for this calculation unless unearned. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per common share are restated for all stock splits and dividends through the date of issue of the financial statements.

The basic and diluted weighted average common shares outstanding for the three and nine month periods ended September 30, 2004 and 2003 were:

Reclassifications: Some items in the prior year consolidated financial statements have been reclassified to conform with the current year presentation.

NOTE B - STOCK COMPENSATION

The following table illustrates the effect on net income and earnings per common share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock Based Compensation.

NOTE C - SUBORDINATED DEBENTURES AND TRUST PREFERRED SECURITIES

In March 2004, Southern Michigan Bancorp Capital Trust I, a trust formed by the Company, closed a pooled private offering of 5,000 trust preferred securities with a liquidation amount of $1,000 per security. The Company issued $5,155,000 of subordinated debentures to the trust in exchange for ownership of all of the common security of the trust and the proceeds of the preferred securities sold by the trust. The Company may redeem the subordinated debentures, in whole or in part, in a principal amount with integral multiples of $1,000, on or after April 7, 2009 at 100% of the principal amount, plus accrued and unpaid interest. The subordinated debentures mature on April 6, 2034. The subordinated debentures are also redeemable in whole or in part from time to time, upon the occurrence of specific events defined within the trust indenture. The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.

The $5,000,000 in trust preferred securities may be included in Tier I capital (with certain limitations applicable) under current regulatory guidelines and interpretations.

The trust preferred securities and subordinated debentures have a variable rate of interest equal to the sum of the three month London Interbank Offered Rate (LIBOR) and 2.75%. The rate at September 30, 2004 was 4.35%. The Company's investment in the common stock of the trust was $155,000 and is included in other assets.

NOTE D - NEWLY ISSUED ACCOUNTING STANDARDS

EITF Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, contains accounting guidance regarding other-than-temporary impairment on securities that was to take effect for the quarter ended September 30, 2004.  However, the effective date of portions of this guidance has been delayed, and more interpretive guidance is to be issued in the near future.  The effect of this new and pending guidance on the Company's financial statements is not known, but it is possible this guidance could change management's assessment of other-than-temporary impairment in future periods.

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

FORWARD LOOKING STATEMENTS

Statements contained in this quarterly report include 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 Company itself. Words such as "anticipate", "believe", "can be", "designed", "estimate", "expect", "intend", "is likely, "may be", "opinion", "probable", "project", "seek", variations of such terms, and similar expressions are intended to identify such forward-looking statements. The information concerning interest rate sensitivity in Item 3 is forward looking. Management's determination of the provision and allowance for loan losses involve judgments which are inherently forward looking. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions 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. Internal and external factors that may cause such a difference include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; the bank's ability to manage non-earning assets; changes in advances; governmental and regulator policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior and customer ability to repay loans; and changes in the local, national or world economy. The Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

FINANCIAL CONDITION

During the first nine months of 2004, cash and cash equivalents decreased 35.6% or $5,807,000. During the same period, securities available for sale decreased by 16.1% or $8,735,000. The proceeds of the maturities and calls of securities were used to repay $11,000,000 in Federal Home Loan Bank (FHLB) advances and $533,000 of other borrowings.

Gross loans have increased 2.8%, or $6,590,000 during the first nine months of 2004. The largest increase was in the installment loan portfolio which grew $4,066,000 or 27.4%. In 2003 the Bank hired individuals with consumer loan experience to increase the portfolio. The commercial portfolio also increased by $3,481,000 or 2.4%.

The allowance for loan losses is based on regular, quarterly assessments of the probable estimated losses inherent in the loan portfolio. The allowance is based on two principles of accounting, Statement of Financial Accountings Standard (SFAS) No. 5 "Accounting for Contingencies", and SFAS No. 114 "Accounting by Creditors for Impairment of a Loan". The methodology used relies on several key features, including historical loss experience, specific allowances for identified problem loans, and an unallocated allowance.

The historical loss component of the allowance is based on the three and five year historical loss experience for each loan category. The component may be adjusted for significant factors that, in management's opinion, will affect the collectibility of the portfolio. These factors include current economic conditions, delinquency and charge off trends, loan volume, portfolio mix, concentrations of credit, and lending policies, procedures and personnel. The resulting loss estimate could differ from the losses actually incurred in the future.

Specific allowances are established in cases where management has identified significant conditions or circumstances related to a specific loan credit. These allowances are calculated in accordance with SFAS No. 114.

The allowance for loan losses is being maintained at a level which, in management's opinion, is adequate to absorb probable incurred loan losses in the loan portfolio as of September 30, 2004. While management uses the best information available to make these estimates, future adjustments to allowances may be necessary due to economic, operating or regulatory conditions which may be beyond the Company's control.

The allowance for loan losses was $3,401,000 or 1.42% of gross loans at September 30, 2004. As of December 31, 2003, the allowance for loan losses was $3,252,000 or 1.40% of gross loans. Non-performing loans (defined as loans over 90 days past due or non accrual loans) increased slightly to $3,608,000 at September 30, 2004, from $3,588,000 at December 31, 2003. However, this increase included a loan added during the third quarter of 2004 which has a balance of $1,401,000. The loan is well

secured and in the process of collection. Management has no concerns about the collectibility of this loan. Without this loan in the non performing totals, non performing loans would have decreased 38.5% from the prior year end. In addition, net recoveries of $149,000 were recorded for the nine months ending September 30, 2004. Offsetting the recoveries and reduced risk from the non performing loans, there was an increase of $261,000 in the specific allowances for identified problem loans from year end.

As mentioned in Note C - the Company issued $5,155,000 in subordinated debt in March 2004 in exchange for the proceeds of preferred securities sold by the trust and ownership of common securities of the trust.

CAPITAL RESOURCES

The Federal Reserve Board (FRB) has imposed risk-based capital guidelines applicable to the Company. These guidelines require that banks and bank holding companies maintain capital commensurate with both on and off balance sheet credit risks of their operations. Under the guidelines, a bank must have a minimum ratio of total capital to risk-weighted assets of 8 percent. In addition, a bank and a bank holding company must maintain a minimum ratio of Tier 1 capital equal to 4 percent of risk-weighted assets. Tier 1 capital includes common shareholders' equity, qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries less goodwill, core deposit intangibles and 10% of mortgage servicing rights assets.

As a supplement to the risk-based capital requirements, the FRB has also adopted leverage capital ratio requirements. The leverage ratio requirements are intended to ensure that adequate capital is maintained against risk other than credit risk. The leverage ratio requirements establish a minimum ratio of Tier 1 capital to total assets of 3 percent for the most highly rated bank holding companies and banks that do not anticipate and are not experiencing significant growth. All other bank holding companies are required to maintain a ratio of Tier 1 capital to assets of 4 to 5 percent, depending on the particular circumstances and risk profile of the institution.

Regulatory agencies have determined that the capital component created by the adoption of FASB Statement 115 should not be included in Tier 1 capital. As such, the net unrealized appreciation or depreciation on available for sale securities is not included in the ratio, but the common stock subject to repurchase obligation in the Company's employee stock ownership plan (ESOP) is included.

The following table summarizes the Company's capital ratios as of September 30, 2004 and December 31, 2003:

The above table indicates that the Company exceeds the well capitalized requirements at September 30, 2004.

RESULTS OF OPERATIONS

Net Interest Income

The net yield on interest earning assets increased for the nine months ended September 30, 2004 as compared to the same period last year. Although interest income the first nine months of 2004 was down as a result of repricing assets, the Company was also able to reprice interest bearing liabilities, resulting in an overall increase in the net yield.

The following table shows the year to date daily average balances for interest earning assets and interest bearing liabilities, interest earned or paid, and the annualized effective rate, for the nine month periods ended September 30, 2004 and 2003 (Dollars in Thousands):

Provision for Loan Losses

The provision for loan losses is based on an analysis of outstanding loans. In assessing the adequacy of the allowance for loan losses, management reviews the characteristics of the loan portfolio in order to determine the overall quality and risk profile. Some factors considered by management in determining the level at which the allowance is maintained include a continuing evaluation of those loans identified as being subject to possible problems in collection, results of examinations by regulatory agencies, current economic conditions, historical loan loss experience, delinquency and charge off trends, loan volume, portfolio mix, concentrations of credit and lending policies, procedures and personnel.

The provision for loan losses was $0 for the first nine months of 2004 compared to $825,000 for the same period of 2003. The Bank recorded net recoveries of $149,000 for the first nine months of 2004 compared to net charge offs totaling $685,000 for the same period of 2003. As mentioned above, non-performing loans increased slightly, but overall risk in the non performing loans has decreased. The specific allowances for identified problem loans increased during the nine month period. Management added specific reserves in the amount of $600,000 for two identified problem loans. One loan is out of compliance with its loan covenants, but continues to perform. A specific reserve of $300,000 was placed on that loan. A reserve was added for the second loan as the borrower has experienced financial difficulties. That loan also continues to perform, but a $300,000 specific reserve was added. The net increase in specific reserves was $261,000. Due to the volume of net recoveries and management's belief that non performing loans have improved, no provision was necessary for the nine months ending September 30, 2004.

Non-interest Income

Non-interest income decreased $150,000 and $1,254,000, or 11.7% and 28.1%, for the three and nine month periods ended September 30, 2004 compared to the same periods in 2003.

The three and nine month declines are the result of an increase in mortgage rates from the prior year's historic lows and the resulting decline in refinancing activity. The Bank originated for sale $33,725,000 in loans during the first nine months of 2004 compared to $86,654,000 during the same period of 2003. Net gain on sale of loans decreased $1,227,000 or 66.4% for the nine month period ending September 30, 2004 compared to the same period in 2003.

Offsetting the decline was an increase in earnings on life insurance assets during the three and six month periods ended September 30, 2004. This increase was due to a life insurance policy being paid out with a face amount in excess of its cash surrender value resulting in $54,000 of additional income.

Other non-interest income increased for the three months ending September 30, 2004 6.3% or $30,000. The bank recorded a gain of $28,000 on the sale of an OREO property during the quarter.

Other non-interest income decreased $112,000 for the nine month period ending September 30, 2004 as an insurance settlement of $199,000 was received during the same period in 2003.

Non-interest Expense

Non-interest expenses increased by $121,000 during the three month period ended September 30, 2004 compared to the same period in 2003.

The salaries and employee benefits increase for the three months ended September 30, 2004 is attributable to an increase in the expense relating to the pension plan and to a reversal of incentive pay made during the third quarter of 2003. The nine month decrease is a result of lower commissions being paid to mortgage loan originators as volumes have decreased.

The Company saw a decrease in professional and outside services expense during the three and nine month periods ending September 30, 2004. During the first quarter of 2003, a consulting firm specializing in revenue enhancements and efficiency studies completed an analysis for the Bank. In addition to costs associated with the consultant, $48,000 was paid in legal fees in 2003 relating to the $199,000 settlement received.

Contingent and Contractual Obligations

At September 30, 2004, the Bank had no commitments under commercial letters of credit.

The Bank had commitments under performance letter of credit agreements of $129,000 at September 30, 2004.

Under standby letter of credit agreements, the Bank agrees to honor certain commitments in the event that its customers fail to do so. At September 30, 2004, commitments under outstanding standby letters of credit were $209,000.

Loan commitments outstanding to extend credit totaled $32,931,000 at September 30, 2004.

Management does not anticipate any losses as a result of the above transactions; however the above amount represents the maximum exposure to credit loss for loan commitments and commercial, performance and standby letters of credit.

Liquidity

Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Bank maintains certain levels of liquid assets (the most liquid of which are cash and cash equivalents and investment securities) in order to meet these demands. Also, Federal Home Loan Bank advances and short-term borrowings provide additional sources of liquidity for the Company

ITEM 3.  Quantitative and Qualitative Disclosures About Market Risk.

Net interest income is the largest component of the Company's earnings. Net interest income is the difference between the yield on interest earning assets and the cost of interest bearing liabilities. Interest rate sensitivity management seeks to avoid fluctuating net interest margins and enhance consistent growth of net interest income through periods of changing interest rates.

Interest rate risk arises when the maturity or repricing characteristics of assets differ significantly from the maturity or the repricing characteristics of liabilities. Accepting this risk can be an important source of profitability and shareholder value, however excessive levels of interest rate risk could pose a significant threat to the Company's earnings and capital base. Accordingly, effective risk management that seeks to maintain interest rate risk at prudent levels is essential to the Company's safety and soundness.

A number of tools are used to monitor and manage interest rate risk, including income simulation and market value of equity analyses. The income simulation model is used to estimate the effect that specific interest rate changes would have on net interest income assuming 1-2% up and down ramped changes to interest rates. Assumptions in the simulation are based on management's estimates, and are inherently uncertain. As a result, the models cannot predict precisely the impact of higher or lower interest rates on net interest income. Based on the results of the simulation model as of September 30, 2004, the Bank is within the guidelines set and approved by the Company's Board of Directors. There has been no material change to the methods used by the Company to monitor and evaluate interest rate risk during the current year.

Other than the issuance of subordinated debentures, and the repayment of the FHLB advance, there have been no significant changes in the distribution of the Company's financial instruments that are sensitive to changes in interest rates during the first nine months of 2004. As mentioned in Note C, the subordinated debentures are a variable rate instrument due on April 6, 2034. Their rate at September 30, 2004 was 4.35%.

ITEM 4.  Controls and Procedures.

The Company maintains disclosure controls and procedures designed to ensure that the information the Company must disclose in its filings with the Securities and Exchange Commission is recorded, processed, summarized and reported on a timely basis. The Company's Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective in bringing to their attention on a timely basis material information relating to the Company required to be included in the Company's periodic filings under the Exchange Act. During the period covered by this report, there was no change in the Company's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1.  Legal Proceedings.

The Bank is engaged in litigation from time to time, both as plaintiff and defendant, which is incidental to its business. In certain proceedings, claims or counterclaims may be asserted against the Bank. Based on the facts known to date, management of the Company does not currently anticipate that the ultimate liability, if any, arising out of any such litigation will have a material adverse effect on the Company's financial condition or results of operations.

The Company previously reported claims in Note A of the Notes to the Company's Consolidated Financial Statements contained in the Company's annual report on Form 10-K for the fiscal year ended December 31, 2003. There were no material developments in these proceedings during the quarter ended September 30, 2004.

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

On February 2, 2004, the Company announced that its board of directors had authorized the repurchase of up to 75,000 shares of the Company's Common Stock. The following table summarizes purchases of shares by the Company during the quarterly period covered by this report.

ITEM 3.  Defaults Upon Senior Securities.

None.

ITEM 4.  Submission of Matters to a Vote of Security Holders.

None.

ITEM 5.  Other Information.

None.

ITEM 6.  Exhibits.

          (a)          Exhibits.

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.

INDEX TO EXHIBITS