| Letter to Sharholders April 8, 2007 Dear Shareholders: 2007 will be remembered as a trying year for the banking industry; however, Mercantile Bancorp, Inc. emerged stronger, larger and financially sound. I do not minimize the impact of a slowing economy and a troubled real estate market in many sections of the country and our markets, but for your company it was a year of solidifying, strengthening and extending the Mercantile brand. Our historically prudent lending practices, high levels of customer care, and the stable markets we serve allowed us to avoid many of the problems faced by financial institutions nationwide. Entering 2008, economic predictions uniformly projected a rather flat economy with continuing loan issues. Mercantile Bancorp is not immune to potential isolated problems, although we feel confident in the high quality of our loan portfolios and our assets. Our 2007 loan loss provision was actually lower than in the previous year. We believe this is just one factor that validates our confidence in the quality of our loan portfolio. We anticipated the Federal Reserve Board lowering interest rates throughout 2007 and positioned ourselves to remain flexible in our pricing and investing on our balance sheet, thereby minimizing the impact of changing interest rates on our margins. Although we did not receive those rate cuts in 2007, our conservative principles and interest rate risk planning prepared us when the Federal Reserve dramatically lowered the discount rate early in 2008, though the best preparation would insulate no balance sheet to the dramatic shift in pricing that was delivered. Due to continuing pricing issues, we anticipate some margin compression this coming year. I will later discuss our outlook in greater detail. Let’s first review Mercantile Bancorp’s 2007 performance. Solidifying Our Brand We made good on our promise to pursue our three-pronged growth strategy: internal growth through core bank holdings, earnings and asset growth through acquisition, and income growth through strategic investments in start-up banks. Total assets rose to $1.6 billion at year-end compared with $1.4 billion at the end of the prior year, a result of organic growth and the acquisition of HNB Financial Services, Inc., which was completed in September 2007. Mercantile’s loan portfolio grew to $1.2 billion at the end of 2007 compared with $1.0 billion at the end of the prior year. This growth further strengthened the company, giving us greater size and resources to increase market share and to continue to seek operating efficiencies. In a year when many banks saw their share prices fall, sometimes precipitously, the value of Mercantile Bancorp shares hit an all-time high. We completed a 3- for-2 stock split in December, creating additional shares for trading and bringing the stock price back into a range we believe is more conducive to purchase MBR shares. We anticipate the larger number of outstanding shares will, in time, lead to increased daily trading volume. Net income for the year ended December 31, 2007 was $10.0 million, or $1.15 per share, on 8.7 million weighted average shares outstanding, compared with net income of $10.3 million, or $1.18 cents per share in 2006 on the then-existing shares. A significant reason for the year-over-year earnings difference is the company’s larger gains from the sale of two equity investments in start-up banks in 2006. In 2007, pretax gains from equity investment sales equaled $2.7 million, compared to $4.3 million in 2006. Equity investments in start-up banks are a modest but opportunistic part of our overall three-prong growth strategy. Untimed sales of the positions can cause an irregular net income stream, but the quality returns on investment received have proven them worthy considerations. Depending on the individual circumstances of a sale, we may take our gains in cash, stock in the acquiring company, or a combination of the two. Note that investments in start-up bank equity increase assets on our balance sheet but, prior to liquidation of the investments, are non-earning to the income statement, thereby reducing the return on equity ratio to the company. Investing in a start-up corresponds to our core business of community banking, and doing so with a long-term, strategic perspective, and noting the modest impact on our overall capital structure, has delivered a reasonable and qualified risk. Interest and dividend income of $95.9 million increased considerably last year, from $76.2 million, fueled by greater income from commercial and residential real estate loans. Non-interest income was approximately $13.9 million – on par with non-interest income in 2006. However, excluding gains from the sale of equity investments, non-interest income rose significantly as customer service fees and income from the company’s trust, brokerage and land management businesses grew year-over-year. Building Our Brand in Core Markets Acquiring HNB Financial Services provided Mercantile five additional full-service bank locations in northeastern Missouri, adding approximately $167 million in assets and a quality group of managers and employees. We anticipate the HNB acquisition will in time facilitate operating efficiencies, generate economies of scale and create higher loan limits that will enhance lending opportunities. Adding HNB to Mercantile Bancorp’s group of core holdings has created a continuous 100-mile presence from Quincy, Ill. to suburban St. Louis. We plan to seek regulatory approval in 2008 to combine one of Mercantile’s existing Missouri-chartered banks, Perry State Bank, with certain operations of HNB Bank in early 2009. If approved by the regulators, Perry State Bank would operate as HNB Bank to capitalize on the existing strong brand recognition. The combined operations would have more than $330 million in assets and operate in the Missouri communities of Hannibal, Perry, Monroe City, Palmyra, Bowling Green, Troy and Wentzville. The increased number of HNB locations provides greater presence and market share in the Quincy- Hannibal area, a regional business hub, and will complement existing Mercantile Bank locations in the market. In addition, it will allow for further extension of trust, brokerage and land-management business throughout the region, a valuable opportunity to increase non-interest income. The presence of an HNB facility in the vibrant St. Louis suburb of St. Charles prompted us to sell our 37 percent equity interest in New Frontier Bancshares, Inc., also in St. Charles, for $6.8 million, a 7.6 percent annualized gain on our investment. In addition, this sale allowed us to extend the trust office of Mercantile Bank into a private office park facility in St. Charles, which is proving to be an excellent growth opportunity for trust services to the company. In early 2008, the need to replace a retiring bank president at The Royal Palm Bank of Florida afforded an opportunity to attract a Naples-based banking leader to our franchise. We were fortunate to find that individual in J. Gregory Murphy, a 20-year resident of Naples who stepped into the president’s position in early March and immediately attracted opportunities to improve the franchise. From its acquisition and through the economic downturn in Florida, we have held steadfast in our belief that from a long-term perspective, this charter offers great opportunities in the decade ahead. Going forward, under Greg’s leadership, I am firm in that commitment. A combination of prudent growth while maintaining high standards for service continues to offer tremendous opportunity for a community bank holding company to succeed. We must compete on pricing at all levels while managing inherent risk; we must have qualified and well trained personnel in our banks; and we must provide the internal and external technology that our associates, existing and potential customers have come to expect. We will continue to invest in all of those resources and needs. Combined, these steps will allow our banks to compete at all levels in their markets, ensuring growth and future success for the company. Strengthening Our Operations Our commitment to the future was one of many reasons to build a new main bank facility in Quincy, completed in 2007, and opened for business in January 2008. It allowed for consolidating various groups of employees serving Mercantile Bank and the holding company in common areas, rather than working from crowded and inefficient quarters in several Mercantile Bank facilities. The new building is not only a full-service banking facility for customers of the Quincy region; it serves as headquarters for the holding company’s executives as well. We are fortunate to have a well-led and talented Data Services team, which is helping the company to increase efficiencies and develop state-of-the art product and service offerings to its customers. Our experience and investment in operations management and technology also improve our ability to integrate and coordinate operations as we grow organically and through acquisition. Late in 2007, we announced plans to merge the operations of one of our core bank holdings, Farmers State Bank of Northern Missouri, into Mercantile Bank. Although Farmers State Bank has a fine reputation and a quality team of bankers, we believe its locations in Savannah and St. Joseph, Mo. will derive greater benefit and name recognition under the Mercantile Bank name and charter. The change is subject to regulatory approval and our plan is to complete the merger in second quarter 2008. This strategy is consistent with our actions in 2006, when we consolidated the operations of five Illinois-chartered banks into two entities. We made the moves to maintain a high level of customer service while reducing administrative, regulatory and compliance costs. We anticipate similar benefits for Farmers State Bank operations. The merger will also facilitate expanding trust and land management services in that region, complementing and enhancing the established and successful brokerage unit in place with significant assets under management. This brokerage group has successfully demonstrated the ability to deliver quality asset management services through a community bank platform. Successfully executing this strategy will provide a template for expanding trust, brokerage and land management services at our wholly owned banks. One of our key philosophies is some of our best customers are asset management customers. They are loyal and most likely to consolidate their banking and financial services needs with us. Expanding Our Income The success of our trust, brokerage and land management expansion strategy is a key reason non-interest income, excluding the sales of equity investments in start-up banks, rose significantly in 2007. Also, increased interest income was very encouraging. We look forward to income contributions from HNB this year. We experienced robust growth in our commercial and real estate lending, which contributed to year-over-year growth of interest income. Contrary to some national trends, agricultural and commercial land values in many of our served markets actually increased, leading to borrowings and reasonably healthy real estate markets. I believe some of this trend is due to recognition that the land in our communities has long been valued attractively. These markets look appealing compared to other, more volatile areas. We remain disciplined in our loan review processes, balancing prudence and care with a willingness to continue to make loans to qualifying individuals and businesses. Our excellent customer relationships enable us to more effectively qualify new loans and to monitor existing loans. Our liquidity and strong capital position enabled us to continue lending to good credits when others were pulling back. We plan to continue this practice while keeping abreast of the economies in our markets. The real estate value corrections in various markets will affect credits in most loan portfolios; however, the vast majority of our credit extensions are to quality borrowers with supporting cash flows. An area we are monitoring is the dramatic correction of Florida real estate values, but we are confident our exposure is limited. We do not make sub-prime loans, so there are no direct issues related to those products. We make a modest number of jumbo home loans and we have supportive buyers in selling our mortgages to our secondary market sources. Freddie Mac, one of the key secondary market buyers for non-jumbo real estate loans, is tightening the standards for loans it will purchase, but we believe the loans we generate will continue to pass muster with Freddie Mac, Fannie Mae, the Federal Home Loan Bank system and any quality secondary market buyers we source. We are carefully monitoring our real estate development loans, particularly in Florida, but as of this writing, we do not see any major issues looming. We expect our strategic investments in start-up community banks serving growing markets will continue to make long-term contributions to income. In 2007 we sold one and added three equity investments to our portfolio, bringing our current total to 10 investments. We used some of the proceeds from the sale of New Frontier to finance these investments, which are generally less than 5 percent of the equity in these banks. We limit our equity investments to 10 percent or less of our total capital. We invested in the start-up of Manhattan Bancorp, parent of Bank of Manhattan, a community bank serving the needs of the South Bay section of Los Angeles County California. The South Bay portion has a population of 1.3 million and is experiencing rapid growth in bank deposits. We also acquired a stake in Brookhaven Bank, Atlanta, a bank focusing primarily on serving the needs of businesses, professional organizations, and, to a lesser extent, retail-banking customers. Brookhaven’s principal market is DeKalb County, Georgia, a fast-growing and affluent section of the greater Atlanta metroplex. In addition, we took a stake in Solera National Bancorp, Inc., headquartered in Lakewood, Colorado, a fast-growing suburb of Denver, which studies report is one of the nation’s fastest growing metropolitan areas. The new bank serves the needs of residents, small-to-medium-size businesses and licensed professionals in the Denver market. However, its focus is on customers of Hispanic origin. Denver’s Hispanics have among the nation’s highest Hispanic per-capita income levels. The number of Hispanic residents and Hispanic-owned businesses in the Denver area is growing rapidly. Despite being in multiple geographic regions and serving different markets, the high growth and community bank focus of our equity investments is clear and consistent with our own operating philosophy. An additional benefit of our relationship with these banks is their ability to call on us to participate in larger loans that require a partner with greater capital reserves and lending capabilities. We have participated in several such opportunities after reviewing the loans and finding them consistent with our criteria. In time, we may have the option of increasing our stake in these banks, or to acquire them ourselves. As investments, they require little of our management’s time, resources or attention. We stay focused on running our business. We are also committed to enhancing shareholder value through cash dividends. In February 2007 our board increased the cash dividend rate by 12.5 percent. Given the strong valuation of our stock this past year, we repurchased only a few shares and most of these were part of a private buyback from a longtime investor. Extending Our Brand Although an important part of our growth strategy is acquisition, management and your board believe the best strategy is to maximize the value of every bank in our holding company. We have plenty of opportunities to build our business organically through increased lending, deposits and asset management services. Right now, we are focused on strengthening and solidifying our existing operations, though we will always consider opportunities that have potential to create significant value. Our stock performance last year was gratifying, positioning the company to utilize its stock as currency in future opportunities. We will weigh carefully any consideration we may receive if we issue shares of our stock in an acquisition. Our price-to-book value ratio ascended in 2007 while the bank industry’s declined on average. Our price-to-book ratio, which was below the NASDAQ bank average in 2006, now stands above the NASDAQ average. We want to expand our visibility with shared marketing efforts among our banks and innovative products and services. We plan to maximize efficiency by implementing common technology platforms throughout our company. As I write this, the economic forecasts for growth, at least for the first half of the year, are quite conservative. That said, we will continue to seek opportunities to expand our presence by building business in existing locations, possibly through additional branches, but mainly by investing in quality people. As always, we will focus on communities that fit the profile we have developed—stable communities that are centers for business, housing, and finance. Early this year, we opened a loan production office in Carmel, Indiana, a community of about 70,000 adjacent to the north side of Indianapolis. This office will focus on business lending relationships, but in the near future we intend to seek regulatory approval to develop it into a full-service banking facility. This is our first facility in Indiana and it has retail and business opportunities similar to our existing markets, markets we know how to serve. We hired Kevin P. Murphy as regional president. Kevin is an experienced banker with a lifetime of contacts in the Indianapolis area, and he has the support and guidance of a quality group of local business leaders. In conclusion, I’d like to thank Chairman Dan S. Dugan and your Board of Directors for their support and guidance throughout the year. I took over the day-to-day management from Dan early in 2007. His continuing leadership, enthusiastic participation and valued support created a seamless transition for my senior management team and me. Our shareholders benefited from our entire board’s insights and skill as we navigated the economics of this past year. I extend my thanks as well to our long-time and new shareholders for participating in our vision for Mercantile Bancorp. We continue with diligence to seek growth, create value and maintain your continued trust and confidence. Sincerely, Ted T. Awerkamp
|
|
