10-K 1 k02512e10vk.txt ANNUAL REPORT FOR FISCAL YEAR ENDED 12/31/05 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005 COMMISSION FILE #0-16640 UNITED BANCORP, INC. (Exact name of registrant as specified in its charter) MICHIGAN 38-2606280 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.)
205 E. CHICAGO BOULEVARD, TECUMSEH, MI 49286 (Address of principal executive offices, including Zip code) Registrant's telephone number, including area code: (517) 423-8373 Securities registered pursuant to Section 12(b) of the Act: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, no par value (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] 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 and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. Large Accelerated Filer [ ] Accelerated Filer [X] Non-Accelerated Filer [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act. Yes [ ] No [X] As of June 30, 2005, the aggregate market value of the voting stock held by non-affiliates of the registrant was $126,447,000, based on a closing price of $67.00 as reported on the OTC Bulletin Board. As of February 8, 2006, there were 2,499,059 outstanding shares of registrant's common stock, no par value. Documents Incorporated By Reference: Portions of the registrant's definitive 2006 Proxy Statement in connection with the 2006 Annual Meeting of Shareholders are incorporated by reference into Part III. Page 1 CROSS REFERENCE TABLE
Page ITEM NO. DESCRIPTION Numbers -------- ----------- ------- PART I 1. Business 3 I Selected Statistical Information 9 (A) Distribution of Assets, Liabilities and Shareholders' Equity 9 (B) Interest Rates and Interest Differential 9 II Investment Portfolio 10 III Loan Portfolio 10 (A) Types of Loans 10 (B) Maturities and Sensitivities of Loans to Changes in Interest Rates 10 (C) Risk Elements 11 (D) Other Interest Bearing Assets 11 IV Summary of Loan Loss Experience 11 (A) Changes in Allowance for Loan Losses 11 (B) Allocation of Allowance for Loan Losses 12 V Deposits 12 VI Return on Equity and Assets 12 VII Short-Term Borrowings 12 1A. Risk Factors 12 1B. Unresolved Staff Comments 16 2. Properties 16 3. Legal Proceedings 16 4. Submission of Matters to a Vote of Security Holders 16 PART II 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 17 6. Selected Financial Data 17 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 7A. Quantitative and Qualitative Disclosures About Market Risk 18 8. Financial Statements and Supplementary Data 18 9. Changes in and Disagreements With Accountants on Accounting & Financial Disclosure 18 9A. Controls and Procedures 19 9B. Other Information 20 PART III 10. Directors and Executive Officers of the Registrant 21 11. Executive Compensation 21 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 21 13. Certain Relationships and Related Transactions 21 14. Principal Accounting Fees and Services 22 PART IV 15. Exhibits and Financial Statement Schedules 22 Signatures 25 Power of Attorney 26 Exhibit Index 27
Page 2 PART I ITEM 1 - BUSINESS United Bancorp, Inc. (the "Company") was incorporated on May 31, 1985 as a business corporation under the Michigan Business Corporation Act, pursuant to the authorization and direction of the Directors of United Bank & Trust ("UBT"). The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). The Company has corporate power to engage in such activities as permitted to business corporations under the Michigan Business Corporation Act, subject to the limitations of the Bank Holding Company Act and regulations of the Federal Reserve System. In general, the Bank Holding Company Act and regulations restrict the Company with respect to its own activities and activities of any subsidiaries to the business of banking or such other activities which are closely related to the business of banking. United Savings Bank ("USB") opened in 1933 as a result of a merging of charters of Lilley State Bank and Tecumseh State Savings Bank. United Savings Bank was acquired by the Company on January 1, 1986. USB changed its name to United Bank & Trust on January 1, 1992, at the time it acquired Thompson Savings Bank in Hudson. In November of 2000, the Company filed applications with its regulators for permission to establish a second bank as a subsidiary of the Company. United Bank & Trust - Washtenaw ("UBTW") opened for business on April 2, 2001, and is headquartered in Ann Arbor. UBTW operates with its own local management and board of directors, and targets the Washtenaw County market for its growth. In 2003, UBT sold its three Washtenaw County offices to UBTW. UBT delivers financial services through a system of eleven banking offices and one Trust office, plus thirteen automated teller machines, located in Lenawee and Monroe Counties, Michigan. The business base of the area is primarily agricultural and light manufacturing, with its manufacturing sector exhibiting moderate dependence on the automotive and refrigeration and air conditioning industries. Banking services are delivered by UBTW through four banking offices and four automated teller machines in Washtenaw County, Michigan. The employment base of Washtenaw County is centered around health care, education and automotive high technology. Economic stability is provided to a great extent by the University of Michigan, which is a major employer and is not as economically sensitive to the fluctuations of the automotive industry. The services and public sectors account for a substantial percentage of total industry employment, in a large part due to the University of Michigan and the University of Michigan Medical Center. The Company's subsidiary banks (the "Banks") offer a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking, NOW accounts, savings, time deposit accounts, money market deposit accounts, safe deposit facilities and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, credit card and check-credit loans, home equity loans, accounts receivable and inventory financing, equipment lease financing and construction financing. The Banks maintain correspondent bank relationships with a small number of larger banks, which involve check clearing operations, securities safekeeping, transfer of funds, loan participation, and the Page 3 purchase and sale of federal funds and other similar services. UBTW also maintains a correspondent banking relationship with UBT. The Banks offer the sale of nondeposit investment products through licensed representatives in their banking offices, and sell credit and life insurance products. In addition, the Company and/or the Banks are co-owners of Michigan Banker's Title Insurance Company of Mid-Michigan LLC, and derive income from the sale of various insurance products to banking clients. The following table shows comparative information concerning the Banks as of December 31, 2005, in thousands of dollars:
Assets Loans Deposits -------- -------- -------- United Bank & Trust $490,224 $365,106 $403,522 United Bank & Trust - Washtenaw 224,621 193,006 188,406
UBT operates a trust department, and provides trust services to UBTW on a contract basis. The Trust & Investment Group offers a wide variety of fiduciary services to individuals, corporations and governmental entities, including services as trustee for personal, corporate, pension, profit sharing and other employee benefit trusts. The department provides securities custody services as an agent, acts as the personal representative for estates and as a fiscal, paying and escrow agent for corporate customers and governmental entities, and provides trust services for clients of the Banks. Supervision and Regulation General. The Company and the Banks are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of security holders. Set forth below is a description of the significant elements of some of the laws and regulations applicable to the Company and the Banks. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to the Company and the Banks could have a material effect on the business of the Company and the Banks. As a bank holding company within the meaning of the Bank Holding Company Act, the Company is required to file quarterly and annual reports of its operations and such additional information as the Federal Reserve Board may require and is subject, along with its subsidiaries, to examination by the Federal Reserve Board. The Federal Reserve Board is the primary regulator of the Company. The Bank Holding Company Act requires every bank holding company to obtain prior approval of the Federal Reserve Board before it may merge with or consolidate into another bank holding company, acquire substantially all the assets of any bank, or acquire ownership or control of any voting shares of any bank if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank holding company or bank. The Federal Reserve Board may not approve the acquisition by the Company of voting shares or substantially all the assets of any bank located in any state other than Michigan unless the laws of such other state specifically authorize such an acquisition. The Bank Holding Company Act also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. However, holding companies may engage in, and may own shares of companies engaged in, certain businesses found by the Federal Reserve Board to be so closely related to banking or the management or control of banks as to be a Page 4 proper incident thereto. Under current regulations of the Federal Reserve Board, a holding company and its nonbank subsidiaries are permitted, among other activities, to engage, subject to certain specified limitations, in such banking related business ventures as sales and consumer finance, equipment leasing, credit bureau services and software operations, data processing and services transmission, discount securities brokerage, insurance, mortgage banking and brokerage, sale and leaseback and other forms of real estate banking. The Bank Holding Company Act does not place territorial restrictions on the activities of nonbank subsidiaries of bank holding companies. In addition, federal legislation prohibits acquisition of "control" of a bank or bank holding company without prior notice to certain federal bank regulators. "Control" in certain cases may include the acquisition of as little as 10% of the outstanding shares of capital stock. In March of 2000, the Gramm-Leach-Bliley Act of 1999 (the "GLB Act") was enacted. Under the GLB Act, new opportunities became available for bank holding companies, banks and other depository institutions, insurance companies and securities firms to enter into combinations that permit a single financial services organization to offer customers a more complete array of financial products and services. The GLB Act provided a new regulatory framework for regulation through the "financial holding company," with the Federal Reserve Board as the umbrella regulator. Functional regulation of the separately regulated subsidiaries of a financial holding company are conducted by their primary functional regulator. The Company became a financial holding company in 2000. UBT and UBTW are Michigan banking corporations, and as such are subject to the regulation of, and supervision and regular examination by, the Michigan Office of Financial and Insurance Services ("OFIS") and the FDIC. OFIS is the primary regulator of the Banks. Deposit accounts of the Banks are insured by the FDIC. Requirements and restrictions under the laws of the United States and the State of Michigan include the requirement that banks maintain reserves against certain deposits, restrictions on the nature and amount of loans which may be made by a bank and the interest that may be charged thereon, restrictions on the payment of interest on certain deposits and restrictions relating to investments and other activities of a bank. Dividends. The Company is a legal entity, separate and distinct from the Banks. Most of the Company's revenue will be received in the form of dividends, if any, paid by UBT and UBTW. Thus, the Company's ability to pay dividends to its shareholders will be limited by statutory and regulatory restrictions on UBT and UBTW concerning dividends. Michigan's banking laws restrict the payment of cash dividends by a state bank by providing, subject to certain exceptions, that dividends may be paid only out of net profits then on hand after deducting therefrom its losses and bad debts and no dividends may be paid unless the bank will have a surplus amounting to not less than twenty percent (20%) of its capital after the payment of the dividend. Federal law generally prohibits a bank from making any capital distribution (including payment of a dividend) or paying any management fee to its parent company if the depository institution would thereafter be undercapitalized. The Federal Deposit Insurance Corporation ("FDIC") may prevent an insured bank from paying dividends if the Bank is in default of payment of any assessment due to the FDIC. In addition, the FDIC may prohibit the payment of dividends by a bank, if such payment is determined, by reason of the financial conditions of the bank, to be an unsafe and unsound banking practice. Holding Company Support of Subsidiary Banks. Under Federal Reserve Board policy, the Company is expected to act as a source of financial and managerial strength to its Banks and to commit resources to support such subsidiaries. This support of its subsidiary banks may be required at times when, absent such Federal Reserve Board policy, the Company might not otherwise be inclined to provide it. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in Page 5 right of payment to deposits and certain other indebtedness of such subsidiary banks. Liability of Commonly Controlled Depository Institutions. Under the Federal Deposit Insurance Act, as amended ("FDIA"), FDIC-insured depository institutions, such as any of the Banks, can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the "default" of a commonly controlled FDIC-insured depository institution, or (ii) any assistance provided by the FDIC to any commonly controlled depository institution in "danger of default." For these purposes, the term "default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur without federal regulatory assistance. Capital Adequacy and Prompt Corrective Action. The Federal Reserve Board and the FDIC have established guidelines for risk-based capital by bank holding companies and banks. These guidelines establish a risk adjusted ratio relating capital to risk- weighted assets and off-balance-sheet exposures. These capital guidelines primarily define the components of capital, categorize assets into different risk classes, and include certain off-balance- sheet items in the calculation of capital requirements. Generally, Tier 1 capital consists of shareholders' equity less intangible assets and unrealized gain or loss on securities available for sale, and Tier 2 capital consists of Tier 1 capital plus qualifying loan loss reserves. The FDIC Improvement Act of 1991 established a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, federal banking regulators have established five capital categories, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each of the categories. Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the under-capitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval. Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, such a bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless the bank could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time. The capital ratios of the Company and the Banks exceed the regulatory guidelines for well capitalized institutions. Information in Note 18 on Page A-38 hereof provides additional information regarding the Company's capital ratios, and is incorporated herein by reference. The federal regulatory authorities' risk-based capital guidelines are based upon the 1988 capital accord of the Basel Committee on Banking Supervision (the "BIS"). The BIS is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country's supervisors in determining the supervisory policies they apply. In 2004, the BIS published a new capital accord to replace its 1988 capital accord. The new capital accord would, among other things, set capital requirements for operational risk and refine the existing capital requirements for Page 6 credit risk and market risk. Operational risk is defined to mean the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems in connection with external events. The 1988 capital accord does not include separate capital requirements for operational risk. The United States federal regulatory authorities are currently expected to release proposed rules to implement the BIS's new capital accord in the first quarter of 2006. The Company cannot predict the timing or final form of the United States rules implementing the new capital accord and their impact on the Company. The new capital requirements that may arise from the final rules could increase the minimum capital requirements applicable to the Company and the Banks. Affiliate Transactions. Banks are subject to restrictions imposed by federal law on extensions of credit to, purchases of assets from, and certain other transactions with affiliates and on investments in stock or other securities issued by affiliates. Such restrictions prevent the Banks from making loans to affiliates unless the loans are secured by collateral in specified amounts and have terms at least as favorable to the Banks as the terms of comparable transactions between the Banks and non-affiliates. Further, applicable federal and state laws significantly restrict extensions of credit by the Banks to directors, executive officers and principal stockholders and related interests of such persons. Deposit Insurance. Substantially all of the deposits of the Banks are insured up to applicable limits by the Bank Insurance Fund ("BIF") of the FDIC and are subject to deposit insurance assessments to maintain the BIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a matrix that takes into account a bank's capital level and supervisory rating. The Banks paid insurance premiums of $74,009 in 2005, however, it is possible that the FDIC could impose assessment rates in the future in connection with declines in the insurance funds or increases in the amount of insurance coverage. An increase in the assessment rate could have a material adverse effect on the Company's earnings, depending on the amount of the increase. During 2005, the Banks paid $5,994 in Financing Corporation ("FICO") assessments related to outstanding FICO bonds to the FDIC as collection agent. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings and Loan Insurance Corporation. Depositor Preference. The FDIA provides that, in the event of the "liquidation or other resolution" of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution. Community Reinvestment Act. The Community Reinvestment Act of 1977 ("CRA") requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and area assigned ratings. In order for a financial holding company to commence any new activity permitted by the Bank Holding Company Act, or to acquire any company engaged in any new activity permitted by the Bank Holding Company Act, each insured depository institution subsidiary of the financial holding Page 7 company must have received a rating of at least "satisfactory" in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of a proposed transaction. Financial Privacy. In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted and conveyed to outside vendors. Anti-Money Laundering Initiatives and the USA Patriot Act. A major focus of governmental policy on financing institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the "USA Patriot Act") substantially broadened the scope of the United States and anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as the Banks. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing by verifing the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institutions. Legislative Initiatives. From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations or regulatory policies applicable to the Company or the Banks could have a material effect on the business of the Company. Consumer Protection Regulation. Other aspects of the lending and deposit businesses of the Banks that are subject to federal and state regulation include disclosure requirements with respect to interest, payment and other terms of consumer and residential mortgage loans, disclosure of interest and fees and other terms of, and the availability of, funds for withdrawal from consumer deposit accounts, prohibiting certain forms of discrimination in credit transactions, and imposing certain recordkeeping, reporting and disclosure requirements with respect to residential mortgage loan applications. Accounting Standards Information regarding accounting standards adopted by the Company are discussed beginning on Page A-26 hereof, and is incorporated herein by reference. Page 8 Competition The banking business in the Company's service area is highly competitive. In their markets, the Banks compete with a number of community banks and subsidiaries of large multi-state, multi-bank holding companies. In addition, the banks face competition from credit unions, savings associations, finance companies, loan production offices and other financial services companies. The Company believes that the market perceives a competitive benefit to an independent, locally controlled commercial bank. Much of the Company's competition comes from affiliates of organizations controlled from outside the area. Against these competitors, the subsidiary banks continue to expand their loan and deposit portfolios. Employees On December 31, 2005, the Company and its subsidiaries employed 195 full-time and 39 part-time employees. This compares to 190 full-time and 47 part-time employees at December 31, 2004. On January 1, 2005, the operations and support areas of UBT moved to the Company. As a result, the Company has 69 full-time and part-time employees as of December, 31, 2005. I SELECTED STATISTICAL INFORMATION (A) DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; (B) INTEREST RATES AND INTEREST DIFFERENTIAL: The information required by these sections are contained on Pages A-3 through A-9 hereof, and is incorporated herein by reference. II INVESTMENT PORTFOLIO The following table reflects the carrying values and yields of the Company's securities portfolio for 2005. Average yields are based on amortized costs and the average yield on tax exempt securities of states and political subdivisions is adjusted to a taxable equivalent basis, assuming a 34% marginal tax rate.
Carrying Values and Yields of Investments In thousands of dollars where applicable 0 - 1 1 - 5 5 - 10 Over 10 Available For Sale Year Years Years Years Total ------- ------- ------- ------- ------- U.S. Treasury and government agencies (1) $40,138 $18,419 $ -- $ -- $58,557 Weighted average yield 3.43% 3.50% -- -- 3.45% Obligations of states and political subdivisions $13,306 $12,643 $13,824 $1,837 $41,610 Weighted average yield 3.28% 3.95% 3.84% 4.62% 3.73% Equity and other securities (2) $ 3,265 $ -- $ -- $ -- $ 3,265 Weighted average yield 4.25% -- -- -- 4.25% Total securities $56,709 $31,062 $13,824 $1,837 $103,432 Weighted average yield 3.43% 3.68% 3.84% 4.62% 3.58%
(1) Reflects the scheduled amortization and an estimate of future prepayments based on past and current experience of amortizing U.S. agency securities. (2) Reflects the scheduled amortization and an estimate of future prepayments based on past and current experience of the issuer for various collateralized mortgage obligations. As of December 31, 2005, the Company's securities portfolio contains no concentrations by issuer greater than 10% of shareholders' equity. Additional information concerning the Company's securities portfolio is included on Page A-9, and in Note 3 on Page A-29 hereof, and is incorporated herein by reference. Page 9 III LOAN PORTFOLIO (A) TYPES OF LOANS The tables below show loans outstanding (net of unearned interest) at December 31, and the percentage makeup of the portfolios. All loans are domestic and contain no concentrations by industry or customer. Balances are stated in thousands of dollars.
2005 2004 2003 2002 2001 -------- -------- -------- -------- -------- Personal $ 81,571 $ 74,142 $ 70,301 $ 71,010 $ 62,792 Business and commercial mortgage 320,188 278,838 256,778 212,611 163,329 Tax exempt 3,133 3,325 1,476 1,417 1,878 Residential mortgage (1) 67,246 76,228 85,156 110,985 117,553 Construction 85,975 64,365 33,109 34,503 33,172 -------- -------- -------- -------- -------- Total loans (1) $558,112 $496,898 $446,820 $430,526 $378,724 ======== ======== ======== ======== ======== Personal 14.6% 14.9% 15.7% 16.5% 16.6% Business and commercial mortgage 57.4% 56.1% 57.5% 49.4% 43.1% Tax exempt 0.6% 0.7% 0.3% 0.3% 0.5% Residential mortgage (1) 12.0% 15.3% 19.1% 25.8% 31.0% Construction 15.4% 13.0% 7.4% 8.0% 8.8% -------- -------- -------- -------- -------- Total loans (1) 100.0% 100.0% 100.0% 100.0% 100.0% ======== ======== ======== ======== ========
(1) Includes loans held for sale (B) MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES The following table presents the maturity of total loans outstanding, other than residential mortgages and personal loans, as of December 31, 2005, according to scheduled repayments of principal. All figures are stated in thousands of dollars.
0 - 1 1 - 5 After 5 Year Years Years Total -------- -------- ------- -------- Business and commercial mortgage - fixed rate $ 25,863 $ 95,884 $10,015 $131,762 Business and commercial mortgage - variable rate 52,917 82,977 52,530 188,424 Tax exempt - fixed rate 279 620 2,234 3,133 Tax exempt - variable rate -- -- -- -- Construction -fixed rate 4,942 6,778 -- 11,720 Construction -variable rate 71,652 2,602 -- 74,254 -------- -------- ------- -------- Total fixed rate 31,084 103,282 12,249 146,616 Total variable rate 124,569 85,579 52,530 262,679 -------- -------- ------- -------- Total $155,654 $188,862 $64,779 $409,295 ======== ======== ======= ========
(C) RISK ELEMENTS Non-Accrual, Past Due and Restructured Loans The following shows the effect on interest revenue of nonaccrual and troubled debt restructured loans as of December 31, 2005, in thousands of dollars: Gross amount of interest that would have been recorded at original rate $363 Interest that was included in revenue -- ---- Net impact on interest revenue $363 ====
Page 10 Additional information concerning nonperforming loans, the Company's nonaccrual policy, and loan concentrations is provided on Pages A-10 through A-13, in Note 1 on Pages A-26 and A-27 and Notes 5 and 6 on Page A-31 hereof, and is incorporated herein by reference At December 31, 2005, the Banks had fifteen loans, other than those disclosed above, for a total of $2,542,000 which would cause management to have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms. These loans were included on the Banks' "watch lists" and were classified as impaired; however, payments are current. (D) OTHER INTEREST BEARING ASSETS As of December 31, 2005, other than $871,000 in other real estate, there were no other interest bearing assets that would be required to be disclosed under Item III, Parts (C)(1) or (C)(2) of the Loan Portfolio listing if such assets were loans. IV SUMMARY OF LOAN LOSS EXPERIENCE (A) CHANGES IN ALLOWANCE FOR LOAN LOSSES The table below summarizes changes in the allowance for loan losses for the years 2001 through 2005, in thousands of dollars. CHANGES IN ALLOWANCE FOR LOAN LOSSES
2005 2004 2003 2002 2001 ------ ------ ------ ------ ------ Balance at beginning of period $5,766 $5,497 $4,975 $4,571 $4,032 Charge-offs: Business and commercial mortgage 516 739 139 338 73 Residential mortgage 1 7 19 -- 50 Personal 362 320 512 484 238 ------ ------ ------ ------ ------ Total charge-offs 879 1,066 670 822 361 ------ ------ ------ ------ ------ Recoveries: Business and commercial mortgage 58 188 20 16 40 Residential mortgage 2 -- 3 -- -- Personal 82 99 100 105 138 ------ ------ ------ ------ ------ Total recoveries 142 287 123 121 178 ------ ------ ------ ------ ------ Net charge-offs 737 779 547 701 183 ------ ------ ------ ------ ------ Additions charged to operations 1,332 1,048 1,069 1,105 722 Adjustment for credit cards sold -- -- -- -- -- ------ ------ ------ ------ ------ Balance at end of period $6,361 $5,766 $5,497 $4,975 $4,571 ====== ====== ====== ====== ====== Ratio of net charge-offs to average loans 0.14% 0.17% 0.13% 0.13% 0.05% Allowance as percent of total loans 1.14% 1.16% 1.23% 1.16% 1.21%
The allowance for loan losses is maintained at a level believed adequate by Management to absorb losses inherent in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, amount and composition of the loan portfolio, and other factors. The provision charged to earnings was $1,332,000 in 2005, compared to $1,048,000 in 2004 and $1,069,000 in 2003. The allowance is based on the analysis of the loan portfolio and a four year historical average of net charge offs to average loans of 0.14% of the portfolio. Page 11 (B) ALLOCATION OF ALLOWANCE FOR LOAN LOSSES The following table presents the portion of the allowance for loan losses applicable to each loan category in thousands of dollars, as of December 31. A table showing the percent of loans in each category to total loans is included in Section III (A), above.
2005 2004 2003 2002 2001 ------ ------ ------ ------ ------ Business and commercial mortgage $5,471 $5,036 $4,775 $3,950 $3,060 Tax exempt -- -- -- -- -- Residential mortgage 14 20 37 15 20 Personal 777 710 685 571 496 Construction -- -- -- -- -- Unallocated 99 -- -- 439 995 ------ ------ ------ ------ ------ Total $6,361 $5,766 $5,497 $4,975 $4,571 ====== ====== ====== ====== ======
The allocation method used takes into account specific allocations for identified credits and a four year historical loss average in determining the allocation for the balance of the portfolio. V DEPOSITS The information concerning average balances of deposits and the weighted-average rates paid thereon, is included on Page A-5 and maturities of time deposits is provided in Note 9 on Page A-32 hereof, and is incorporated herein by reference. There were no foreign deposits. As of December 31, 2005, outstanding time certificates of deposit in amounts of $100,000 or more were scheduled to mature as shown below. All amounts are in thousands of dollars.
Time Certificates ----------------- Within three months $17,135 Over three through six months 14,950 Over six through twelve months 15,889 Over twelve months 20,088 ------- Total $68,062 =======
VI RETURN ON EQUITY AND ASSETS Various ratios required by this section and other ratios commonly used in analyzing bank holding company financial statements are included on Page A-3 and A-4 hereof, and are incorporated herein by reference. VII SHORT-TERM BORROWINGS The information required by this section is contained in Note 10 on Page A-32 hereof, and is incorporated herein by reference. No additional information is required as for all reporting periods, there were no categories of short-term borrowings for which the average balance outstanding during the period was 30% or more of shareholders' equity at the end of the period. ITEM 1A - RISK FACTORS An investment in the Company's common stock is subject to risks inherent to the Company's business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional Page 12 risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company's business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, the Company's financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company's common stock could decline significantly, and you could lose all or part of your investment. RISKS RELATED TO THE COMPANY'S BUSINESS The Company Is Subject To Interest Rate Risk The Company's earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Company receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Company's ability to originate loans and obtain deposits, and (ii) the fair value of the Company's financial assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Company's net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. The Company Is Subject To Lending Risk There are inherent risks associated with the Company's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company. As of December 31, 2005, approximately 73% of the Company's loan portfolio consisted of business and commercial mortgage and construction loans. Because the Company's loan portfolio contains a significant number of business and commercial and mortgage and personal construction loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non- performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company's financial condition and results of operations. The Company's Allowance For Possible Loan Losses May Be Insufficient The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management's best estimate of probable losses that may be incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management's continuing evaluation of industry Page 13 concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company's control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Company's allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Any increases in the allowance for possible loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Company's financial condition and results of operations. The Company's Profitability Depends Significantly On Economic Conditions In The State Of Michigan The Company's success depends primarily on the general economic conditions of the State of Michigan and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Lenawee, Monroe and Washtenaw Counties, Michigan. The local economic conditions in these areas have a significant impact on the demand for the Company's products and services as well as the ability of the Company's customers to repay loans, the value of the collateral securing loans and the stability of the Company's deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company's financial condition and results of operations. See, however, the disclosure under "Management's Discussion and Analysis of Financial Condition and Results of Operations - Background" on page A2. The Company Operates In A Highly Competitive Industry and Market Area The Company faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include credit unions, savings associations and various finance companies and loan production offices, in addition to a number of community banks and subsidiaries of large multi-state and multi-bank holding companies. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Company's competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Company can. The Company believes that the market perceives a competitive benefit to an independent, locally controlled commercial bank. Much of the Company's competition comes from affiliates of organizations controlled from outside the area. Against these competitors, the subsidiary banks continue to expand their loan and deposit portfolios. Page 14 The Company Is Subject To Extensive Government Regulation and Supervision The Company and the Banks are subject to extensive federal and state regulation and supervision as disclosed under "Item 1. Business - Supervision and Regulation." Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Company's lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. The Company Continually Encounters Technological Change The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company's future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company's operations. Many of the Company's competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. The Company's Stock Price Can Be Volatile Stock price volatility may make it more difficult for you to resell your common stock when you want to and at prices you find attractive. The Company's stock price can fluctuate significantly in response to a variety of factors. General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company's stock price to decrease regardless of operating results. In addition, the trading volume in the Company's common stock is significantly less than that of other larger financial services companies. This can make the Company's stock price volatile as significant sales of the Company's common stock, or the expectation of these sales, could cause the Company's stock price to fall. An Investment In The Company's Common Stock Is Not An Insured Deposit The Company's common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. Investment in the Company's common stock is inherently risky for the reasons described in this "Risk Factors" section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire the Company's common stock, you may lose some or all of your investment. The Company's Controls and Procedures May Fail or Be Circumvented Management regularly reviews and updates the Company's internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company's controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company's business, results of operations and financial condition. Page 15 ITEM 1B - UNRESOLVED STAFF COMMENTS None. ITEM 2 - PROPERTIES The executive offices of the Company are located at the main office (Hickman Financial Center) of United Bank & Trust, 205 East Chicago Boulevard, Tecumseh, Michigan. UBT owns and occupies the entire two-story building, which was built in 1980. On January 1, 2005, UBI acquired a 12,000 square foot operations and training center from UBT. The facility is located in Tecumseh. UBT operates three other banking offices in the Tecumseh area, two in the city of Adrian, one each in the cities of Hudson and Morenci, one in the village of Blissfield, and one each in Clinton, Rollin and Raisin Townships, all in Lenawee County. In addition, the bank operates one office in Dundee, Monroe County, Michigan. In 2005, the Bank moved its Trust & Investment Group to a new leased facility in Tecumseh. The bank owns all of the buildings except for the Trust facility, and leases the land for one office in the city of Adrian. All offices other than the Hickman Financial Center offer drive-up facilities. United Bank & Trust - Washtenaw operates one banking office in the City of Ann Arbor and one office each in the city of Saline and the villages of Dexter and Manchester, Washtenaw County, Michigan. The bank owns the Saline and Dexter buildings, leases the building for the Manchester office, and leases the land for the Dexter office. UBTW holds a long-term lease on the facilities for its administrative and banking offices, which it moved into in 2003. All offices offer ATM services, and all offices other than Manchester offer drive-up facilities. ITEM 3 - LEGAL PROCEEDINGS The Company and its subsidiaries are not involved in any material legal proceedings. They are involved in ordinary routine litigation incident to its business; however, no such proceedings are expected to result in any material adverse effect on the operations or earnings of the Company. Neither the Company nor it subsidiaries are involved in any proceedings to which any director, principal officer, affiliate thereof, or person who owns of record or beneficially more than five percent (5%) of the outstanding stock of the Company, or any associate of the foregoing, is a party or has a material interest adverse to the Company. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 2005. Page 16 PART II ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES PRICE RANGE FOR COMMON STOCK The following table shows the high and low selling prices of common stock of the Company for each quarter of 2005 and 2004 as quoted on the OTC Bulletin Board, under the symbol of UBMI.OB. These prices do not reflect private trades not involving brokers or dealers. Such over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The Company had 1,366 shareholders of record as of December 31, 2005. The prices and dividends per share have been adjusted to reflect the 2005 and 2004 stock dividends.
2005 2004 --------------------------- --------------------------- Market price Cash Market price Cash --------------- dividends --------------- dividends Quarter High Low declared High Low declared ------- ------ ------ --------- ------ ------ --------- 1st $65.71 $62.86 $0.333 $59.41 $57.14 $0.309 2nd 67.00 62.86 0.350 63.81 59.41 0.324 3rd 68.00 62.00 0.370 63.81 63.81 0.333 4th 66.00 59.50 0.370 63.81 63.81 0.333
ITEM 6 - SELECTED FINANCIAL DATA The following tables present five years of financial data for the Company, for the years ended December 31 (In thousands, except per share data).
FINANCIAL CONDITION 2005 2004 2003 2002 2001 ------------------- -------- -------- -------- -------- -------- ASSETS Cash and demand balances in other banks $ 20,416 $ 18,188 $ 21,425 $ 16,719 $ 15,980 Federal funds sold -- -- -- 7,700 10,800 Securities available for sale 103,432 103,786 108,734 97,380 90,243 Net loans 551,751 491,132 441,323 425,551 374,153 Other assets 38,180 37,245 38,291 26,549 27,526 -------- -------- -------- -------- -------- Total Assets $713,779 $650,351 $609,773 $573,899 $518,702 ======== ======== ======== ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Noninterest bearing deposits $ 88,404 $ 85,598 $ 78,184 $ 71,976 $ 61,845 Interest bearing certificates of deposit of $100,000 or more 68,062 40,057 30,946 28,439 29,462 Other interest bearing deposits 434,186 404,223 393,453 371,135 359,991 -------- -------- -------- -------- -------- Total deposits 590,652 529,878 502,583 471,550 451,298 Short term borrowings 6,376 8,726 8,076 75 1,019 Other borrowings 42,228 42,847 35,375 41,867 12,009 Other liabilities 6,901 6,676 6,356 7,027 6,199 -------- -------- -------- -------- -------- Total Liabilities 646,157 588,127 552,390 520,519 470,525 Shareholders' Equity 67,622 62,224 57,383 53,380 48,177 -------- -------- -------- -------- -------- Total Liabilities and Shareholders' Equity $713,779 $650,351 $609,773 $573,899 $518,702 ======== ======== ======== ======== ========
Page 17
RESULTS OF OPERATIONS 2005 2004 2003 2002 2001 --------------------- ------- ------- ------- ------- ------- Interest income $38,649 $31,720 $30,835 $33,535 $34,400 Interest expense 12,286 8,423 8,507 10,716 14,919 ------- ------- ------- ------- ------- Net Interest Income 26,363 23,297 22,328 22,819 19,481 Provision for loan losses 1,332 1,048 1,069 1,105 722 Noninterest income 11,669 11,010 11,822 9,999 8,641 Noninterest expense 25,195 22,646 22,669 21,644 20,537 ------- ------- ------- ------- ------- Income before Federal income tax 11,505 10,613 10,412 10,069 6,863 Federal income tax 3,181 2,960 3,024 2,934 1,857 ------- ------- ------- ------- ------- Net Income $ 8,324 $ 7,653 $ 7,388 $ 7,135 $ 5,006 ======= ======= ======= ======= ======= Basic earnings per share (1) (2) $ 3.31 $ 3.07 $ 2.99 $ 2.90 $ 2.04 Diluted earnings per share (1) (2) 3.29 3.05 2.97 2.89 2.04 Cash dividends declared per share (2) 1.42 1.30 1.20 1.15 1.07
(1) Earnings per share data is based on average shares outstanding plus average contingently issuable shares. (2) Adjusted to reflect the stock dividends paid in 2005, 2004, 2003, 2002, and 2001. ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is contained on pages A-2 through A-20 hereof, and is incorporated by reference herein. ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is contained on pages A-13 through A-16 hereof, and is incorporated by reference herein. ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Selected Quarterly Financial Data - The information required by this item is contained on page A-3 hereof, and is incorporated by reference herein. Other information required by this item is contained on pages A-22 through A-41 hereof, and is incorporated by reference herein.
INDEX TO FINANCIAL STATEMENTS Page No. ----------------------------- ---------- Report of Independent Registered Public Accounting Firm A-21 Consolidated Financial Statements Consolidated Balance Sheets A-22 Consolidated Statements of Income A-23 Consolidated Statements of Cash Flow A-24 Consolidated Statements of Changes in Shareholders' Equity A-25 Notes to Consolidated Financial Statements A-26--A-40
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None Page 18 ITEM 9A - CONTROLS AND PROCEDURES (a) The term "disclosure controls and procedures" is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the "Exchange Act"). These rules refer to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported, within required time periods. Our Chief Executive Officer and Principal Financial Officer have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report (the "Evaluation Date"), and have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in providing them with material information relating to the Company known to others within the Company which is required to be included in our periodic reports filed under the Exchange Act. (b) The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control system was designed to provide reasonable assurance to the Company's management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of Treadway Commission (COSO) in "Internal Control - Integrated Framework." Based on our assessment we believe that, as of December 31, 2005, the Company's internal control over financial reporting is effective based on those criteria. The Company's independent auditors have issued an audit report on our assessment of the Company's internal control over financial reporting. The report immediately follows this report. /S/ Robert K. Chapman /S/ Dale L. Chadderdon ------------------------------------- ---------------------------------------- Robert K. Chapman Dale L. Chadderdon President and Chief Executive Officer Executive Vice President and Chief Financial Officer (c) To the Shareholders of United Bancorp, Inc.: We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that United Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was Page 19 maintained in all material respects. An audit includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals. A company's internal control over financial reporting includes these policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principals, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention of timely detection or unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatement. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that United Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, United Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of United Bancorp, Inc. and our report dated January 20, 2006, expressed an unqualified opinion thereon. /S/ BKD, LLP ---------------------------------------- BKD, LLP Indianapolis, Indiana January 20, 2006 (d) There has been no change in the Company's internal control over financial reporting that occurred during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to affect, the Company's internal control over financial reporting. ITEM 9B - OTHER INFORMATION None Page 20 PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT On December 9, 2003, the Company adopted a code of ethics (the "Code") that applies to all co-workers, officers and Directors of the Company and its subsidiaries. The Code is designed to deter wrongdoing and to promote: - Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; - Full, fair, accurate, timely and understandable disclosure in reports and documents that the Company files with, or submits to, the Commission and in other public communications made by the registrant; - Compliance with applicable governmental laws, rules and regulations; - Prompt internal reporting of violations of the Code to an appropriate person or persons identified in the Code; and - Accountability for adherence to the Code. A copy of the Code is included in this report as Exhibit 14. The information required by this item, other than as set forth above, is contained under the heading "Directors and Executive Officers, Committees and Meetings of the Board of Directors" and "Beneficial Ownership Reporting Compliance" in the Company's 2006 Proxy Statement and is incorporated herein by reference. ITEM 11 - EXECUTIVE COMPENSATION The information required by this item is contained under the heading "Compensation of Directors and Executive Officers" in the Company's 2006 Proxy Statement and is incorporated herein by reference. ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item is contained under the heading "Equity Compensation Plan Information", "Security Ownership of Certain Beneficial Owners," and "Security Ownership of Management" in the Company's 2006 Proxy Statement and is incorporated herein by reference. ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is contained under the heading "Directors, Executive Officers, Principal Shareholders and their Related Interests - Transactions with the Banks" in the Company's 2006 Proxy Statement and in Note 14 on Page A-35 hereof and is incorporated herein by reference. Page 21 ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item is contained under the heading "Relationship With Independent Public Accountants" in the Company's 2006 Proxy Statement and is incorporated herein by reference. PART IV ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) The following documents are filed as a part of this report:
INDEX TO FINANCIAL STATEMENTS PAGE NO. ----------------------------- ---------- Report of Independent Registered Public Accounting Firm A-21 Consolidated Financial Statements Consolidated Balance Sheets A-22 Consolidated Statements of Income A-23 Consolidated Statements of Cash Flow A-24 Consolidated Statements of Changes in Shareholders' Equity A-25 Notes to Consolidated Financial Statements A-26--A-40
2. Financial statement schedules are not applicable. (b) Listing of Exhibits (numbered as in Item 601 of Regulation S-K): Exhibit # 3(a) Restated Articles of Incorporation of United Bancorp, Inc., filed as Exhibit (4)(a) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference. 3(b) Bylaws of United Bancorp, Inc., filed as Exhibit (4)(b) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference. 4(a) Restated Articles of Incorporation of United Bancorp, Inc., filed as Exhibit (4)(a) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference. 4(b) Bylaws of United Bancorp, Inc., filed as Exhibit (4)(b) to registrant's registration statement on Form S-8 (File Number 333-03305) dated May 8, 1996, and incorporated herein by reference. 4(c) United Bancorp, Inc. Director Retainer Stock Plan, filed as Appendix A to registrant's proxy statement dated March 25, 1996 (file number 0-16640) and incorporated herein by reference. 4(d) United Bancorp, Inc. Senior Management Bonus Deferral Stock Plan, filed as Appendix B to registrant's proxy statement dated March 25, 1996 (file number 0-16640) and incorporated herein by reference. Page 22 Exhibits (continued) 4(e) United Bancorp, Inc. 1999 Stock Option Plan, filed as Appendix B to the Company's proxy statement dated March 24, 2000 (file number 0-16640) and incorporated herein by reference. 4(f) United Bancorp, Inc. 2005 Stock Option Plan, filed as Appendix B to the Company's proxy statement dated March 15, 2004 (file number 0-16640) and incorporated herein by reference. 10.1 Management Agreement effective January 1, 2006, between United Bancorp, Inc. and David S. Hickman, filed as Exhibit C to the Company's Form 8-K dated December 3, 2005 (file number 0-16640) and incorporated herein by reference. 10.2 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Robert K. Chapman, filed as Exhibit 10.1 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.3 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Randal J. Rabe, filed as Exhibit 10.2 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.4 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Dale L. Chadderdon, filed as Exhibit 10.3 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.5 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Todd C. Clark, filed as Exhibit 10.4 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.6 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Thomas C. Gannon, filed as Exhibit 10.5 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.7 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and Jamice W. Guise, filed as Exhibit 10.6 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 10.8 Employment Agreement effective January 1, 2006, between United Bancorp, Inc. and John A. Odenweller, filed as Exhibit 10.7 to the Company's Form 8-K dated January 11, 2006 (file number 0-16640) and incorporated herein by reference. 11 Statement re Computation of Per Share Earnings - this information is incorporated by reference in Note 1 on Page A-29 and Note 19 on Page A-39 hereof. 14 Registrant's Code of Business Conduct and Ethics as adopted December 9, 2003 21 Listing of Subsidiaries, filed herewith. 23 Consent of BKD LLP, Independent Accountants, filed herewith. 24 Power of Attorney contained on the signature pages of the 2005 Annual Report on Form 10-K. Page 23 Exhibits (continued) 31.1 Certification of Principal Executive Officer 31.2 Certification of Principal Accounting Officer 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (d) All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
Date Filed Purpose ---------- ------- October 18, 2005 Relating to press release regarding third quarter 2005 earnings. December 15, 2005 Relating to press release regarding declaration of cash dividend December 23, 2005 Relating to press release regarding entry into material agreement and change in Director or Principal Officer.
Page 24 UNITED BANCORP, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND CONSOLIDATED FINANCIAL STATEMENTS TABLE OF CONTENTS The Business of United Bancorp, Inc. A-2 Management's Discussion and Analysis of Financial Condition and Results of Operations Background A-2 Executive Summary A-3 Results of Operations A-3 Financial Condition A-9 Liquidity, Funds Management and Market Risk A-13 Capital Resources A-16 Contractual Obligations A-17 Prospective Accounting and Regulatory Changes A-17 Critical Accounting Policies A-18 Forward-Looking Statements A-19 Report of Independent Registered Public Accounting Firm A-21 Consolidated Financial Statements Consolidated Balance Sheets A-22 Consolidated Statements of Income A-23 Consolidated Statements of Cash Flows A-24 Consolidated Statements of Changes in Shareholders' Equity A-25 Notes to Consolidated Financial Statements A-26
Page A-1 NATURE OF BUSINESS United Bancorp, Inc. is a Michigan Bank Holding Company headquartered in Tecumseh, Michigan. The Company's subsidiary banks (the "Banks") have local Boards of Directors and are locally managed. The Banks offer a full range of financial services through a system of seventeen banking offices located in Lenawee, Monroe and Washtenaw Counties. While the Company's chief decision makers monitor the revenue streams of the various Company products and services, operations are managed and financial performance is evaluated on a Companywide basis. Accordingly, all of the Company's financial services operations are considered by management to be aggregated in one reportable operating segment. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion provides information about the consolidated financial condition and results of operations of United Bancorp, Inc. (the "Company") and its subsidiary banks (the "Banks"), United Bank & Trust ("UBT") and United Bank & Trust - Washtenaw ("UBTW"). In accordance with Rule 14a-3 (c) of the Securities Exchange Act of 1934 (the "Exchange Act"), the information contained in the narrative and tabular information and in the consolidated financial statements and notes thereto is provided solely for the information of shareholders and the Securities and Exchange Commission (the "Commission"). Such information shall not be deemed to be "soliciting material" or to be "filed" with the Commission or subject to Regulation 14A under the Exchange Act (except as provided in Rule 14a-3) or to the liabilities of Section 18 of the Exchange Act, unless, and only to the extent that, it is expressly incorporated by reference into the Form 10-K of the Company for its fiscal year ended December 31, 2005. BACKGROUND The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act. The Company has corporate power to engage in such activities as permitted to business corporations under the Michigan Business Corporation Act, subject to the limitations of the Bank Holding Company Act and regulations of the Federal Reserve System. The Company's subsidiary banks offer a full range of services to individuals, corporations, fiduciaries and other institutions. Banking services include checking, NOW accounts, savings, time deposit accounts, money market deposit accounts, safe deposit facilities and money transfers. Lending operations provide real estate loans, secured and unsecured business and personal loans, consumer installment loans, and check-credit loans, home equity loans, accounts receivable and inventory financing, equipment lease financing and construction financing. The Company's Banks offer the sale of nondeposit investment products through licensed representatives in their banking offices, and sell credit and life insurance products. In addition, the Company and/or the Banks are co-owners of Michigan Banker's Title Insurance Company of Mid-Michigan LLC, and derive income from the sale of various insurance products to banking clients. UBT operates a trust department, and provides trust services to UBTW on a contract basis. The Trust & Investment Group offers a wide variety of fiduciary services to individuals, corporations and governmental entities, including services as trustee for personal, corporate, pension, profit sharing and other employee benefit trusts. The department provides securities custody services as an agent, acts as the personal representative for estates and as a Page A-2 fiscal, paying and escrow agent for corporate customers and governmental entities, and provides trust services for clients of the Banks. These products help to diversify the Company's sources of income. While unemployment in Michigan remains among the highest in the U.S., the markets served by the Banks are only marginally impacted. In particular, the Ann Arbor market has much lower unemployment levels than does the rest of the State. While recent downturns in the economy have impacted some small companies, in general the Banks have not felt the impact of this decline. In addition, in part through the addition of its Ann Arbor subsidiary in 2001, the Company continues to gain market share in its market areas. EXECUTIVE SUMMARY Net income of the Company for 2005 improved over 2004 as a result of increased net interest income and noninterest income, and in spite of increased noninterest expenses. Net interest income increased significantly, as spread and net interest margin improved as a result of rising interest rates and balance sheet growth. Noninterest income was up from 2004, with most categories experiencing improvement. The Company's provision for loan loss and other expenses were also up from 2004, as a result of continued growth. The second half of 2005 was stronger than the first half of the year, as net interest income continued its steady improvement quarter over quarter. Noninterest income declined slightly in the last two quarters of 2005, and expenses were consistent between quarters. The chart below shows the trends of the major components of earnings for the four quarters of 2005.
in thousands of dollars, where appropriate 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr ------- ------- ------- ------- Net interest income before provision $6,984 $6,710 $6,524 $6,145 Provision for loan losses 378 329 302 323 Noninterest income 2,961 3,060 2,949 2,699 Noninterest expense 6,359 6,294 6,469 6,073 Federal income tax provision 889 882 745 665 Net income $2,319 $2,265 $1,957 $1,783 Return on average assets (a) 1.30% 1.27% 1.14% 1.09% Return on average shareholders' equity (a) 13.77% 13.64% 12.04% 11.45%
(a) Annualized RESULTS OF OPERATIONS Earnings Summary and Key Ratios Consolidated net income improved 8.8% over record levels achieved in 2004, with growth at United Bank & Trust - Washtenaw contributing significantly to that improvement. This percentage increase compares to an increase in 2004 of 3.6% over 2003 levels. Increases in short-term interest rates during the year caused the Company's net interest margin to improve as a result of the asset-sensitive position of the balance sheet. Improvement in margin was also aided by strong growth in loans and deposits, and net interest income improved 13.2% over the prior year, compared to an increase of 4.3% in 2004 over 2003. Page A-3 At the same time, noninterest income increased 6.0% from the levels achieved in 2004. Income from the sale and servicing of residential real estate mortgages in the secondary market was flat from 2004, and income from bank-owned life insurance declined. These reductions of income were more than offset by increases in other areas, as the diversity of the Company's earnings stream was evident. Expenses were up 11.3% from 2004, and the provision for loan loss also increased. The end result was an improvement in net income. Return on average assets was flat compared to 2004, while return on average equity improved slightly compared to 2004. At the same time, book value per share and cash dividends per share continue to provide improving returns to shareholders. The following chart shows trends in these and other ratios. All figures are adjusted to reflect stock dividends.
5 Year Performance Ratios 2005 2004 2003 Average ------ ------ ------ ------- Return on average assets 1.21% 1.21% 1.25% 1.19% Return on average shareholders' equity 12.75% 12.72% 13.30% 12.70% Average equity to average total assets 9.5% 9.5% 9.4% Dividend payout ratio 42.6% 42.0% 39.9% Book value per share $27.12 $25.16 $23.39 Cash dividends per share $1.423 $1.299 $1.201
Book value per share is based on shares outstanding at December 31 of 2,493,238 for 2005, 2,472,852 for 2004 and 2,453,022 for 2003 as adjusted for stock dividends. Dividends per share does not include contingently issuable shares, and is based on average adjusted shares outstanding of 2,489,589 for 2005, 2,469,964 for 2004 and 2,450,702 for 2003, as adjusted for stock dividends. Net Interest Income United Bancorp, Inc. derives the greatest portion of its income from net interest income. As interest rates declined in 2002 and 2003, the Banks took the opportunity to lengthen the maturity of their liabilities, in preparation for possible future increases in interest rates. This had the impact of reducing net interest income in anticipation of rising rates in future periods. While this strategy was basically sound, interest rates did not increase consistently across the yield curve, and the rising rates in 2004 did not improve net interest income as much as if the entire yield curve had shifted up. In 2005, the Banks remained relatively asset-sensitive, and continued increases in short-term rates combined with balance sheet growth. Net interest income increased 13.2% over 2004, compared to an increase of 4.3% in 2004 over 2003. Yields on earning assets improved to 6.18% for 2005, up from 5.79% in 2004, with the greatest portion of that improvement occurring in the loan portfolio. The average cost of funds also increased, but tax equivalent spread moved from 3.82% in 2004 to 3.86% in 2005. Net interest margin experienced similar improvement, moving from 4.12% in 2004 to 4.25% in 2005. The following table provides insight into the various components of net interest income, as well as the results of changes in balance sheet makeup that have impacted the margin. Page A-4 YIELD ANALYSIS OF CONSOLIDATED AVERAGE ASSETS AND LIABILITIES
Dollars in Thousands 2005 2004 2003 -------------------------- -------------------------- -------------------------- Average Yield/ Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Balance Interest Rate -------- -------- ------ -------- -------- ------ -------- -------- ------ ASSETS Interest earning assets (a) Federal funds sold $ 5,762 $ 193 3.35% $ 3,906 $ 51 1.30% $ 19,287 $ 214 1.11% Taxable securities 70,375 2,032 2.89% 75,755 2,058 2.72% 66,860 2,218 3.32% Tax exempt securities (b) 31,937 1,778 5.57% 28,981 1,680 5.80% 30,672 1,791 5.84% Taxable loans 524,156 35,085 6.69% 469,749 28,426 6.05% 424,719 27,138 6.39% Tax exempt loans (b) 3,259 207 6.37% 1,387 92 6.63% 1,385 95 6.85% -------- ------- ---- -------- ------- ---- -------- ------- ---- Total interest earning assets (b) 635,489 $39,297 6.18% 579,778 $32,306 5.57% 542,923 $31,456 5.79% Cash and due from banks 19,024 21,052 17,959 Premises and equipment, net 10,913 14,232 14,375 Intangible assets 3,469 3,469 3,469 Other assets 26,795 20,278 14,823 Unrealized gain on securities available for sale (137) 570 1,434 Allowance for loan losses (6,029) (5,698) (5,256) -------- -------- -------- Total Assets $689,524 $633,681 $589,727 ======== ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Interest bearing liabilities NOW accounts $122,904 $ 1,478 1.20% $115,140 $ 696 0.60% $100,809 $ 633 0.63% Savings deposits 176,582 2,805 1.59% 175,658 1,671 0.95% 164,959 1,614 0.98% CDs $100,000 and over 59,047 2,030 3.44% 38,853 1,138 2.93% 26,783 1,033 3.86% Other int. bearing deposits 124,399 3,971 3.19% 106,496 2,950 2.77% 120,966 3,358 2.78% -------- ------- ---- -------- ------- ---- -------- ------- ---- Total int. bearing deposits 482,932 10,285 2.13% 436,147 6,455 1.48% 413,517 6,638 1.61% Short term borrowings 2,283 74 3.24% 2,447 38 1.55% 138 1 0.62% Other borrowings 42,729 1,927 4.51% 42,343 1,930 4.56% 38,265 1,869 4.88% -------- ------- ---- -------- ------- ---- -------- ------- ---- Total int. bearing liab. 527,944 12,286 2.33% 480,937 8,423 1.75% 451,920 8,508 1.88% ------- ------- ------- Nonint. bearing deposits 86,779 86,156 75,511 Other liabilities 9,539 6,398 6,735 Shareholders' equity 65,262 60,190 55,561 -------- -------- -------- Total Liabilities and Shareholders' Equity $689,524 $633,681 $589,727 ======== ======== ======== Net interest income (b) 27,011 23,883 22,948 Tax-equivalent adjustment 648 586 620 ------- ------- ------- Net interest income, GAAP basis $26,363 $23,297 $22,328 ======= ======= ======= Net spread 3.86% 3.82% 3.91% Net yield on interest earning assets (b) 4.25% 4.12% 4.23% Ratio of interest earning assets to interest bearing liabilities 1.20 1.21 1.20
(a) Non-accrual loans and overdrafts are included in the average balances of loans. (b) Fully tax-equivalent basis, net of nondeductible interest impact; 34% tax rate. Page A-5 The following tables support the fact that the increase in net interest income during 2005 was a result of balance sheet growth, combined with changes in yields and rate. For the year, the net increase in net interest income as a result of changes in volume was three times larger than the increase resulting from changes in rate. These tables demonstrate the effect of volume and rate changes on net interest income on a taxable equivalent basis for the past two years. The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Nonaccrual loans are included in total loans, and changes are treated as volume variances.
2005 compared to 2004 2004 compared to 2003 Increase (decrease) due to: Increase (decrease) due to: --------------------------- --------------------------- In thousands of dollars Volume Rate Net Volume Rate Net ------ ------- ------ ------ ------- ------ Interest earned on: Federal funds sold $ 33 $ 109 $ 142 $ (194) $ 31 $ (163) Taxable securities (151) 126 (25) 272 (433) (161) Tax exempt securities 166 (68) 98 (98) (13) (111) Taxable loans 3,475 3,184 6,659 2,776 (1,488) 1,288 Tax exempt loans 119 (3) 116 -- (3) (3) ------ ------- ------ ------ ------- ------ Total interest income $3,642 $ 3,348 $6,990 $2,756 $(1,906) $ 850 Interest expense on: NOW accounts $ 50 $ 733 $ 783 $ 87 $ (24) $ 63 Savings deposits 9 1,125 1,134 103 (46) 57 Interest bearing CDs of 100,000 or greater 668 224 892 393 (288) 105 Other int. bearing deposits 536 485 1,021 (401) (7) (408) Short term borrowings (3) 39 36 34 3 37 Other borrowings 18 (21) (3) 191 (130) 61 ------ ------- ------ ------ ------- ------ Total interest expense $1,278 $ 2,585 $3,863 $ 407 $ (492) $ (85) ------ ------- ------ ------ ------- ------ Net change in net interest income $2,364 $ 763 $3,127 $2,349 $(1,414) $ 935
Provision for Loan Losses The Company's gross charge-offs within its loan portfolio declined in 2005, following an increase in 2004. At the same time, recoveries were down from 2004 levels, and net charge-offs of $737,000 for 2005 were below the 2004 charge-offs of $779,000. The provision for 2005 was up from the prior two years, exceeding the 2004 figure by 27.1%. This provision provides for currently anticipated losses inherent in the current portfolio, and Management continues to evaluate its allocation methodology to assure that the Banks are adequately protected against these losses. The Company has consistently low to moderate levels of nonperforming loans, and loan loss history continues to compare favorably to peers. The use of an independent loan review function for business loans and careful monitoring of loans by Management allows the Banks to maintain a high level of quality in their loan portfolios. These factors combine with the Company's level of residential real estate loans to support an allowance as a percent of total loans at a level that Management believes is appropriate for the risks in its loan portfolio. Page A-6 Noninterest Income Total noninterest income increased 6.0% in 2005 over 2004. This follows declines of 6.9% and increases of 15.7% in 2004 and 2003, respectively. The following table summarizes changes in noninterest income by category for 2005 and 2004, in thousands of dollars where appropriate. Change in Categories of Noninterest Income
2005 2004 Change 2003 Change ------- ------- ------ ------- ------ Service charges on deposit accounts $ 3,017 $ 2,774 8.8% $ 2,623 5.8% Trust & Investment fee income 3,874 3,754 3.2% 3,104 20.9% Gains (losses) on securities transactions (1) (29) -96.6% 105 -127.6% Income from loan sales and servicing 1,215 1,222 -0.6% 2,988 -59.1% ATM, debit and credit card fee income 1,677 1,469 14.2% 1,442 1.9% Sale of nondeposit investment products 798 721 10.7% 751 -4.0% Bank owned life insurance 398 443 -10.2% 250 77.2% Other income 691 656 5.3% 559 17.4% ------- ------- ----- ------- ------ Total Noninterest Income $11,669 $11,010 6.0% $11,822 -6.9% ======= ======= ===== ======= ======
Service charges on deposit accounts were up 8.8% in 2005, compared to an increase of 5.8% in 2004 and 12.6% in 2003 This is consistent with the fact that total deposits grew 11.5% during 2005, with short-term deposit products making up a smaller portion of total deposits. Those categories of deposits generate fee income, while certificates of deposit do not. 2005 marked the first full year of the Banks' utilization of a High Performance Checking promotion as a method of gathering deposits. Deposit service charges were restructured as a result of this new program. The Trust & Investment Group of UBT continues to provide a steady contribution to the Company's income statement. Trust fee income increased modestly in 2005 compared to 2004, when fee income grew 20.9% over the prior year. Assets managed by the department at December 31, 2005 were $605.9 million, compared to $616.9 million at the end of 2004 and $579.7 million at the end of 2003. The Trust department implemented a small fee increase late in 2004, which provided some benefit to 2005 earnings and helped to offset the decline in asset balances. Future changes in Trust fee income are dependent on the growth of the Department and the market value of assets managed. The Banks generally market their production of fixed rate long-term residential mortgages in the secondary market, and retain adjustable rate mortgages for their portfolios. The Company maintains a portfolio of sold residential real estate mortgages, which it continues to service. This servicing provides ongoing income for the life of the loans. During 2005, clients continued to exhibit a preference for fixed rate loans as market rates declined, resulting in a portion of those loans originated by the Banks being sold in the secondary market. In addition, some of the mortgages previously held on the balance sheets of the Banks were refinanced and sold in the secondary market, providing additional servicing income. Income from loan sales and servicing was virtually flat in 2005 compared to 2004, following a decline of 59.1% in 2004 over 2003. As a result of the continued slowdown in refinancing volume in 2005 and 2004, the Company experienced improved fee income as the write-off of unamortized servicing rights declined with the slowing of the pace of refinancing within the residential real estate mortgage portfolios. As the Company is conservative in its approach to valuation of mortgage servicing rights, no write-downs in mortgage servicing rights were required in 2005, 2004 or 2003 as a result of impairment or other reasons. Page A-7 ATM, debit and credit card fee income continues to provide a steady source of noninterest income for the Company. The Banks operate seventeen ATMs throughout their market areas, and Bank clients are active users of debit cards. The Banks continue to receive ongoing fee income from credit card referrals and operation of its credit card merchant business. Income from these areas was up 14.2% in 2005 over 2004, compared to an increase of 1.9% from 2003 to 2004. Income from the sale of nondeposit investment products is derived from the sale of investments and insurance products to clients, including credit and title insurance policies, annuities, mutual funds and other investment vehicles. This category of income increased 10.7% in 2005 over 2004, following a decline in 2004 compared to 2003. The improvement reflects higher sales volumes, primarily of annuities and mutual fund products. The decline in income from bank-owned life insurance in 2005 reflects yields that have lagged market rates. However, future yields should reflect the recent increases in interest rates. Other noninterest income during the year consisted of income from various fee-based banking services, including sale of official checks, wire transfer fees, safe deposit box income and other fees. This category of noninterest income improved 5.3% from 2004 to 2005, following an increase of 17.4% from 2003 to 2004, with no one area contributing significantly more to the improvement. Overall, total noninterest income increased $659,000 from 2004 to 2005, reflecting the diversity of the Company's noninterest income sources. Management anticipates continued improvement in the future as the sources of noninterest income remain fluid. Noninterest Expense The following table summarizes changes in noninterest expense by category for 2005 and 2004, in thousands of dollars where appropriate. Change in Categories of Noninterest Expense
2005 2004 Change 2003 Change ------- ------- ------ ------- ------ Salaries and employee benefits $14,662 $13,502 8.6% $13,672 -1.2% Occupancy and equipment expense, net 4,074 4,019 1.4% 3,927 2.3% External data processing 1,283 1,125 14.0% 1,208 -6.9% Advertising and marketing 1,106 382 189.5% 360 6.1% Director fees 384 367 4.6% 340 7.9% Other expense 3,686 3,251 13.4% 3,162 2.8% ------- ------- ----- ------- ---- Total Noninterest Expense $25,195 $22,646 11.3% $22,669 -0.1% ======= ======= ===== ======= ====
Total noninterest expenses were up 11.3% in 2005, while total assets grew 9.8% from the end of 2004 to 2005. The largest percentage increases for the year were in external data processing, advertising and marketing expenses. The Company continues to emphasize cost controls, while continuing to make the expenditures necessary to remain competitive. Salaries and benefits are the organization's largest single area of expense. During 2005, this category of expense increased 8.6% from 2004 levels, compared to a decline of 1.2% in 2004 over 2003. Benefits costs continue to be a large contributor to personnel expense, while the amounts paid to co-workers for profit sharing bonuses and 401(k) profit sharing contributions increased in 2005 as the Company exceeded its earnings targets and other objectives. Occupancy and equipment expense increased 1.4% in 2005, compared to an increase of 2.3% in 2004. This modest increase reflects the fact that there were no significant additions to the Company's technology or banking office infrastructure in 2005. Page A-8 Advertising and marketing expenses provided the largest percentage increase in expense for 2005, up 189.5% over 2004. This increase includes costs of the High Performance Checking program, along with the cost of increased marketing and advertising presence in the communities served by the Banks. Other expenses were up 13.4% over 2004, with no one category contributing disproportionately to the increase in expenses. Federal Income Tax The following chart shows the effective federal tax rates of the Company for the past three years, in thousands of dollars where applicable.
Effective Tax Rates 2005 2004 2003 ------------------- ------- ------- ------- Income before tax $11,505 $10,613 $10,412 Federal income tax $ 3,181 $ 2,960 $ 3,024 Effective federal tax rate 27.6% 27.9% 29.0%
The Company's effective federal tax rate for 2005 declined slightly from 2004, continuing the downward trend noted in recent years. Income from bank owned life insurance and tax credits from participation in low-income housing partnerships have helped reduce the Company's federal income taxes. Tax exempt income continues to be a significant factor in the tax calculation for the Company, due to the percentage of the investment portfolio carried in tax exempt municipal securities and loans. The Banks intend to continue to invest in these assets as long as liquidity, safety and tax equivalent yields make them an attractive alternative. FINANCIAL CONDITION Securities Dollars of loan growth in excess of net deposit growth resulted in a slight decline in the Company's securities portfolio during 2005. The makeup of the Company's investment portfolio continues to evolve with the growth of the Company, and the mix of the consolidated investment portfolio has continued to shift to meet liquidity and interest rate risk needs. On a consolidated basis, investment in mortgage backed agency securities declined in 2005, while other categories of investments have increased somewhat. The changes in the various categories of the portfolio are shown in the chart below.
Change in Categories of Securities Portfolio, in thousands of dollars 2005 2004 ---------------------------------- ------- ------- U.S. Treasury and agency securities $ 1,130 $ 1,762 Mortgage backed agency securities (7,665) 4,086 Obligations of states and political subdivisions 6,118 (6,976) Corporate, asset backed and other securities 63 (3,820) ------- ------- Change in total securities $ (354) $(4,948) ======= =======
These changes are also reflected in the percentage makeup of the portfolio. The following chart shows the percentage mix of the securities portfolio.
Percentage Makeup of Securities Portfolio at December 31, 2005 2004 ------------------------------- ----- ----- U.S. Treasury and agency securities 42.2% 41.0% Mortgage backed agency securities 14.4% 21.7% Obligations of states and political subdivisions 40.2% 34.2% Corporate, asset backed and other securities 3.2% 3.1% ----- ----- Total securities 100.0% 100.0% ===== =====
Page A-9 Investments in U.S. Treasury and agency securities are considered to possess low credit risk. Obligations of U.S. government agency mortgage-backed securities possess a somewhat higher interest rate risk due to certain prepayment risks. The municipal portfolio contains a small amount of geographic risk, as approximately 12% of that portfolio is issued by political subdivisions located within Lenawee County, Michigan. The Company's portfolio contains no "high risk" mortgage securities or structured notes. The Company's current and projected tax position continues to make carrying tax-exempt securities valuable to the Banks, and the Company does not anticipate being subject to the alternative minimum tax in the near future. The investment in local municipal issues also reflects the Company's commitment to the development of the local area through support of its local political subdivisions. The chart below summarizes unrealized gains and losses in each category of the portfolio at the end of 2005 and 2004, in thousands of dollars.
Unrealized Gains and Losses in the Investment Portfolio 2005 2004 Change ------------------------------------------------------- ----- ----- ------ U.S. Treasury and agency securities $(403) $(268) $(135) Mortgage backed agency securities (176) (174) (2) Obligations of states and political subdivisions 81 509 (428) Corporate, asset backed and other securities 89 84 5 ----- ----- ----- Total investment securities $(409) $ 151 $(560) ===== ===== =====
Unrealized gains and losses within the investment portfolio are temporary, since they are a result of market changes, rather than a reflection of credit quality. Management has no specific intent to sell any securities, although the entire investment portfolio is classified as available for sale. Loans The Company continues to be a significant provider of loans in its markets. As full service lenders, the Banks offer a variety of loan products in their markets. Loan growth was 12.3% in 2005, as business and personal loan volume continued to be strong. At the same time, refinancing and sale of residential portfolio mortgages continued, causing further declines in that portion of the loan portfolio. The chart below shows the percentage change in each category of the loan portfolio for 2005 and 2004.
Percentage Change in Categories of Loan Portfolio 2005 2004 ------------------------------------------------- ----- ----- Personal 10.0% 5.5% Business 14.8% 8.6% Tax exempt -5.8% 125.3% Residential mortgage -11.8% -10.5% Construction 33.6% 94.4% Total loans 12.3% 11.2%
The volume of mortgage loans generated during 2004 and 2003 reached record levels. During this period, as a result of historically low interest rates available in the market, most residential mortgage clients chose fixed rate mortgage products. Since the Banks sell most of their fixed-rate mortgage loans on the secondary market, this increase in mortgage origination volume was not reflected on the Company's balance sheet. It was instead reflected in its portfolio of loans sold with servicing retained, resulting in improved fee income during the year. That rate of reduction in the mortgage portfolio was anticipated to slow in 2005 as a result of rising rates. However, the yield curve flattened and eventually inverted, extending the attractiveness of long term fixed rate mortgages. As a result of continued refinancing, the Company experienced a 11.8% reduction in portfolio residential mortgages in 2005, compared to a decline of 10.5% in 2004. Page A-10 Construction loan activity increased again in 2005, following a strong year in 2004. Construction loan volume reflects continued growth of the commercial mortgage and residential housing activity in the Company's market area. Residential construction loans will convert to residential mortgages to be retained in the Banks' portfolios or to be sold in the secondary market, while commercial construction loans will eventually be converted to commercial mortgages. Personal loan balances grew 10.0% in 2005, following a 5.5% increase in 2004. Activity in 2005 was in all categories of personal loans, but the largest growth was in home equity loans and lines of credit. Personal loans on the Company's balance sheet include direct and indirect loans for automobiles, boats and recreational vehicles, and other items for personal use. In addition, amounts outstanding in personal lines of credit and home equity loans are included in this loan category. Business loans also experienced excellent growth during 2005, up significantly from the growth experienced in 2004. Total loans outstanding to businesses increased 14.8% in 2005, compared to growth of 8.6% in the prior year. This growth in loans to commercial enterprises is derived from all of the markets the Banks serve, including significant contributions from the Ann Arbor and Dexter markets. Continued participation in tax exempt financing reflects continued involvement in funding local community expansion at local municipalities and school districts, reduced by normal amortizations of loan balances. Tax-exempt declined slightly in 2005, following a large increase in 2004. Credit Quality The Company continues to maintain a high level of asset quality as a result of actively monitoring delinquencies, nonperforming assets and potential problem loans. The aggregate amount of non-performing loans is presented in the table below. For purposes of that summary, loans renewed on market terms existing at the time of renewal are not considered troubled debt restructurings. The accrual of interest income is discontinued when a loan becomes ninety days past due unless it is both well secured and in the process of collection, or the borrower's capacity to repay the loan and the collateral value appear sufficient. The chart below shows the amount of nonperforming assets by category for each of the past five years.
Nonperforming Assets, in thousands of dollars 2005 2004 2003 2002 2001 --------------------------------------------- ------ ------ ------ ------ ------ Nonaccrual loans $5,609 $3,709 $3,635 $1,583 $1,084 Accruing loans past due 90 days or more 1,153 1,674 761 748 1,104 Troubled debt restructurings -- -- -- -- 130 ------ ------ ------ ------ ------ Total nonperforming loans 6,762 5,383 4,396 2,331 2,318 Other real estate 871 844 593 467 179 ------ ------ ------ ------ ------ Total nonperforming assets $7,633 $6,227 $4,989 $2,798 $2,497 ====== ====== ====== ====== ====== Percent of nonperforming loans to total loans 1.21% 1.08% 0.98% 0.54% 0.61% ====== ====== ====== ====== ====== Percent of nonperforming assets to total assets 1.07% 0.96% 0.82% 0.49% 0.48% ====== ====== ====== ====== ======
The Company's percentage of nonperforming loans to total loans increased from 2004 to 2005, primarily reflecting an increase in nonaccrual loans and assets held as other real estate. The unusually high level of delinquent loans at the end of 2004 included balances of just under $600,000 for one loan that were paid current immediately following the end of the year. Collection efforts continue with all delinquent clients, to bring them back to performing status or to finish liquidation. The allowance for loan losses provides adequate allocation for loan losses that may result from shortfalls in these loans. The balance of loans in nonaccrual status was up considerably from 2004 to 2005, but in January of 2006, one large nonaccrual commercial loan was paid off, reducing the Company's level of nonaccrual loans to near December 31, 2004 levels. Loans are generally moved to nonaccrual status when ninety days or more past due or in bankruptcy. Page A-11 The amount listed in the previous table as other real estate reflects three properties that were acquired through foreclosure or in lieu of foreclosure. All are vacant and are for sale, and no significant loss on these properties is anticipated. One of the properties was subsequently sold in January of 2006. Total dollars in this category have increased from 2004 levels, but remain relatively low as a percentage of assets. Credit quality is dependent in part on the makeup of the loan portfolio. The following chart shows the percentage makeup of the loan portfolio.
Percentage Makeup of Loan Portfolio at December 31, 2005 2004 ------------------------- ----- ----- Personal 14.6% 14.9% Business 57.4% 56.1% Tax exempt 0.6% 0.7% Residential mortgage 12.0% 15.3% Construction 15.4% 13.0% ----- ----- Total loans 100.0% 100.0% ===== =====
Loans to finance residential mortgages, including construction loans, make up 27.4% of the portfolio at year-end, compared to 28.3% at the end of 2004. This decline is primarily reflected in reductions in portfolio mortgages that were refinanced and sold on the secondary mortgage market. Loans in this category are well-secured and have had historically low levels of net losses. The personal loan portfolio consists of direct and indirect installment, home equity and unsecured revolving line of credit loans. Installment loans consist primarily of loans for consumer durable goods, principally automobiles. Indirect personal loans consist of loans for automobiles, boats and manufactured housing, but make up a small percent of the personal loans. Business loans carry the largest balances per loan, and therefore, any single loss would be proportionally larger than losses in other portfolios. Because of this, the Banks use an independent loan review firm to assess the continued quality of its business loan portfolio. This is in addition to the precautions taken with credit quality in the other loan portfolios. Business loans consist of approximately 62.5% of loans secured by nonfarm, nonresidential real estate. There are no other significant concentrations in the business loan portfolio. Further information concerning credit quality is contained in Note 6 of the Notes to Consolidated Financial Statements. Deposits Deposit totals increased $60.8 million in 2005, or 11.5% for the year, compared to deposit growth of 5.4% in 2004. Products such as money market deposit accounts, Cash Management Checking and Cash Management Accounts continue to be very popular with clients, aiding in continued deposit growth. Although clients continue to evaluate alternatives to certificates of deposit in search of the best yields on their funds, traditional banking products continue to be an important part of the Company's product line. The Banks do not support their growth through purchased or brokered deposits. The Banks' deposit rates are consistently competitive with other banks in its market area. The majority of the Company's deposits are derived from core client sources, relating to long term relationships with local personal, business and public clients. The following chart shows the percentage change in deposits by category for 2005 and 2004. Page A-12
Percentage Change in Deposits by Category 2005 2004 ----------------------------------------- ---- ---- Noninterest bearing deposits 3.3% 9.5% Interest bearing deposits 13.0% 4.7% Total deposits 11.5% 5.4%
The chart below shows the percentage makeup of the deposit portfolio in 2005 and 2004.
Percentage Breakdown of Deposit Portfolio as of December 31, 2005 2004 ------------------------------- ----- ----- Noninterest bearing deposits 15.0% 16.2% Interest bearing deposits 85.0% 83.8% ----- ----- Total deposits 100.0% 100.0% ===== =====
Cash Equivalents and Borrowed Funds The Company maintains correspondent accounts with a number of other banks for various purposes. In addition, cash sufficient to meet the operating needs of its banking offices is maintained at its lowest practical levels. At times, the Banks are participants in the federal funds market, either as borrowers or sellers. Federal funds are generally borrowed or sold for one-day periods. The Banks also have the ability to utilize short term advances from the Federal Home Loan Bank of Indianapolis ("FHLBI") and borrowings at the discount window of the Federal Reserve Bank as additional short-term funding sources. Federal funds were used during 2005 and 2004, and short term advances and discount window borrowings were not utilized during either year. The Company periodically finds it advantageous to utilize longer term borrowings from the FHLBI. These long-term borrowings, as detailed in Note 11 of the Notes to Consolidated Financial Statements, served to provide a balance to some of the interest rate risk inherent in the Company's balance sheet. Additional information regarding borrowed funds is found in the section below. LIQUIDITY, FUNDS MANAGEMENT AND MARKET RISK Liquidity During 2005, the Company's cash and cash equivalents increased as a result of normal activities within the balance sheet and income statement. Throughout 2005, the Company participated in the federal funds market; at times as a provider of funds and at other times as a purchaser. Funding needs varied throughout the year, and overall, the Company's net excess funds during 2005 were higher than in 2004. The Company averaged net federal funds sold of $3.5 million during 2005, compared to $1.5 million during 2004. These changes were primarily a result of timing differences between loan, investment and deposit growth. Deposits grew $60.8 million in 2005, and FHLB advances declined by $619,000 as a result of maturities in excess of new borrowings. Net portfolio loans increased by $60.6 million, and total investments declined by $354,000. All of these changes contributed to the Company's increase in excess funds. The Banks monitor their liquidity position regularly, and are in compliance with regulatory guidelines for liquidity. The cash flows of the Company are relatively predictable. While loan and deposit cash flows are determined to a large extent by the actions of its clients, the Company is able to control its cash flows with regard to borrowings and investments. The Company has a number of liquidity sources other than deposits, including federal funds and other lines of credit with correspondent banks, securities available for sale, and lines of credit with the FHLB. Information concerning available lines is contained in Note 10 of the Notes to Consolidated Financial Statements. Page A-13 Funds Management and Market Risk The composition of the Company's balance sheet consists of investments in interest earning assets (loans and investment securities) that are funded by interest bearing liabilities (deposits and borrowings). These financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Policies of the Company place strong emphasis on stabilizing net interest margin, with the goal of providing a sustained level of satisfactory earnings. The Funds Management, Investment and Loan policies provide direction for the flow of funds necessary to supply the needs of depositors and borrowers. Management of interest sensitive assets and liabilities is also necessary to reduce interest rate risk during times of fluctuating interest rates. Interest rate risk is the exposure of the Company's financial condition to adverse movements in interest rates. It results from differences in the maturities or timing of interest adjustments of the Company's assets, liabilities and off-balance-sheet instruments; from changes in the slope of the yield curve; from imperfect correlations in the adjustment of interest rates earned and paid on different financial instruments with otherwise similar repricing characteristics; and from interest rate related options embedded in the Company's products such as prepayment and early withdrawal options. A number of measures are used to monitor and manage interest rate risk, including interest sensitivity and income simulation analyses. An interest sensitivity model is the primary tool used to assess this risk, with supplemental information supplied by an income simulation model. The simulation model is used to estimate the effect that specific interest rate changes would have on twelve months of pretax net interest income assuming an immediate and sustained up or down parallel change in interest rates of 200 basis points. Key assumptions in the models include prepayment speeds on mortgage related assets; cash flows and maturities of financial instruments; changes in market conditions, loan volumes and pricing; and management's determination of core deposit sensitivity. These assumptions are inherently uncertain and, as a result, the models cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions. Based on the results of the simulation model as of December 31, 2005, the Company would expect a maximum potential reduction in net interest margin of less than 6% if market rates increased or decreased under an immediate and sustained parallel shift of 200 basis points. During 2004 and 2003, the Company increased its usage of long term fixed rate FHLB advances in order to lock in its cost of funds at historically low rates. In 2005, balances of advances outstanding declined, as noted above. In addition, the Company continued to be asset-sensitive in the twelve-month timeframe based on internal interest sensitivity measures. The following table provides information about the Company's financial instruments used for purposes other than trading that are sensitive to changes in interest rates. For loans, securities, and liabilities with contractual maturities, the table presents principal cash flows and related weighted average interest rates by the earlier of the contractual maturity or call dates as well as market and historical experience of the impact of interest rate fluctuations on the prepayment of mortgage-backed securities. Weighted average variable rates are based on current rates and indexes. The Company currently has no market sensitive instruments entered into for trading purposes and no off-balance-sheet interest rate swaps or caps. The information is in thousands of dollars as of December 31, 2005 and 2004. Page A-14 FINANCIAL INSTRUMENTS AT DECEMBER 31, 2005
Principal Amount Maturing In: ------------------------------------------------ Fair 2006 2007 2008 2009 2010 Thereafter Total Value -------- ------- ------- ------- ------- ---------- -------- -------- RATE-SENSITIVE ASSETS: Fixed Rate: Loans $ 40,937 $39,672 $37,069 $25,458 $35,175 $62,224 $240,535 $235,229 Avg Int. Rate 6.8% 7.1% 6.8% 6.8% 6.8% 5.8% 6.6% Investments $ 57,273 $ 7,868 $ 4,205 $ 2,049 $ 3,465 $15,209 $ 90,069 $ 89,767 Avg Int. Rate 3.4% 3.3% 4.1% 3.6% 5.0% 4.0% 3.6% Variable Rate: Loans $134,500 $33,308 $24,722 $23,781 $18,228 $85,039 $319,578 $319,008 Avg Int. Rate 7.7% 7.1% 6.6% 6.0% 5.5% 7.7% 7.3% Investments $ 5,434 $ 3,682 $ 773 $ 169 $ 129 $ 406 $ 10,593 $ 10,491 Avg Int. Rate 3.1% 3.3% 3.6% 3.9% 3.7% 4.2% 3.3% Other interest earning assets $ 3,176 $ 3,176 $ 3,176 Average interest rate 3.8% 3.8% RATE-SENSITIVE LIABILITIES: Noninterest bearing demand $88,396 $ 88,396 $ 88,396 Savings & interest bearing demand $317,085 $317,085 $317,085 Avg Int. Rate 1.7% 1.7% Time deposits $119,896 $40,891 $14,899 $ 8,644 $ 803 $ 30 $185,163 $186,046 Avg Int. Rate 3.6% 3.8% 3.9% 4.1% 3.0% 0.0% 3.7% Fixed rate borrowings $ 8,021 $20,349 $ 8,940 $ 3,012 $ 1,013 $ 893 $ 42,228 $ 41,848 Avg Int. Rate 4.2% 5.0% 3.9% 3.5% 4.0% 5.2% 4.5% Other interest bearing liabilities $ 6,376 $ 6,376 $ 6,376 Average interest rate 4.3% 4.3%
FINANCIAL INSTRUMENTS AT DECEMBER 31, 2004
Principal Amount Maturing In: ------------------------------------------------ Fair 2005 2006 2007 2008 2009 Thereafter Total Value -------- ------- ------- ------- ------- ---------- -------- -------- RATE-SENSITIVE ASSETS: Fixed Rate: Loans $ 36,945 $30,137 $34,305 $38,045 $24,357 $43,304 $207,093 $209,926 Avg Int. Rate 6.6% 6.8% 7.0% 6.6% 6.7% 6.0% 6.6% Investments $ 40,490 $26,461 $ 7,931 $ 2,868 $ 877 $ 7,784 $ 86,411 $ 86,684 Avg Int. Rate 2.9% 2.9% 3.3% 4.4% 4.4% 5.0% 3.2% Variable Rate: Loans $105,868 $44,543 $16,997 $15,553 $21,270 $85,574 $289,805 $289,940 Avg Int. Rate 5.8% 5.5% 5.1% 4.8% 5.0% 6.4% 5.8% Investments $ 5,329 $ 4,018 $ 1,810 $ 1,001 $ 662 $ 1,288 $ 14,108 $ 13,984 Avg Int. Rate 3.0% 2.9% 3.2% 3.1% 3.1% 3.1% 3.0% Other interest earning assets $ 3,118 $ 3,118 $ 3,118 Average interest rate 3.7% 3.7% RATE-SENSITIVE LIABILITIES: Noninterest bearing demand $85,598 $ 85,598 $ 85,598 Savings & interest bearing demand $314,143 $314,143 $314,143 Avg Int. Rate 1.1% 1.1% Time deposits $ 55,272 $40,630 $23,169 $ 4,708 $ 6,358 $ -- $130,137 $132,033 Avg Int. Rate 2.8% 3.4% 3.6% 3.4% 4.0% 0.0% 3.2% Fixed rate borrowings $ 1,568 $ 8,011 $20,339 $ 8,929 $ 3,000 $ 1,000 $ 42,847 $ 43,336 Avg Int. Rate 3.8% 4.2% 5.0% 3.9% 2.9% 5.6% 4.4% Other interest bearing liabilities $ 8,726 $ 8,726 $ 8,726 Average interest rate 2.4% 2.4%
Page A-15 The Company's primary market risk exposure decreased from 2004 to 2005, based on data supplied by its measurement systems. This market risk exposure is if rates decline. The Company's exposure to market risk is reviewed on a regular basis by the Funds Management Committee. The policy objective is to manage the Company's assets and liabilities to provide an optimum and consistent level of earnings within the framework of acceptable risk standards. The Funds Management Committee is also responsible for evaluating and anticipating various risks other than interest rate risk. Those risks include prepayment risk, credit risk and liquidity risk. The Committee is made up of senior members of management, and continually monitors the makeup of interest sensitive assets and liabilities to assure appropriate liquidity, maintain interest margins and to protect earnings in the face of changing interest rates and other economic factors. The Funds Management policy provides for a level of interest sensitivity which, Management believes, allows the Company to take advantage of opportunities within the market relating to liquidity and interest rate risk, allowing flexibility without subjecting the Company to undue exposure to risk. In addition, other measures are used to evaluate and project the anticipated results of Management's decisions. The following table shows the rate sensitivity of earning assets and interest bearing liabilities as of December 31, 2005. Loans and investments are categorized using the earlier of their scheduled payment, call, or repricing dates, where applicable. Savings, NOW and money market deposit accounts are considered to be immediately repriceable. All other liabilities are reported by their scheduled maturities, and no adjustments for possible prepayments are included in the table. INTEREST SENSITIVITY SUMMARY
Over 10 In thousands of dollars 0-3 Mo. 4-12 Mo. 1-5 Yrs 5-10 Yrs Years Total -------- -------- -------- -------- -------- -------- Securities $ 21,886 $ 47,202 $ 19,543 $13,439 $ 1,362 $103,432 Loans 242,600 55,660 220,679 27,660 11,513 558,112 -------- -------- -------- ------- -------- -------- Total earning assets $264,486 $102,862 $240,222 $41,099 $ 12,875 $661,544 Interest bearing deposits $354,071 $ 82,910 $ 65,237 $ 30 $ -- $502,248 Other borrowings 9,376 5,021 33,315 63 829 48,604 -------- -------- -------- ------- -------- -------- Total interest bearing liabilities $363,447 $ 87,931 $ 98,552 $ 93 $ 829 $550,852 Net asset (liability) interest sensitivity exposure $(98,961) $ 14,931 $141,670 $41,006 $ 12,046 $110,692 Cumulative net asset (liability) exposure $(98,961) $(84,030) $ 57,640 $98,646 $110,692 Cumulative ratio of asset to liability exposure 0.73 0.81 1.10 1.18 1.20 to one Cumulative exposure as a percent of total assets -13.9% -11.8% 8.1% 13.8% 15.5%
CAPITAL RESOURCES It is the policy of the Company to pay 30% to 45% of net earnings as cash dividends to shareholders. The payout ratio for 2005 was 42.6%, compared to 42.0% for 2004. Cash dividends have resulted in a dividend yield of approximately 2.31% and 2.15% in 2005 and 2004, respectively. Five percent stock dividends were paid to shareholders in 2005 and 2004. The stock of the Company is traded over the counter, and the Company is not a member of an organized exchange. Page A-16 The ratios of average equity to average assets of the Banks and the Company increased in 2005 over 2004, as average capital grew at a faster pace than did average assets as a result of strong earnings. The Company's capital ratios exceed the levels required by its regulators, and Management continues to evaluate methods to optimize the high levels of equity of the Company. The table in Note 18 of the Notes to Consolidated Financial Statements details the capital ratios of the Company. The Company and the Banks are considered to be well-capitalized by the regulators. The Company maintains a five year plan, and utilizes a formal strategic planning process. Management and the Board continue to monitor long term goals, which include maintaining capital growth in relation to asset growth, and the retention of a portion of earnings to fund growth while providing a reasonable return to shareholders. Succession planning is in place for Management of the Company, in order to continue the transition relating to the retirement of Chairman and CEO David S. Hickman at the end of 2005. CONTRACTUAL OBLIGATIONS The following table details the Company's known contractual obligations at December 31, 2005, in thousands of dollars: Payments due by period
Less than More than Contractual Obligations 1 year 1-3 years 3-5 years 5 years Total --------- --------- --------- --------- ------- Long term debt (FHLB advances) $8,021 $29,289 $4,025 $1,000 $42,335 Capital lease obligations -- -- -- -- -- Operating lease arrangements 824 1,733 1,571 3,646 7,774 Purchase agreements -- -- -- -- -- ------ ------- ------ ------ ------- Total $8,845 $31,022 $5,596 $4,646 $50,109
PROSPECTIVE ACCOUNTING AND REGULATORY CHANGES In December, 2004, the Financial Accounting Standards Board ("FASB") issued an amendment to Statement of Financial Accounting Standards ("SFAS") 123 (SFAS 123R) which eliminates the ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using a fair value-based method. SFAS 123R will be effective for the Company beginning January 1, 2006. SFAS 123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. The cumulative effect of initially applying this Statement, if any, is recognized as of the required effective date. As of the required effective date, the Company will apply SFAS 123R using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for either recognition or pro forma disclosures. For periods before the required effective date, a company may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by SFAS 123. Page A-17 Management is currently evaluating the effect of the recognition and measurement provisions of SFAS 123R but we currently believe the adoption of SFAS 123R will not result in a material impact on the Company's results of operations or financial condition. Management is not aware of any other trends, events or uncertainties that are likely to have a material effect on the Company's liquidity, capital resources, or operations. In addition, Management is not aware of any current recommendations by regulatory authorities, other than those previously discussed, which would have such an effect. CRITICAL ACCOUNTING POLICIES The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The Company's significant accounting policies are described in detail in the notes to the Company's consolidated financial statements for the year ended December 31, 2005. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company's financial condition and results, and they require management to make estimates that are difficult, subjective, or complex. Allowance for Credit Losses The allowance for credit losses provides coverage for probable losses inherent in the Company's loan portfolio. Management evaluates the adequacy of the allowance for credit losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management's estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs. The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan's observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan's effective interest rate. Regardless of the extent of the Company's analysis of client performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a client's financial condition or changes in their unique business conditions, the judgmental nature of individual Page A-18 loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or client-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company's evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. Mortgage Servicing Rights Mortgage servicing rights ("MSRs") associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets. Goodwill and Other Intangibles The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required by SFAS 141. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line and accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. FORWARD-LOOKING STATEMENTS Statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations 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," "determine," "estimate," "expect," forecast, "intend," "is likely," "plan," "project," "opinion," variations of such terms, and similar expressions are intended to identify such forward-looking statements. The presentations and discussions of the provision and allowance for loan losses and determinations as to the need for other allowances presented in this report are inherently forward-looking statements in that they involve judgments and statements of belief as to the outcome of future events. Page A-19 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 those discussed under "Risk Factors" in Part I, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2005 and generally include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking 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 and customer ability to repay loans; software failure, errors or miscalculations; and the vicissitudes of the national 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. Page A-20 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM United Bancorp, Inc. and Subsidiaries (BKD LLP LOGO) Shareholders and Board of Directors United Bancorp, Inc. Tecumseh, Michigan We have audited the accompanying consolidated balance sheets of United Bancorp, Inc. as of December 31, 2005 and 2004 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of United Bancorp, Inc. as of December 31, 2005 and 2004 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Bancorp, Inc. internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated January 20, 2006 expressed unqualified opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting. (BKD, LLP) BKD, LLP Indianapolis, Indiana January 20, 2006 Page A-21 CONSOLIDATED BALANCE SHEETS United Bancorp, Inc. and Subsidiaries
December 31, ------------------- In thousands of dollars 2005 2004 -------- -------- ASSETS Cash and demand balances in other banks $ 20,416 $ 18,188 Federal funds sold -- -- -------- -------- Total cash and cash equivalents 20,416 18,188 Securities available for sale 103,432 103,786 Loans held for sale 1,060 1,102 Portfolio loans 557,052 495,796 -------- -------- Total loans 558,112 496,898 Less allowance for loan losses 6,361 5,766 -------- -------- Net loans 551,751 491,132 Premises and equipment, net 12,998 13,147 Goodwill 3,469 3,469 Bank-owned life insurance 11,091 10,694 Accrued interest receivable and other assets 10,622 9,935 -------- -------- TOTAL ASSETS $713,779 $650,351 ======== ======== LIABILITIES Deposits Noninterest bearing deposits $ 88,404 $ 85,598 Interest bearing deposits 502,248 444,280 -------- -------- Total deposits 590,652 529,878 Short term borrowings 6,376 8,726 Other borrowings 42,228 42,847 Accrued interest payable and other liabilities 6,901 6,676 -------- -------- TOTAL LIABILITIES 646,157 588,127 -------- -------- COMMITMENTS AND CONTINGENT LIABILITIES SHAREHOLDERS' EQUITY Common stock and paid in capital, no par value; 5,000,000 shares authorized, 2,493,238 shares issued and outstanding in 2005 and 2,355,097 in 2004 63,186 54,133 Retained earnings 4,705 7,992 Accumulated other comprehensive income (loss), net of tax (269) 99 -------- -------- TOTAL SHAREHOLDERS' EQUITY 67,622 62,224 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $713,779 $650,351 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. Page A-22 CONSOLIDATED STATEMENTS OF INCOME United Bancorp, Inc. and Subsidiaries
For the years ended December 31, ----------------------------- In thousands of dollars, except per share data 2005 2004 2003 -------- -------- ------- INTEREST INCOME Loans $35,225 $28,488 $27,202 Securities Taxable 2,032 2,057 2,219 Tax exempt 1,199 1,124 1,200 Federal funds sold 193 51 214 ------- ------- ------- Total interest income 38,649 31,720 30,835 ------- ------- ------- INTEREST EXPENSE Deposits 10,285 6,455 6,637 Short term borrowings 74 38 1 Other borrowings 1,927 1,930 1,869 ------- ------- ------- Total interest expense 12,286 8,423 8,507 ------- ------- ------- NET INTEREST INCOME 26,363 23,297 22,328 Provision for loan losses 1,332 1,048 1,069 ------- ------- ------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 25,031 22,249 21,259 ------- ------- ------- NONINTEREST INCOME Service charges on deposit accounts 3,017 2,774 2,623 Trust & Investment fee income 3,874 3,754 3,104 Gains (losses) on securities transactions (1) (29) 105 Income from loan sales and servicing 1,215 1,222 2,988 ATM, debit and credit card fee income 1,677 1,469 1,442 Sale of nondeposit investment products 798 721 751 Income from bank-owned life insurance 398 443 250 Other income 691 656 559 ------- ------- ------- Total noninterest income 11,669 11,010 11,822 ------- ------- ------- NONINTEREST EXPENSE Salaries and employee benefits 14,662 13,502 13,672 Occupancy and equipment expense, net 4,074 4,019 3,927 External data processing 1,283 1,125 1,208 Advertising and marketing 1,106 382 360 Director fees 384 367 340 Other expense 3,686 3,251 3,162 ------- ------- ------- Total noninterest expense 25,195 22,646 22,669 ------- ------- ------- INCOME BEFORE FEDERAL INCOME TAX 11,505 10,613 10,412 Federal income tax 3,181 2,960 3,024 ------- ------- ------- NET INCOME $ 8,324 $ 7,653 $ 7,388 ======= ======= ======= Basic earnings per share $ 3.31 $ 3.07 $ 2.99 Diluted earnings per share 3.29 3.05 2.97
The accompanying notes are an integral part of these consolidated financial statements. Page A-23 CONSOLIDATED STATEMENTS OF CASH FLOWS United Bancorp, Inc. and Subsidiaries
For the years ended December 31, -------------------------------- In thousands of dollars 2005 2004 2003 --------- -------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 8,324 $ 7,653 $ 7,388 ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FROM OPERATING ACTIVITIES Depreciation and amortization 1,892 2,419 2,827 Provision for loan losses 1,332 1,048 1,069 (Gain) Loss on sale of loans (940) (957) (3,318) Proceeds from sales of loans originated for sale 57,961 66,928 205,844 Loans originated for sale (56,979) (66,983) (194,743) (Gain) Loss on securities transactions 1 29 (105) Deferred income taxes 313 43 202 Increase in cash surrender value on bank owned life insurance (398) (443) (250) (Gain) Loss on investment in limited partnership 234 86 (87) Change in accrued interest receivable and other assets (898) 1,735 (677) Change in accrued interest payable and other liabilities 204 329 (355) -------- -------- --------- Total adjustments 2,722 4,234 10,407 -------- -------- --------- Net cash from operating activities 11,046 11,887 17,795 -------- -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Securities available for sale Purchases (30,664) (50,113) (73,241) Sales -- 4,626 6,358 Maturities and calls 20,688 41,737 47,381 Principal payments 9,423 7,255 6,109 Net increase in portfolio loans (62,484) (51,328) (24,895) Net investment in bank owned life insurance -- -- (10,000) Net premises and equipment expenditures (1,126) (455) (2,165) -------- -------- --------- Net cash from investing activities (64,163) (48,278) (50,453) -------- -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 60,774 27,295 31,033 Net change in short term borrowings (2,350) 650 8,001 Principal payments on other borrowings (1,569) (528) (9,492) Proceeds from other borrowings 950 8,000 3,000 Proceeds from common stock transactions 987 880 262 Dividends paid (3,447) (3,143) (3,140) -------- -------- --------- Net cash from financing activities 55,345 33,154 29,664 -------- -------- --------- NET CHANGE IN CASH AND CASH EQUIVALENTS 2,228 (3,237) (2,994) Cash and cash equivalents at beginning of year 18,188 21,425 24,419 -------- -------- --------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 20,416 $ 18,188 $ 21,425 ======== ======== ========= SUPPLEMENTAL DISCLOSURES: Interest paid $ 11,571 $ 8,373 $ 8,673 Income tax paid 3,100 2,450 2,800 Loans transferred to other real estate 491 1,483 271
The accompanying notes are an integral part of these consolidated financial statements. Page A-24 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY United Bancorp, Inc. and Subsidiaries For the years ended December 31, 2005, 2004, 2003
IN THOUSANDS OF DOLLARS, Common Retained EXCEPT PER SHARE DATA Shares Stock (1) Earnings AOCI (2) Total --------- --------- -------- -------- ------- Balance, January 1, 2003 2,114,765 $39,122 $12,977 $1,281 $53,380 Net income, 2003 7,388 7,388 Other comprehensive income: Net change in unrealized gains (losses) on securities available for sale, net (701) (701) ------- Total comprehensive income 6,687 Cash dividends declared, $1.201 per share (2,946) (2,946) Five percent stock dividend declared 105,737 6,344 (6,344) -- Common stock transactions 4,461 46 46 Tax effect of options exercised 82 82 Director and management deferred stock plans 215 (81) 134 --------- ------- ------- ------ ------- Balance, December 31, 2003 2,224,963 $45,809 $10,994 $ 580 $57,383 Net income, 2004 7,653 7,653 Other comprehensive income: Net change in unrealized gains (losses) on securities available for sale, net (481) (481) ------- Total comprehensive income 7,172 Cash dividends declared, $1.299 per share (3,211) (3,211) Five percent stock dividend declared 111,776 7,321 (7,321) -- Common stock transactions 18,358 615 615 Tax effect of options exercised 188 188 Director and management deferred stock plans 200 (123) 77 --------- ------- ------- ------ ------- Balance, December 31, 2004 2,355,097 $54,133 $ 7,992 $ 99 $62,224 Net income, 2005 8,324 8,324 Other comprehensive income (loss): Net change in unrealized gains (losses) on securities available for sale, net (368) (368) ------- Total comprehensive income 7,956 Cash dividends declared, $1.423 per share (3,545) (3,545) Five percent stock dividend declared 118,681 7,952 (7,952) -- Common stock transactions 19,460 527 527 Tax effect of options exercised 265 265 Director and management deferred stock plans 309 (114) 195 --------- ------- ------- ------ ------- Balance, December 31, 2005 2,493,238 $63,186 $ 4,705 $ (269) $67,622 ========= ======= ======= ====== =======
(1) Includes Paid In Capital (2) Accumulated Other Comprehensive Income (Loss), Net of Tax The accompanying notes are an integral part of these consolidated financial statements. Page A-25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS United Bancorp, Inc. and Subsidiaries NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES NATURE OF OPERATIONS AND BASIS OF PRESENTATION The consolidated financial statements include the accounts of United Bancorp, Inc. ("Company") and its wholly owned subsidiaries, United Bank & Trust and United Bank & Trust - Washtenaw ("Banks"), after elimination of significant intercompany transactions and accounts. The Company is engaged 100% in the business of commercial and retail banking, including insurance, and trust and investment services, with operations conducted through its offices located in Lenawee, Washtenaw, and Monroe Counties in southeastern Michigan. These counties are the source of substantially all of the Company's deposit, loan, insurance and trust activities. USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period as well as affecting the disclosures provided. Actual results could differ from those estimates. The allowance for loan losses and the fair values of financial instruments are particularly subject to change. SECURITIES Securities available for sale consist of bonds and notes which might be sold prior to maturity. Securities classified as available for sale are reported at their fair values and the related net unrealized holding gain or loss is reported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried at cost. Premiums and discounts on securities are recognized in interest income using the interest method over the period to maturity. Realized gains or losses are based upon the amortized cost of the specific securities sold. LOANS HELD FOR SALE Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or market value in the aggregate. Net unrealized losses, if any, are recognized in a valuation allowance by charges to income. LOANS Loans that Management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and the allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Loans are placed on non-accrual status at ninety days or more past due and interest is considered a loss, unless the loan is well-secured and in the process of collection. Page A-26 ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level believed adequate by Management to absorb probable incurred credit losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, amount and composition of the loan portfolio, and other factors. The allowance is increased by provisions for loan losses charged to income. Loan losses are charged against the allowance when Management believes the uncollectability of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance. Loan impairment is reported when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan's existing rate, or the fair value of collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require increase, such increase is reported as a component of the provision for loan losses. Loans are evaluated for impairment when payments are delayed or when the internal grading system indicates a substandard or doubtful classification. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage, consumer, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. When credit analysis of borrower operating results and financial condition indicates that underlying cash flows of the borrower's business are not adequate to meet its debt service requirements, including the Banks' loans to the borrower, the loan is evaluated for impairment. Often this is associated with a delay or shortfall of payments of thirty days or more. Loans are generally moved to nonaccrual status when ninety days or more past due or in bankruptcy. These loans are often also considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible. This typically occurs when the loan is 120 or more days past due unless the loan is both well-secured and in the process of collection. PREMISES AND EQUIPMENT Premises and equipment are stated at cost, less accumulated depreciation. The provisions for depreciation are computed principally by the straight line method, based on useful lives of ten to forty years for premises and three to eight years for equipment. OTHER REAL ESTATE OWNED Other real estate consists of properties acquired through foreclosure or acceptance of a deed in lieu of foreclosure and property acquired for possible future expansion. Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value, less estimated selling costs, at the date of foreclosure establishing a new cost basis. After foreclosure, valuations are periodically performed and the real estate is carried at the lower of cost basis or fair value, less estimated selling costs. The historical average holding period for such properties is less than eighteen months. As of December 31, 2005 and 2004, other real estate owned totaled $871,000 and $844,000, and is included in other assets on the consolidated balance sheets. GOODWILL Goodwill is tested annually for impairment. If the implied fair value of goodwill is lower than its carrying amount, a goodwill impairment is indicated and goodwill is written down to its implied fair value. Subsequent increases in goodwill value are not recognized in the financial statements. Page A-27 SERVICING RIGHTS Servicing rights are recognized as assets for the allocated value of retained servicing on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates, remaining loan terms and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance. LONG-TERM ASSETS Long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are written down to discounted amounts. INCOME TAX The Company records income tax expense based on the amount of taxes due on its tax return plus deferred taxes computed based on the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, using enacted tax rates, adjusted for allowances made for uncertainty regarding the realization of deferred tax assets. EARNINGS PER SHARE Amounts reported as earnings per share are based upon the weighted average number of shares outstanding plus the weighted average number of contingently issuable shares associated with the Directors' and Senior Management Group's deferred stock plans. In 2005, 2004 and 2003, the Company paid five percent stock dividends. Earnings per share, dividends per share, and weighted average shares have been restated to reflect the stock dividends. STOCK BASED COMPENSATION At December 31, 2005, the Company has a stock-based employee compensation plan, which is described more fully in Note 16. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the grant date. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.
In thousands of dollars, except per share data 2005 2004 2003 ------ ------ ------ Net income, as reported $8,324 $7,653 $7,388 Less: Total stock-based employee compensation cost determined under the fair value based method, net of taxes (128) (70) (86) ------ ------ ------ Pro forma net income $8,196 $7,583 $7,302 Earning per share: Basic As reported $ 3.31 $ 3.07 $ 2.99 Basic Pro forma 3.26 3.04 2.95 Diluted As reported 3.29 3.05 2.97 Diluted Pro forma 3.24 3.02 2.93 ====== ====== ======
Page A-28 For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Based on the use of estimates and the subjective nature of the assumptions used, the information presented above may not be representative of the pro forma impact in future years. STATEMENTS OF CASH FLOWS For purposes of this Statement, cash and cash equivalents include cash on hand, demand balances with banks, and federal funds sold. Federal funds are generally sold for one day periods. The Company reports net cash flows for client loan and deposit transactions, deposits made with other financial institutions, and short term borrowings with an original maturity of ninety days or less. COMPREHENSIVE INCOME Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes net unrealized gains and losses on securities available for sale, net of tax, which are also recognized as separate components of shareholders' equity. INDUSTRY SEGMENT The Company and its subsidiaries are primarily organized to operate in the banking industry. Substantially all revenues and services are derived from banking products and services in southeastern Michigan. While the Company's chief decision makers monitor various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's banking operations are considered by Management to be aggregated in one business segment. NOTE 2 - RESTRICTIONS ON CASH AND DEMAND BALANCES IN OTHER BANKS The Banks are subject to average reserve and clearing balance requirements in the form of cash on hand or balances due from the Federal Reserve Bank. These reserve balances vary depending on the level of client deposits in the Banks. The amounts of reserve and clearing balances required at December 31, 2005 and 2004 totaled approximately $25,000 and $25,000. NOTE 3 - SECURITIES The fair value of securities as of December 31, 2005 and 2004 are as follows, in thousands of dollars:
SECURITIES AVAILABLE FOR SALE Fair Value Gains Losses ---------- ----- ------ 2005 U.S. Treasury and agency securities $ 43,692 $ 6 $(409) Mortgage backed agency securities 14,865 27 (203) Obligations of states and political subdivisions 41,610 402 (321) Corporate, asset backed and other securities 3,265 89 -- -------- ---- ----- Total $103,432 $524 $(933) ======== ==== ===== 2004 U.S. Treasury and agency securities $ 42,562 $ 9 $(277) Mortgage backed agency securities 22,530 103 (277) Obligations of states and political subdivisions 35,492 586 (77) Corporate, asset backed and other securities 3,202 84 -- -------- ---- ----- Total $103,786 $782 $(631) ======== ==== =====
Page A-29 The Company's temporarily impaired investment securities as of December 31, 2005 and 2004 are shown below.
Less than 12 Months 12 Months or Longer Total ------------------- ------------------- ------------------- In thousands of dollars Fair Value Losses Fair Value Losses Fair Value Losses ---------- ------ ---------- ------ ---------- ------ 2005 U.S. Treasury and agency securities $13,974 $ (97) $27,021 $(312) $40,995 $(409) Mortgage backed agency securities 1,847 (10) 10,188 (193) 12,035 (203) Obligations of states and political subdivisions 15,899 (238) 10,042 (83) 25,941 (321) ------- ----- ------- ----- ------- ----- Total $31,720 $(345) $47,251 $(588) $78,971 $(933) ======= ===== ======= ===== ======= ===== 2004 U.S. Treasury and agency securities $33,638 $(219) $ 4,837 $ (58) $38,475 $(277) Mortgage backed agency securities 10,099 (154) 8,038 (123) 18,137 (277) Obligations of states and political subdivisions 7,938 (57) 4,178 (20) 12,116 (77) ------- ----- ------- ----- ------- ----- Total $51,675 $(430) $17,053 $(201) $68,728 $(631) ======= ===== ======= ===== ======= =====
Unrealized losses within the investment portfolio are temporary, as they are a result of market changes rather than a reflection of credit quality. Management has no specific intent to sell any securities, although the entire investment portfolio is classified as available for sale. Sales activities for securities for the years indicated are shown in the following table. All sales were of securities identified as available for sale.
In thousands of dollars 2005 2004 2003 ---- ------ ------ Sales proceeds $-- $4,626 $6,358 Gross gains on sales -- -- 105 Gross gains (losses) on calls (1) (29) --
The fair value of securities available for sale by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Asset-backed securities are included in periods based on their estimated lives.
In thousands of dollars Fair Value ---------- As of December 31, 2005 Due in one year or less $ 53,444 Due after one year through five years 31,062 Due after five years through ten years 13,824 Due after ten years 1,838 Equity securities 3,264 -------- Total securities $103,432 ========
Securities carried at $15,090,000 and $18,493,000 as of December 31, 2005 and 2004 were pledged to secure deposits of public funds, funds borrowed, repurchase agreements, and for other purposes as required by law. Page A-30 NOTE 4 - LOANS The table below shows total loans outstanding, including loans held for sale, at December 31. All loans are domestic and contain no concentrations by industry or client.
In thousands of dollars 2005 2004 -------- -------- Personal $ 81,571 $ 74,142 Business, including commercial mortgages 320,188 278,838 Tax exempt 3,133 3,325 Residential mortgage 66,186 75,126 Residential mortgages held for sale 1,060 1,102 Construction 85,975 64,365 -------- -------- Total loans $558,112 $496,898 ======== ========
At December 31, 2005 and 2004, accruing loans delinquent 90 days or more totaled $1,153,000 and $1,674,000. Non-accruing loans at December 31, 2005 and 2004 were $5,609,000 and $3,709,000. NOTE 5 - ALLOWANCE FOR LOAN LOSSES An analysis of the allowance for loan losses for the years ended December 31 follows:
In thousands of dollars 2005 2004 2003 ------ ------- ------ Balance, January 1 $5,766 $ 5,497 $4,975 Loans charged off (879) (1,066) (670) Recoveries credited to allowance 142 287 123 Provision charged to operations 1,332 1,048 1,069 ------ ------- ------ Balance, December 31 $6,361 $ 5,766 $5,497 ====== ======= ======
Information regarding impaired loans for the years ended December 31 follows:
In thousands of dollars 2005 2004 2003 ------ ------- ------ Average investment in impaired loans $8,295 $ 8,668 $4,283 Interest income recognized on impaired loans 216 192 121 Interest income recognized on a cash basis 216 192 121 Balance of impaired loans at December 31 $7,957 $10,045 $3,694 Portion for which no allowance for loan losses is allocated 2,394 2,668 1,059 Portion for which an allowance for loan losses is allocated 5,563 7,377 2,635 Portion of allowance for loan losses allocated to impaired loans 1,087 1,579 782 ====== ======= ======
NOTE 6 - LOAN SERVICING Mortgage loans serviced for others are not included in the accompanying consolidated financial statements. The unpaid principal balance of mortgage loans serviced for others was $237,221,000 and $256,357,000 at December 31, 2005 and 2004. The balance of loans serviced for others related to servicing rights that have been capitalized was $235,512,000 and $254,562,000 at December 31, 2005 and 2004. No valuation allowance was considered necessary at December 31, 2005 and 2004. Unamortized cost of mortgage servicing rights for the years ended December 31 was as follows:
In thousands of dollars 2005 2004 2003 ------ ------ ------ Balance, January 1 $1,820 $1,832 $1,352 Amount capitalized 171 377 1,406 Amount amortized (346) (389) (926) ------ ------ ------ Balance, December 31 $1,645 $1,820 $1,832 ====== ====== ======
Page A-31 NOTE 7 - PREMISES AND EQUIPMENT Depreciation expense was approximately $1,275,000 in 2005, $1,344,000 in 2004 and $1,430,000 in 2003. Premises and equipment as of December 31 consisted of the following:
In thousands of dollars 2005 2004 ------ ------- Land $ 1,580 $ 1,579 Buildings and improvements 13,772 13,615 Furniture and equipment 12,339 11,472 Total cost 27,691 26,666 Less accumulated depreciation (14,693) (13,519) ------- ------- Premises and equipment, net $12,998 $13,147 ======= =======
The company has several noncancellable operating leases, primarily for banking facilities, that expire over the next fifteen years. The leases generally contain renewal options for periods ranging from one to five years. Rental expense for these leases was $710,000, $630,000 and $567,000 for the years ended December 31, 2005, 2004 and 2003, respectively. Future minimum lease payments under operating leases are:
In thousands of dollars 2006 $ 824 2007 871 2008 862 2009 806 2010 765 Thereafter 3,646 ------ Total Minimum Lease Payments $7,774 ======
NOTE 8 - GOODWILL The Company follows the provisions of Statement of Financial Accounting Standards No. 142 and Statement of Financial Accounting Standards No. 147 with regard to accounting and financial reporting for goodwill and other intangible assets. There was no impairment of goodwill in 2005, 2004 or 2003. NOTE 9 - DEPOSITS Information relating to maturities of time deposits as of December 31 is summarized below:
In thousands of dollars 2005 2004 -------- -------- Within one year $119,926 $ 55,272 Between one and two years 40,891 40,630 Between two and three years 14,899 23,168 Between three and four years 8,644 4,708 Between four and five years 803 6,359 More than five years -- -- -------- -------- Total time deposits $185,163 $130,137 ======== ======== Interest bearing time deposits in denominations of $100,000 or more $ 68,062 $ 40,057 ======== ========
NOTE 10 - SHORT TERM BORROWINGS The Company has several credit facilities in place for short term borrowing which are used on occasion as a source of liquidity. These facilities consist of borrowing authority totaling $45.9 million from correspondent banks to purchase federal funds on a daily basis. There was $6.3 and $8.7 million of fed funds purchased outstanding at December 31, 2005 and 2004. Page A-32 The Banks may also enter into sales of securities under agreements to repurchase (repurchase agreements). These agreements generally mature within one to 120 days from the transaction date. U.S. Treasury, agency and other securities involved with the agreements are recorded as assets and are generally held in safekeeping by correspondent banks. Repurchase agreements are offered principally to certain clients as an investment alternative to deposit products. The maximum amount of outstanding agreements at any month end during 2005 and 2004 totaled $76,000 and $76,000 and the daily average of such agreements totaled $76,000 and $76,000. The balance outstanding at December 31, 2005 and 2004 was $76,000 and $76,000. NOTE 11 - OTHER BORROWINGS The Banks carried fixed rate, noncallable advances from the Federal Home Loan Bank of Indianapolis totaling $42.2 million and $42.8 million at December 31, 2005 and 2004. As of December 31, 2005, the rates on the advances ranged from 2.69% to 6.18% with a weighted average rate of 4.49%. These advances are primarily collateralized by residential mortgage loans under a blanket security agreement. The unpaid principal balance of the loans pledged as collateral must equal at least 145% of the funds advanced. Interest payments are made monthly, with principal due annually and at maturity. If principal payments are paid prior to maturity, advances are subject to a prepayment penalty. Maturities and scheduled principal payments for other borrowings over the next five years as of December 31 are shown below.
In thousands of dollars 2005 2004 ------- ------- Within one year $ 8,021 $ 1,568 Between one and two years 20,350 8,011 Between two and three years 8,940 20,339 Between three and four years 3,012 8,929 Between four and five years 1,013 3,000 More than five years 892 1,000 ------- ------- Total $42,228 $42,847 ======= =======
NOTE 12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Banks are party to financial instruments with off-balance-sheet risk in the normal course of business to meet financing needs of their clients. These financial instruments include commitments to make loans, unused lines of credit, and letters of credit. The Banks' exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Banks follow the same credit policy to make such commitments as is followed for loans and investments recorded in the consolidated financial statements. The Banks' commitments to extend credit are agreements at predetermined terms, as long as the client continues to meet specified criteria, with fixed expiration dates or termination clauses. The following table shows the commitments to make loans and the unused lines of credit available to clients at December 31:
2005 2004 ----------------- ----------------- Variable Fixed Variable Fixed In thousands of dollars Rate Rate Rate Rate -------- ------ -------- ------ Commitments to make loans $ 26,179 $7,580 $18,290 $5,200 Unused lines of credit 109,677 3,362 97,445 3,677 Standby letters of credit 9,866 -- 7,964 --
Commitments to make loans generally expire within thirty to ninety days, while unused lines of credit expire at the maturity date of the individual loans. At December 31, 2005, the rates for amounts in the fixed rate category ranged from 5.63% to 7.88%. Page A-33 In December 2001, United Bank & Trust ("UBT") entered into a limited partnership agreement to purchase tax credits awarded from the construction, ownership and management of an affordable housing project and a residual interest in the real estate. As of December 31, 2005 and 2004, the total recorded investment including the obligation to make additional future investments amounted to $1,895,000 and $2,208,000 and was included in other assets. As of December 31, 2005 and 2004, the obligation of UBT to the limited partnership amounted to $1,831,000 and $1,908,000 which was reported in other liabilities. While UBT is a 99% partner, the investment is accounted for on the equity method as UBT is a limited partner and has no control over the operation and management of the partnership or the affordable housing project. NOTE 13 - FEDERAL INCOME TAX Income tax expense consists of the following for the years ended December 31:
In thousands of dollars 2005 2004 2003 ------ ------ ------ Current $2,868 $2,917 $2,822 Deferred 313 43 202 ------ ------ ------ Total income tax expense $3,181 $2,960 $3,024 ====== ====== ======
The components of deferred tax assets and liabilities at December 31, are as follows:
In thousands of dollars 2005 2004 ------ ------ Deferred tax assets: Allowance for loan losses $2,163 $1,851 Deferred compensation 592 494 Other 169 140 ------ ------ Total deferred tax assets 2,924 2,485 ====== ======
2005 2004 ------ ------ Deferred tax liabilities: Property and equipment (383) (451) Mortgage servicing rights (559) (619) Unrealized appreciation on securities available for sale (49) (51) Other (1,168) (912) ------ ------ Total deferred tax liabilities (2,159) (2,033) ------ ------ Net deferred tax asset $ 765 $ 452 ====== ======
No valuation allowance was considered necessary at December 31, 2005 and 2004. A reconciliation between total federal income tax and the amount computed through the use of the federal statutory tax rate for the years ended is as follows:
In thousands of dollars 2005 2004 2003 ------ ------ ------ Income taxes at statutory rate of 34% $3,912 $3,608 $3,540 Non-taxable income, net of nondeductible interest expense (427) (387) (411) Income on non-taxable bank owned life insurance (135) (151) (85) Affordable housing credit (184) (132) (36) Other 15 22 16 ------ ------ ------ Total federal income tax $3,181 $2,960 $3,024 ====== ====== ======
Page A-34 NOTE 14 - RELATED PARTY TRANSACTIONS Certain directors and executive officers of the Company and the Banks, including their immediate families and companies in which they are principal owners, are clients of the Banks. Loans to these parties did not, in the opinion of Management, involve more than normal credit risk or present other unfavorable features. The aggregate amount of these loans at December 31, 2004 was $43,349,000. During 2005, new and newly reportable loans to such related parties amounted to $15,055,000 and repayments amounted to $12,339,000, resulting in a balance at December 31, 2005 of $46,065,000. Related party deposits totaled $13,062,000 and $11,078,000 at December 31, 2005 and 2004. NOTE 15 - RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS OR ADVANCES Banking laws and regulations restrict the amount the Banks can transfer to the Company in the form of cash dividends and loans. At December 31, 2005, $16.3 million of retained earnings of the Banks were available for distribution to the Company as dividends without prior regulatory approval. It is not the intent of Management to pay dividends in amounts which would reduce the capital of the Banks to a level below that which is considered prudent by Management and in accordance with the guidelines of regulatory authorities. NOTE 16 - EMPLOYEE BENEFIT PLANS EMPLOYEE SAVINGS PLAN The Company maintains a 401(k) employee savings plan ("plan") which is available to substantially all employees. Individual employees may make contributions to the plan up to 100% of their compensation up to a maximum of $14,000 for 2005, 2004 and 2003. The Banks offers discretionary matching of funds for a percentage of the employee contribution, plus an amount based on Company earnings. The expense for the plan for 2005, 2004, and 2003 was $918,000, $791,000 and $898,000. The plan offers employees the option of purchasing Company stock with the match portion of their 401(k) contribution. On that basis 2,356 shares in 2005, 2,746 shares in 2004 and no shares in 2003 of United Bancorp, Inc. common stock were issued to the 401(k) plan for the benefit of plan participants who so elected Company stock for their match. DIRECTOR RETAINER STOCK PLAN The Company maintains a deferred compensation plan designated as the Director Retainer Stock Plan. The plan provides eligible directors of the Company and the Banks with a means of deferring payment of retainers and certain fees payable to them for Board service. Under the Director Plan, any retainers or fees elected to be deferred under the plan by an eligible director ultimately will be payable in common stock at the time of payment. SENIOR MANAGEMENT BONUS DEFERRAL STOCK PLAN The Company maintains a deferred compensation plan designated as the Senior Management Bonus Deferral Stock Plan. The Management Plan has essentially the same purposes as the Director Plan discussed above and permits eligible employees of the Company and its affiliates to elect cash bonus deferrals and, after employment termination, to receive payouts in whole or in part in the form of common stock on terms substantially similar to those of the Director Plan. Page A-35 STOCK OPTIONS In 2000, Shareholders approved the Company's 1999 Stock Option Plan (the "1999 Plan"). The plan is a non-qualified stock option plan as defined under Internal Revenue Service regulations. Under the plan, directors and management of the Company and subsidiaries are given the right to purchase stock of the Company at a stipulated price, adjusted for stock dividends, over a specific period of time. The 1999 Plan was in effect until the end of 2004. In 2004, Shareholders approved the Company's 2005 Stock Option Plan, which became effective January 1, 2005. The stock subject to the options are shares of authorized and unissued common stock of the Company. As defined in the 2005 plan, options representing no more than 183,750 shares (adjusted for stock dividends declared) are to be made available to the plan, and substantially all options under the 1999 Plan have been granted. Options under both plans are granted to directors and certain key members of management at the then-current market price at the time the option is granted. The options have a three-year vesting period, and with certain exceptions, expire at the end of ten years, or three years after retirement. The following table summarizes option activity for both plans, adjusted for stock dividends:
2005 2004 2003 ------------------ ------------------ ------------------ Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price ------- -------- ------- -------- ------- -------- Balance, January 1 106,025 $45.75 107,523 $41.34 92,403 $38.70 Options granted 53,500 63.88 24,595 57.14 29,933 47.94 Options exercised (36,203) 42.61 (26,093) 38.33 (11,575) 36.49 Options forfeited (2,188) 55.70 -- -- (3,238) 4.21 ------- ------ ------- ------ ------- ------ Balance, December 31 121,134 $54.51 106,025 $45.75 107,523 $41.34 ======= ====== ======= ====== ======= ====== Options exercisable at year-end 43,451 $43.54 55,799 $40.36 55,488 $38.04 Weighted average fair value of options granted during the year $ 6.79 $ 5.20 $ 3.56
The following table provides information regarding stock options under the plan at December 31, 2005:
Options Outstanding Options Exercisable ------------------------------------------------ ---------------------------- Weighted Weighted Weighted Number Average Remaining Average Number Average Range of Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price ----------- ----------------- -------------- ----------- -------------- $35.82 to $67.50 121,134 7.66 Years $54.51 43,451 $43.54 Balance, December 31 121,134 7.66 Years $54.51 43,451 $43.54
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions:
2005 2004 2003 ------- ------- ------- Dividend yield 2.08% 2.15% 2.47% Expected life 5 years 5 years 5 years Expected volatility 8.67% 8.88% 7.55% Risk-free interest rate 3.64% 3.05% 3.14%
Page A-36 NOTE 17 - FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and estimated fair value of principal financial assets and liabilities were as follows:
As of December 31, 2005 2004 ---------------------- ---------------------- Carrying Carrying In thousands of dollars Value Fair Value Value Fair Value --------- ---------- --------- ---------- Financial Assets Cash and cash equivalents $ 20,416 $ 20,416 $ 18,188 $ 18,188 Securities available for sale 103,432 103,432 103,786 103,786 Net loans 551,751 547,876 491,132 494,100 Bank owned life insurance 11,091 11,091 10,694 10,694 Accrued interest receivable 3,521 3,521 2,777 2,777 Financial Liabilities Total deposits $(590,652) $(592,810) $(529,878) $(531,774) Short term borrowings (6,376) (6,376) (8,726) (8,726) Other borrowings (42,228) (41,848) (42,847) (43,336) Accrued interest payable 1,337 1,337 (622) (622)
Estimated fair values require subjective judgments and are approximate. The above estimates of fair value are not necessarily representative of amounts that could be realized in actual market transactions, nor of the underlying value of the Company. Changes in the following methodologies and assumptions could significantly affect the estimated fair value: Cash and cash equivalents, accrued interest receivable and accrued interest payable - Due to the short periods to maturity, the carrying amounts are reasonable estimates of the fair values of these instruments at the respective balance sheet dates. Securities available for sale - Fair values for securities available for sale are based on quoted market prices, if available. If quoted values are not available, the estimated fair value is determined by using quoted market prices for similar securities. Net loans - The carrying amount is a reasonable estimate of fair value for personal loans for which rates adjust quarterly or more frequently, and for business and tax exempt loans which are prime related and for which rates adjust immediately or quarterly. The fair value for residential mortgage loans which are held for sale on the secondary market is the price offered by the secondary market purchaser. The fair value of all other loans is estimated by discounting future cash flows using current rates for loans with similar characteristics and maturities. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. Bank owned life insurance - The carrying value is a reasonable approximation of fair value. Total deposits - With the exception of certificates of deposit, the carrying value is deemed to be the fair value due to the demand nature of the deposits. The fair value of fixed maturity certificates of deposit is estimated by discounting future cash flows using the current rates paid on certificates of deposit with similar maturities. Short term borrowings - The carrying value is a reasonable approximation of fair value. Other borrowings - The fair value is estimated by discounting future cash flows using current rates on advances with similar maturities. Page A-37 Off-balance-sheet financial instruments - Commitments to extend credit, standby letters of credit and undisbursed loans are deemed to have no material fair value as such commitments are generally fulfilled at current market rates. NOTE 18 - REGULATORY CAPITAL REQUIREMENTS The Company and Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and Banks to maintain minimum ratios of Total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets. The Company and UBT were categorized as well-capitalized at year end 2005 and 2004 by their regulators. United Bank & Trust - Washtenaw was categorized by its regulators as well-capitalized at year end 2005 and adequately capitalized at year end 2004. Management is not aware of any conditions or events that have occurred since year end that would change this classification. The following table shows the Company's and the Bank's capital ratios and the Company's amounts compared to regulatory requirements at year end, and the amounts by which the Company's capital, on a consolidated basis, exceeds regulatory requirements. Dollars are shown in thousands of dollars where appropriate.
Tier I Capital to: ----------------------- Total Capital to Average Risk Weighted Risk Weighted Assets Assets Assets ------- ------------- ---------------- Regulatory Minimum for Capital Adequacy (1) 4.0% 4.0% 8.0% Regulatory Minimum to be Well Capitalized (2) 5.0% 6.0% 10.0% As of December 31, 2005 United Bancorp, Inc. (consolidated) 9.4% 11.1% 12.2% United Bank & Trust 8.6% 11.4% 12.5% United Bank & Trust - Washtenaw 9.1% 9.8% 10.8% United Bancorp, Inc. consolidated equity $64,422 $64,422 $70,783 Regulatory requirement for minimum capital adequacy (1) 27,581 23,133 46,267 ------- ------- ------- Capital in excess of regulatory minimums 36,841 $41,289 $24,516 ======= ======= ======= As of December 31, 2004 United Bancorp, Inc. (consolidated) 9.3% 11.5% 12.7% United Bank & Trust 8.8% 12.1% 13.2% United Bank & Trust - Washtenaw 8.2% 9.0% 10.0% United Bancorp, Inc. consolidated equity $58,656 $58,656 $64,422 Regulatory requirement for minimum capital adequacy (1) 25,347 20,345 40,690 ------- ------- ------- Capital in excess of regulatory minimums 33,309 $38,311 $23,732 ======= ======= =======
(1) Represents minimum required to be considered adequately capitalized under Federal regulatory requirements. (2) Represents minimum required to be considered well-capitalized under Federal regulatory prompt corrective action provisions. Page A-38 NOTE 19 - EARNINGS PER SHARE A reconciliation of basic and diluted earnings per share follows:
In thousands of dollars, except per share data 2005 2004 2003 ---------- ---------- ---------- Net income $ 8,324 $ 7,653 $ 7,388 Basic earnings per share: Weighted average common shares outstanding 2,489,589 2,469,964 2,450,702 Weighted average contingently issuable shares 25,811 22,658 20,564 ---------- ---------- ---------- 2,515,400 2,492,622 2,471,266 Basic earnings per share $ 3.31 $ 3.07 $ 2.99 ---------- ---------- ---------- Diluted earnings per share: Weighted average common shares outstanding from basic earnings per share 2,515,400 2,492,622 2,471,266 Dilutive effect of stock options 15,716 18,925 16,982 ---------- ---------- ---------- 2,531,116 2,511,547 2,488,248 Diluted earnings per share $ 3.29 $ 3.05 $ 2.97 ========== ========== ==========
Stock options for 1,000 and 3,000 shares of common stock were not considered in computing diluted earnings per share for 2005 and 2003 because they were not dilutive. No options were excluded from the computation in 2004, as all options were dilutive. NOTE 20 - OTHER COMPREHENSIVE INCOME Other comprehensive income components and related taxes were as follows:
In thousands of dollars 2005 2004 2003 ----- ----- ------- Unrealized gains (losses) on securities available for sale $(559) $(758) $ (957) Reclassification for realized amount included in income 1 29 (105) ----- ----- ------- Other comprehensive income (loss) , before tax effect (558) (729) (1,062) Tax expense (benefit) (190) (248) (361) ----- ----- ------- Other comprehensive income (loss) $(368) $(481) $ (701) ===== ===== =======
NOTE 21 - PARENT COMPANY ONLY FINANCIAL INFORMATION The condensed financial information for United Bancorp, Inc. is summarized below. CONDENSED BALANCE SHEETS
December 31, ----------------- In thousands of dollars 2005 2004 ------- ------- ASSETS Cash and cash equivalents $ 1,157 $ 7 Investment in subsidiaries 65,333 60,011 Other assets 3,361 3,045 ------- ------- TOTAL ASSETS $69,851 $63,063 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities $ 2,229 $ 839 Shareholders' equity 67,622 62,224 ------- ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $69,851 $63,063 ======= =======
Page A-39 CONDENSED STATEMENTS OF INCOME
For the years ended December 31, -------------------------------- In thousands of dollars 2005 2004 2003 ------- ------ ------- INCOME Dividends from subsidiaries $ 6,775 $4,325 $10,283 Other income 6,758 11 5 ------- ------ ------- TOTAL INCOME 13,533 4,336 10,288 TOTAL NONINTEREST EXPENSE 7,125 231 215 ------- ------ ------- Income before undistributed net income of subsidiaries and income taxes 6,408 4,105 10,073 Income tax benefit (121) (75) (71) ------- ------ ------- Net income before undistributed net income of subsidiaries 6,529 4,180 10,144 Equity in undistributed (excess distributed) net income of subsidiaries 1,795 3,473 (2,756) ------- ------ ------- NET INCOME 8,324 7,653 7,388 Net change in unrealized gains on securities available for sale (368) (481) (701) ------- ------ ------- Other comprehensive income (loss) (368) (481) (701) ------- ------ ------- COMPREHENSIVE INCOME $ 7,956 $7,172 $ 6,687 ======= ====== =======
CONDENSED STATEMENTS OF CASH FLOWS
For the years ended December 31, -------------------------------- In thousands of dollars 2005 2004 2003 ------- ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 8,324 $ 7,653 $ 7,388 ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FROM OPERATING ACTIVITIES (Undistributed) excess distributed net income of subsidiaries (1,795) (3,473) 2,756 Change in other assets 2,571 (1,858) 272 Change in other liabilities 418 19 3 ------- ------- ------- Total adjustments 1,194 (5,312) 3,031 ------- ------- ------- Net cash from operating activities 9,518 2,341 10,419 ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of securities available for sale -- (181) (40) Investments in subsidiaries (3,900) -- (7,500) Net premises and equipment expenditures (2,008) -- -- ------- ------- ------- Net cash from investing activities (5,908) (181) (7,540) ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from common stock transactions 987 880 262 Dividends paid (3,447) (3,143) (3,140) ------- ------- ------- Net cash from financing activities (2,460) (2,263) (2,878) ------- ------- ------- NET CHANGE IN CASH AND CASH EQUIVALENTS 1,150 (103) 1 Cash and cash equivalents at beginning of year 7 110 109 ------- ------- ------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 1,157 $ 7 $ 110 ------- ------- -------
Page A-40 NOTE 22 - QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly financial information is summarized below.
Earnings Per Share In thousands of dollars, Interest Net Interest Net ------------------ except per share data Income Income Income Basic Diluted -------- ------------ ------ ----- ------- 2005 First Quarter $ 8,683 $ 6,145 $1,784 $0.71 $0.70 Second Quarter 9,401 6,524 1,957 0.78 0.77 Third Quarter 9,999 6,710 2,264 0.90 0.90 Fourth Quarter 10,566 6,984 2,319 0.92 0.92 ------- ------- ------ ----- ----- Full Year $38,649 $26,363 $8,324 $3.31 $3.29 ======= ======= ====== ===== ===== 2004 First Quarter $ 7,612 $ 5,664 $1,716 $0.69 $0.69 Second Quarter 7,654 5,676 1,751 0.70 0.70 Third Quarter 8,082 5,926 2,103 0.84 0.84 Fourth Quarter 8,372 6,031 2,083 0.84 0.83 ------- ------- ------ ----- ----- Full Year $31,720 $23,297 $7,653 $3.07 $3.05 ======= ======= ====== ===== =====
Page A-41 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. United Bancorp, Inc. /S/ Robert K. Chapman March 8, 2006 ------------------------------------- Date Robert K. Chapman, President and Chief Executive Officer, Director Page 25 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert K. Chapman and Dale L. Chadderdon, and each of them, his true and lawful attorney(s)- in-fact and agent(s), with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this report and to file the same, with all exhibits and schedules thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney(s)-in-fact and agent(s) full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney(s)-in-fact and agent(s), or their substitute(s), may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated, on March 8, 2006. /S/ James D. Buhr /S/ David S. Hickman ------------------------------------- ---------------------------------------- James D. Buhr, Director David S. Hickman, Chairman of the Board /S/ Joseph D. Butcko /S/ James C. Lawson ------------------------------------- ---------------------------------------- Joseph D. Butcko, Director James C. Lawson, Director /S/ Robert K. Chapman /S/ Donald J. Martin ------------------------------------- ---------------------------------------- Robert K. Chapman (Principal Donald J. Martin, Director Executive Officer) Director, President and Chief Executive Officer /S/ George H. Cress /S/ David E. Maxwell ------------------------------------- ---------------------------------------- George H. Cress, Director David E. Maxwell, Director /S/ John H. Foss /S/ Kathryn M. Mohr ------------------------------------- ---------------------------------------- John H. Foss, Director Kathryn M. Mohr, Director /S/ James G. Haeussler /S/ Dale L. Chadderdon ------------------------------------- ---------------------------------------- James G. Haeussler, Director Dale L. Chadderdon (Principal Financial Officer) Executive Vice President & Chief Financial Officer Page 26 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION PAGE NO. ----------- ----------- -------- Exhibit 14 Code of Ethics in accordance with Section 406 of the Sarbanes-Oxley Act as amended. 21 Exhibit 21 Subsidiaries 24 Exhibit 23 Consent of Independent Registered Public Accounting Firm 25 Exhibit 24 Power of Attorney contained on the signature pages of the 2005 Annual Report on Form 10-K. 19 Exhibit 31.1 Certification of Principal Executive Officer 26 Exhibit 31.2 Certification of Principal Financial Officer 27 Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 28
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