SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the transition period from           to                    

Commission File No. 0-2989

 

COMMERCE BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes X  No     

 

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act. (Check one):

 

Large accelerated filer X      Accelerated filer         Non-accelerated filer    

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes    No  X 

 

As of April 30, 2007, the registrant had outstanding 69,601,022 shares of its $5 par value common stock, registrant’s only class of common stock.

 

 

Commerce Bancshares, Inc. and Subsidiaries

 

Form 10-Q

 

 

 

Commerce Bancshares, Inc. and Subsidiaries

See accompanying notes to consolidated financial statements.

Commerce Bancshares, Inc. and Subsidiaries

See accompanying notes to consolidated financial statements.

Commerce Bancshares, Inc. and Subsidiaries

See accompanying notes to consolidated financial statements.

Commerce Bancshares, Inc. and Subsidiaries

See accompanying notes to consolidated financial statements.

Commerce Bancshares, Inc. and Subsidiaries

March 31, 2007 (Unaudited)

 

1. Principles of Consolidation and Presentation

 

The accompanying consolidated financial statements include the accounts of Commerce Bancshares, Inc. and all majority-owned subsidiaries (the Company). The consolidated financial statements in this report have not been audited. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 2006 data to conform to current year presentation. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations for the three month period ended March 31, 2007 are not necessarily indicative of results to be attained for the full year or any other interim periods.

 

The significant accounting policies followed in the preparation of the quarterly financial statements are disclosed in the 2006 Annual Report on Form 10-K.

 

2. Subsequent Events

 

The Company completed its previously announced acquisition of South Tulsa Financial Corporation (South Tulsa) on April 1, 2007. In this transaction, the Company acquired the outstanding stock of South Tulsa and issued 561,951 shares of Company stock valued at $27.6 million. The valuation of Company stock was based on the average closing price of Company stock during the measurement period of March 21 through March 27. The Company’s acquisition of South Tulsa added $114.7 million in loans, $103.9 million in deposits and two branch locations in Tulsa, Oklahoma. Intangible assets recognized as a result of the transaction, consisting primarily of goodwill and core deposit premium, approximated $13.9 million.

 

On April 3, 2007, the Company announced plans to acquire Commerce Bank in Denver, Colorado for approximately $29.5 million in cash. The acquisition will add $96.8 million in assets (including $70.0 million in loans), $75.5 million in deposits and the Company’s first location in Colorado. The transaction is expected to be completed in the third quarter of 2007, pending regulatory approvals, the approval of Commerce Bank’s shareholders and other customary closing conditions.

 

3. Loans and Allowance for Loan Losses

 

Major classifications within the Company’s loan portfolio at March 31, 2007 and December 31, 2006 are as follows.

 

 

Included in the table above are impaired loans amounting to $19,163,000 at March 31, 2007 and $18,236,000 at December 31, 2006. Impaired loans include loans on non-accrual status and other loans classified as substandard and more than 60 days past due.

 

In addition to its basic portfolio, the Company originates other loans which it intends to sell in secondary markets. Loans held for sale amounted to $363,052,000 at March 31, 2007 compared to $278,598,000 at

December 31, 2006. These loans consist mainly of student loans, amounting to $349,091,000 at March 31, 2007, in addition to $13,961,000 of certain fixed rate residential mortgage loans.

 

The following is a summary of the allowance for loan losses for the three months ended March 31, 2007 and 2006.

 

 

4. Investment Securities

 

Investment securities, at fair value, consist of the following at March 31, 2007 and December 31, 2006.

 

 

Available for sale equity securities included short-term investments in money market mutual funds of $31,491,000 at March 31, 2007 and $59,973,000 at December 31, 2006. Equity securities also included common and preferred stock held by the Parent with a fair value of $110,736,000 at March 31, 2007 and $107,840,000 at December 31, 2006.

 

Non-marketable securities included securities held for debt and regulatory purposes, which amounted to $35,030,000 and $35,592,000 at March 31, 2007 and December 31, 2006, respectively, in addition to venture capital and private equity investments, which amounted to $43,495,000 and $38,548,000 at the respective dates. During the first three months of 2007 and 2006, net gains of $3,897,000 and $2,402,000, respectively, were recognized on venture capital and private equity investments, which consisted of both realized gains and losses and fair value adjustments.

 

At March 31, 2007, securities carried at $2.0 billion were pledged to secure public fund deposits, securities sold under agreements to repurchase, trust funds, and borrowing capacity at the Federal Reserve. Securities pledged under agreements pursuant to which the collateral may be sold or re-pledged by the secured parties approximated $536.3 million, while securities pledged under agreements pursuant to which the secured parties may not sell or re-pledge the collateral approximated $1.4 billion at March 31, 2007.

 

5. Goodwill and Other Intangible Assets

 

The following table presents information about the Company’s intangible assets which have estimable useful lives.

 

 

Aggregate amortization expense on intangible assets was $936,000 and $1,000, respectively, for the three month periods ended March 31, 2007 and 2006. Estimated annual amortization expense for the years 2007 through 2011 is as follows.

 

 

Changes in the carrying amount of goodwill and net other intangible assets for the three month period ended March 31, 2007 is as follows.

 

 

Changes in the carrying amount of goodwill by operating segment for the three month period ended March 31, 2007 are as follows.

 

 

6. Guarantees

 

The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the

standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.

 

Upon issuance of standby letters of credit, the Company recognizes a liability for the fair value of the obligation undertaken, which is estimated to be equivalent to the amount of fees received from the customer over the life of the agreement. At March 31, 2007 that net liability was $5,697,000, which will be amortized into income over the remaining life of the respective commitments. The contract amount of these letters of credit, which represents the maximum potential future payments guaranteed by the Company, was $465,315,000 at March 31, 2007.

 

The Company guarantees payments to holders of certain trust preferred securities issued by wholly owned grantor trusts. Preferred securities issued by Breckenridge Capital Trust I, amounting to $4,000,000, are due in 2030 and may be redeemed beginning in 2010. These securities have a 10.875% interest rate throughout their term. Securities issued by West Pointe Statutory Trust  I, amounting to $10,000,000, are due in 2034 and may be redeemed beginning in 2009. These securities have a variable interest rate based on LIBOR, which resets on a quarterly basis. The maximum potential future payments guaranteed by the Company, which includes future interest and principal payments through maturity, was estimated to be approximately $45,078,000 at March 31, 2007. At March 31, 2007, the Company had a recorded liability of $14,070,000 in principal and accrued interest to date, representing amounts owed to the security holders.

 

In 2007, the Company entered into a risk participation agreement (RPA) with another financial institution which mitigates that institution’s credit risk arising from an interest rate swap with a third party. The RPA stipulates that, in the event of default by the third party on the interest rate swap, the Company will reimburse a portion of the loss borne by the financial institution. The Company’s exposure is based on a notional amount of $10,000,000. At inception, the Company recorded a liability of $71,000, representing the fair value of the RPA, which will be amortized to income over the seven year term of the RPA, given no adverse change in the third party’s creditworthiness. The maximum potential future payment guaranteed by the Company cannot be readily estimated, but is dependent upon the fair value of the interest rate swap at the time of default. If an event of default had occurred at March 31, 2007, the Company’s payment under the RPA would have been approximately $150,000.

 

7. Pension

 

The amount of net pension cost (income) for the three months ended March 31, 2007 and 2006 is as follows.

 

 

Substantially all benefits under the Company’s defined benefit pension plan were frozen effective January 1, 2005. During the first three months of 2007, the Company made no funding contributions to its defined benefit pension plan, and made minimal funding contributions to a supplemental executive retirement plan (the CERP), which carries no segregated assets. The Company has no plans to make any further contributions, other than those related to the CERP, during the remainder of 2007. The income recognized for the defined benefit pension plan for the first three months of 2007 was primarily due to the greater than expected return on plan assets for the year ended September 30, 2006 (the valuation date).

 

Recently issued accounting pronouncements required the Company to reflect the funded status of its defined benefit pension plan on its consolidated balance sheet at December 31, 2006. Accordingly, the

Company recorded a pre-tax reduction in accumulated other comprehensive income of $17,532,000, consisting of accumulated net loss, on that date. During the first quarter of 2007, $185,000 of accumulated net loss was recognized as a component of net periodic benefit cost, as shown above, and as an increase in other comprehensive income.

 

8. Common Stock

 

Presented below is a summary of the components used to calculate basic and diluted earnings per share.

 

 

9. Other Comprehensive Income (Loss)

 

The Company’s components of other comprehensive income (loss) consist of the unrealized holding gains and losses on available for sale investment securities and the amortization of accumulated pension loss which has been recognized in net periodic benefit cost.

 

 

10. Segments

 

The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The Consumer segment includes the retail branch network, consumer finance, bank card, student loans, and discount brokerage services. The Commercial segment provides corporate lending, leasing, and international services, as well as business, government deposit, and

cash management services. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment management services.

 

The following table presents selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues among the three segments. Management periodically makes changes to methods of assigning costs and income to its business segments to better reflect operating results. If appropriate, these changes are reflected in prior year information presented below.

 

 

The information presented above was derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. This information is based on internal management accounting policies, which have been developed to reflect the underlying economics of the businesses. The policies address the methodologies applied in connection with funds transfer pricing and assignment of overhead costs among segments. Funds transfer pricing was used in the determination of net interest income by assigning a standard cost (credit) for funds used (provided) by assets and liabilities based on their maturity, prepayment and/or repricing characteristics.

 

The performance measurement of the operating segments is based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The information is also not necessarily indicative of the segments’ financial condition and results of operations if they were independent entities.

 

 

The Company’s interest rate risk management strategy includes the ability to modify the re-pricing characteristics of certain assets and liabilities so that changes in interest rate do not adversely affect the net interest margin and cash flows. Interest rate swaps are used on a limited basis as part of this strategy. At March 31, 2007, the Company had entered into two interest rate swaps with a notional amount of $14,067,000, which are designated as fair value hedges of certain fixed rate loans. The Company also sells swap contracts to customers who wish to modify their interest rate sensitivity. These swaps are offset by matching contracts purchased by the Company from other financial institutions. Because of the matching terms of the offsetting contracts, the effect of these transactions on net income is minimal. The notional amount of these types of swaps at March 31, 2007 was $210,524,000. These swaps are accounted for as free-standing derivatives and changes in their fair value were recorded in other non-interest income.

 

Through its International Department, the Company enters into foreign exchange contracts consisting mainly of contracts to purchase or deliver foreign currencies for customers at specific future dates. Also, mortgage loan commitments and forward sales contracts result from the Company’s mortgage banking operation, in which fixed rate personal real estate loans are originated and sold to other institutions.

 

The Company’s derivative instruments are listed below.

 

 

 

For the first quarter of 2007 income tax expense amounted to $23,582,000, compared to $25,846,000 in the first quarter of 2006. The effective income tax rate for the Company was 31.4% in the current quarter compared to 32.8% in the same quarter last year.

 

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). Upon adoption of FIN 48, the Company recognized a $446,000 decrease to the liability for unrecognized tax benefits which, as required, was accounted for as an increase to the January 1, 2007 balance of retained earnings. The resulting amount of unrecognized tax benefits at January 1, 2007 was $2,379,000, which included $444,000 of related accrued interest and penalties.

 

The Company’s policy is to recognize interest and penalties related to unrecognized tax benefits within income tax expense in the consolidated statements of income.

 

The Company’s federal income tax returns for 2003 through 2006 remain subject to examination by the Internal Revenue Service. Its state tax returns for 2002 through 2006 remain subject to examination by various state jurisdictions, based on individual state statute of limitations.

 

 

The Company usually issues most of its annual stock-based compensation during the first quarter. During the first quarter of 2007, stock-based compensation was issued in the form of stock appreciation rights (SARs) and nonvested stock. The stock-based compensation expense that has been charged against income was $1,518,000 in the first three months of 2007 and $799,000 in the first three months of 2006.

 

The Company’s adoption of SFAS No. 123R, “Share-Based Payment” (the Statement), on January 1, 2006 resulted in a $543,000 reduction in stock-based compensation expense during the first three months of 2006. This adjustment resulted from a change by the Company from its former policy of recognizing the effect of forfeitures only as they occurred to the Statement’s requirement to estimate the number of outstanding instruments for which the requisite service is not expected to be rendered.

 

In determining compensation cost, the Black-Scholes option-pricing model is used to estimate the fair value of SARs and options on date of grant. SARs and stock options are granted with an exercise price equal to the market price of the Company’s stock at the date of grant and have 10-year contractual terms. SARs, which were granted for the first time in 2006, vest on a graded basis over 4 years of continuous service. All SARs must be settled in stock under provisions of the plan. Stock options, which were granted in 2005 and previous years, vest on a graded basis over 3 years of continuous service. The table below shows the fair values of SARs granted during the first three months of 2007 and 2006, including the model assumptions for those grants.

 

 

A summary of option activity during the first three months of 2007 is presented below.

 

 

A summary of SAR activity during the first three months of 2007 is presented below.

 

A summary of the status of the Company’s nonvested share awards, as of March 31, 2007, and changes during the three month period then ended is presented below.

 

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Company’s 2006 Annual Report on Form 10-K. Results of operations for the three month period ended March 31, 2007 are not necessarily indicative of results to be attained for any other period.

 

Forward Looking Information

 

This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include: changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, governmental legislation and regulation, fluctuations in interest rates, changes in liquidity requirements, demand for loans in the Company’s market area, and competition with other entities that offer financial services.

 

Critical Accounting Policies

 

The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, some of which require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the current period or future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments primarily by using internal cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company’s future financial condition and results of operations.

 

The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, and accounting for income taxes.

 

The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further discussion of the methodologies used in establishing the allowance is provided in the Provision and Allowance for Loan Losses section of this discussion.

 

The Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $43.5 million at March 31, 2007. These private equity and venture capital securities are reported at fair value. The values assigned to these securities where no market quotations exist are based upon available information and management’s judgment. Although management believes its estimates of fair value reasonably reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.

 

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations. Further discussion of income taxes is presented in the Income Taxes section of this discussion.

 

Selected Financial Data

 

Results of Operations

 

Summary

 

For the quarter ended March 31, 2007, net income amounted to $51.5 million, a decrease of $1.4 million, or 2.7%, compared to the first quarter of the previous year. For the current quarter, the annualized return on average assets was 1.38%, the annualized return on average equity was 14.41%, and the efficiency ratio was 62.79%. The decrease in net income compared to the first quarter of last year resulted mainly from a 5.0% increase in non-interest expense, mainly in salaries and employee benefits, coupled with a 3.2% decrease in non-interest income. Additionally, the provision for loan losses was $8.2 million for the quarter, an increase of $3.7 million over the first quarter of 2006. These effects were partially offset by a 6.3% increase in net interest income, which was primarily due to increases in loan balances and yields. Diluted earnings per share was $.73, a decrease of 1.4% from $.74 per share in the first quarter of 2006.

 

The Company completed its previously announced acquisition of South Tulsa Financial Corporation (South Tulsa) on April 1, 2007. In this transaction, the Company acquired the outstanding stock of

South Tulsa and issued 561,951 shares of Company stock valued at $27.6 million. The Company’s acquisition of South Tulsa added $114.7 million in loans, $103.9 million in deposits and two branch locations in Tulsa, Oklahoma.

 

On April 3, 2007, the Company and Commerce Bank in Denver, Colorado executed a merger agreement in which Commerce Bank will merge with the Company. The Company’s acquisition of the independent Colorado Commerce Bank will add approximately $96.8 million in assets (including $70.0 million in loans), $75.5 million in deposits, and the Company’s first location in Colorado. Total consideration is estimated to be approximately $29.5 million in cash. It is anticipated that the transaction will be completed in the third quarter of 2007, pending regulatory approvals and certain closing conditions.

 

In the third quarter of 2006, the Company acquired certain assets and assumed certain liabilities of Boone National Savings and Loan Association (Boone) in central Missouri through a purchase and assumption agreement. Loans and deposits of $126.4 million and $100.9 million, respectively, were acquired, and goodwill and core deposit premium of $15.6 million and $2.6 million, respectively, were recorded as a result of this transaction. Also during the quarter, the Company acquired the outstanding stock of West Pointe Bancorp, Inc. (West Pointe) in Belleville, Illinois, which added $508.8 million in assets (including $255.0 million in loans) and $381.8 million in deposits. Goodwill of $38.6 million and core deposit premium of $14.9 million were recorded in this transaction.