SRCE

1st Source Corp. Q3 2006 Filing Summary

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2006, for 1st Source Corporation, a financial services company headquartered in South Bend, Indiana. The company operates as an accelerated filer and reported 22,501,261 shares of common stock outstanding as of October 23, 2006. The financial statements reflect the adoption of SFAS No. 123(R) regarding share-based payment effective January 1, 2006, and include retroactive recognition of a 10% stock dividend declared in July 2006.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability: Net income increased 15.6% year-over-year for the nine-month period ($31.17M vs. $24.65M). Diluted EPS rose to $1.36 from $1.07.
• Asset Growth: Total assets grew 3.14% to $3.62 billion. Total loans and leases increased 6.65% to $2.63 billion, driven by growth across the entire portfolio.
• Nonperforming Assets (NPA): NPAs improved significantly, decreasing 33.34% to $14.69 million (0.54% of net loans) from $22.04 million at year-end 2005. This improvement was seen in commercial, construction, and aircraft financing, though loans secured by real estate saw an increase in nonaccruals.
• Interest Rates: The net interest margin expanded to 3.36% (YTD) from 3.19% in 2005. Average yields on earning assets increased to 6.31% from 5.32%, while the cost of interest-bearing liabilities rose to 3.54% from 2.59% due to higher market rates.
• Noninterest Income: Increased 15.57% YTD to $58.90 million, largely due to a $3.20 million gain on the bulk sale of mortgage servicing rights and growth in equipment rental income.

Outlook, Risks, and Unusual Items

• Accounting Changes: The company adopted SFAS No. 123(R) for stock-based compensation, resulting in a $2.09 million pre-tax expense addition for the nine months ended September 30, 2006. This adoption also reversed previously recognized stock-based compensation expense, reducing salaries and benefits expense by $2.07 million pre-tax.
• Unusual Items: Other expenses were higher year-over-year due to legal expenses and losses related to an employee defalcation in the second quarter. Additionally, the company recorded a $0.22 million loss in venture partnerships in Q3 2006 compared to a gain in the prior year.
• Capital Position: The company remains well-capitalized. Total capital ratio was 14.56% and Tier 1 capital ratio was 13.26%, both significantly exceeding regulatory requirements for "well-capitalized" status.
• Liquidity: The balance sheet was rate-sensitive with $333 million more liabilities than assets scheduled to reprice within one year. Liquidity is supported by core deposits and available-for-sale securities.
• Risks: Management highlighted risks related to interest rate changes, loan prepayment assumptions, and economic downturns affecting credit concentrations. A specific contingency involves a $2.95 million standby letter of credit for a customer in financial distress, which may result in foreclosure and an increase in other real estate assets.

Investor Verification Checklist

• Asset Quality: Verify the trend in nonaccrual loans secured by real estate, which increased despite overall NPA improvement.
• Stock-Based Compensation: Review the impact of SFAS No. 123(R) adoption on future earnings and the $304,300 of unrecognized compensation cost.
• Interest Rate Sensitivity: Assess the impact of the $333 million liability-sensitive gap on net interest income if rates continue to rise.
• Contingent Liabilities: Monitor the status of the $2.95 million standby letter of credit and potential impact on the loan loss reserve.
• Dividend Policy: Note the 10% stock dividend and the trailing four-quarter payout ratio of 29.26%.