SB FINANCIAL GROUP, INC. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations . SB Financial Group, Inc. (“SB Financial”), is a financial holding company registered with the Federal Reserve Board and subject to regulation under the Bank Holding Company Act of 1956, as amended. Through its direct and indirect subsidiaries, including The State Bank and Trust Company (“State Bank”), SB Financial is engaged in commercial and retail banking, wealth management and private client financial services. The following discussion provides a review of the consolidated financial condition and results of operations of SB Financial and its subsidiaries (collectively, the “Company”). This discussion should be read in conjunction with the Company’s consolidated financial statements and related footnotes as of and for the years ended December 31, 2022 and 2021. Strategic Discussion The focus and strategic goal of the Company is to grow into and remain a top decile (>90th percentile) independent financial services company. The Company intends to achieve and maintain that goal by executing our five key initiatives. Increase profitability through ongoing diversification of revenue streams: For the twelve months ended December 31, 2022, the Company generated $18.2 million in noninterest income, or 31.6 percent of total operating revenue, from fee-based products. These revenue sources include fees generated from saleable residential mortgage loans, retail deposit products, wealth management services, saleable business-based loans (small business and farm service) and title agency revenue. For the twelve months ended December 31, 2021, the Company generated $30.7 million in noninterest income, or 44.8 percent of total operating revenue from fee-based products. Strengthen our penetration in all markets served: Over our 119-year history of continuous operation in Northwest Ohio, we have established a significant presence in our traditional markets in Defiance, Fulton, Paulding and Williams counties in Ohio. In our newer markets of Bowling Green, Columbus, Findlay, Toledo (Ohio) and Ft. Wayne (Indiana), our current market penetration is minimal but we believe our potential for growth is significant. In the past years, we have expanded and committed additional resources to our presence in the Findlay and Edgerton markets in particular; however, we continue to seek to expand the presence and penetration in all of our markets. Expand product utilization by new and existing customers: As of December 31, 2022, we operated in 14 counties in Northwest Ohio and Northeast Indiana with 23 full service offices, 23 ATM’s and six loan production offices. Combined in the 14 counties of operation, we command 4.3 percent of the deposit market share, which has steadily grown. 33 Deliver gains in operational excellence: Our management team believes that becoming and remaining a high-performance financial services company will depend upon seamlessly and consistently delivering operational excellence, as demonstrated by the Company’s leadership in the origination and servicing of residential mortgage loans. As of December 31, 2022, the Company serviced 8,514 residential mortgage loans with an aggregate principal balance of $1.35 billion. As of December 31, 2021, the Company serviced 8,614 loans with an aggregate principal balance of $1.36 billion. Sustain asset quality: As of December 31, 2022, the Company’s asset quality metrics remained strong. Specifically, total nonperforming assets were $5.1 million, or 0.38 percent of total assets. Total delinquent loans at December 31, 2022 were 0.27 percent of total loans. As of December 31, 2021, the Company had total nonperforming assets of $6.5 million, or 0.49 percent of total assets. Total delinquent loans at December 31, 2021 were 0.46 percent of total loans. The successful execution of these five strategies have enabled the Company to improve financial performance across a broad series of metrics. These metrics over the last five years are outlined in the following table. Specifically, the Company has increased total assets by $348.8 million, or 35.3 percent. The growth has been on both sides of the balance sheet over the five year period, with loans growing $190.2 million or 24.6 percent and deposits growing $284.1 million or 35.4 percent. During the prior five-year period, the Company has raised capital through the issuance of equity and debt to the market on two separate occasions during the period, which has raised equity capital significantly and expanded liquidity for potential strategic expansion. Strategic expansion has also occurred during the period with the acquisition of a small community bank (The Edon State Bank of Edon, Ohio) in 2020, the opening of three branch offices and the acquisition of two full service title agencies. 34 Financial Highlights Year Ended December 31, ($ in thousands, except per share data) 2022 2021 2020 2019 2018 Earnings Interest income $ 44,569 $ 41,904 $ 42,635 $ 44,400 $ 39,479 Interest expense 5,170 4,020 6,705 9,574 6,212 Net interest income 39,399 37,884 35,930 34,826 33,267 Provision for loan losses - 1,050 4,500 800 600 Noninterest income 18,231 30,697 30,096 18,016 16,624 Noninterest expense 42,314 44,808 43,087 37,410 34,847 Provision for income taxes 2,795 4,446 3,495 2,659 2,806 Net income 12,521 18,277 14,944 11,973 11,638 Preferred stock dividends - - - 950 975 Net income available to common shareholders 12,521 18,277 14,944 11,023 10,663 Per Common Share Data Basic earnings $ 1.79 $ 2.58 $ 1.96 $ 1.71 $ 1.72 Diluted earnings 1.77 2.56 1.96 1.51 1.51 Cash dividends declared 0.48 0.44 0.40 0.36 0.32 Total equity per share 17.08 21.05 19.39 17.53 16.36 Average Balances Average total assets $ 1,318,781 $ 1,322,253 $ 1,161,396 $ 1,027,932 $ 947,266 Average equity 126,963 144,223 139,197 133,190 121,094 Ratios Return on average total assets 0.95 % 1.38 % 1.29 % 1.16 % 1.23 % Return on average equity 9.86 12.67 10.74 8.99 9.61 Cash dividend payout ratio 1 27.25 17.18 20.54 23.84 19.60 Average equity to average assets 9.63 10.91 11.99 12.96 12.78 Period End Totals Total assets $ 1,335,633 $ 1,330,854 $ 1,257,839 $ 1,038,577 $ 986,828 Available-for-sale securities 238,780 263,259 149,406 100,948 90,969 Loans held for sale 2,073 7,472 7,234 7,258 4,445 Total loans & leases 962,075 822,714 872,723 825,510 771,883 Allowance for loan losses 13,818 13,805 12,574 8,755 8,167 Total deposits 1,086,665 1,113,045 1,049,011 840,219 802,552 Advances from FHLB 60,000 5,500 8,000 16,000 16,000 Trust preferred securities 10,310 10,310 10,310 10,310 10,310 Subordinated debt, net 19,594 19,546 - - - Total equity 118,428 144,929 142,923 136,094 130,435 1 Cash dividends on common shares divided by net income available to common. Critical Accounting Policies The accounting and reporting policies of the Company are in accordance with generally accepted accounting principles 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 years ended December 31, 2022 and 2021. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company’s 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. 35 Allowance for Loan Losses: The allowance for loan losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in the nature and amount of problem assets and associated collateral, underwriting activities, 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 each impaired 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 customer 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 customer’s financial condition or changes in their unique business conditions, the subjective nature of individual loan valuations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-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 also 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 imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. 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. 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. Deferred Tax Asset: The Company has evaluated its deferred tax asset to determine if it is more likely than not that the asset will be realized in the future. The Company’s most recent evaluation has determined that the Company will more likely than not be able to realize the remaining deferred tax asset. Income Tax Accounting: The Company files a consolidated federal income tax return. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on our income tax return. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in rates on the deferred tax assets and liabilities is recognized as income or expense in the period that includes the enactment date. Changes in Financial Condition Total assets at December 31, 2022, were $1.34 billion, compared to $1.33 billion at December 31, 2021. Loans (excluding loans held for sale) were $962.1 million at December 31, 2022, compared to $822.7 million at December 31, 2021. Total deposits were $1.09 billion at December 31, 2022, compared to $1.11 billion at December 31, 2021. As client balance sheets and liquidity was utilized in the economy, deposit levels moderated and assets were reallocated from cash and securities into loans. 36 The following are the condensed average balance sheets of the Company for the years ending December 31 and includes the interest earned or paid, and the average interest rate, on each asset and liability: 2022 2021 2020 ($ in thousands) Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate Assets Taxable securities/cash $ 330,549 $ 5,798 1.75 % $ 380,770 $ 3,386 0.89 % $ 185,480 $ 2,328 1.26 % Non-taxable securities 8,106 198 2.44 % 7,802 353 4.52 % 6,625 333 5.03 % Loans, net 1 888,116 38,573 4.34 % 854,521 38,165 4.47 % 880,338 39,974 4.54 % Total earning assets 1,226,771 44,569 3.63 % 1,243,093 41,904 3.37 % 1,072,443 42,635 3.98 % Cash and due from banks 7,296 7,290 14,553 Allowance for loan losses (13,808 ) (13,422 ) (10,165 ) Premises and equipment 24,137 24,710 23,776 Other assets 74,385 60,582 60,789 Total assets $ 1,318,781 $ 1,322,253 $ 1,161,396 Liabilities Savings and interest-bearing demand deposits $ 693,271 $ 2,258 0.33 % $ 672,296 $ 1,813 0.27 % $ 492,267 $ 3,152 0.64 % Time deposits 159,401 1,219 0.76 % 177,918 1,316 0.74 % 247,955 2,918 1.18 % Repurchase agreements & other 20,481 39 0.19 % 22,821 42 0.18 % 22,832 70 0.31 % Advances from FHLB 16,420 515 3.14 % 6,507 188 2.89 % 14,186 309 2.18 % Trust preferred securities 10,310 361 3.50 % 10,310 199 1.93 % 10,310 256 2.48 % Subordianted debt 19,570 778 3.98 % 12,057 462 3.83 % Total interest-bearing liabilities 919,453 5,170 0.56 % 901,909 4,020 0.45 % 787,550 6,705 0.85 % Demand deposits 252,899 255,908 211,004 Other liabilities 19,466 20,213 23,645 Total liabilities 1,191,818 1,178,030 1,022,199 Shareholders’ equity 126,963 144,223 139,197 Total liabilities and shareholders’ equity $ 1,318,781 $ 1,322,253 $ 1,161,396 Net interest income (tax equivalent basis) $ 39,399 $ 37,884 $ 35,930 Net interest income as a percent of average interest-earning assets - GAAP measure 3.21 % 3.05 % 3.35 % Net interest income as a percent of average interest-earning assets - Non-GAAP measure 2 3.22 % 3.06 % 3.36 % -- Computed on a fully tax equivalent basis (FTE) 1 Nonaccruing loans and loans held for sale are included in the average balances. 2 Interest on tax exempt securities and loans is computed on a tax equivalent basis using a 21 percent statutory tax rate, and added to the net interest income. The tax equivalent adjustment was $0.15, $0.15 and $0.15 million in 2022, 2021 and 2020, respectively. The following tables set forth the effect of volume and rate changes on interest income and expense for the periods indicated. For purposes of these tables, changes in interest due to volume and rate were determined as follows: ● Volume variance - change in volume multiplied by the previous year’s rate. ● Rate variance - change in rate multiplied by the previous year’s volume. ● Rate/volume variance - change in volume multiplied by the change in rate. This variance allocates the volume variance and rate variance in proportion to the relationship of the absolute dollar amount of the change in each. 37 Total Variance Variance Attributable To ($ in thousands) 2022/2021 Volume Rate Interest income Taxable securities $ 2,412 $ (447 ) $ 2,859 Non-taxable securities 1 (155 ) 14 (169 ) Loans, net of unearned income and deferred fees 1 408 1,500 (1,092 ) Total interest income 2,665 1,067 1,598 Interest expense Savings and interest-bearing demand deposits 445 57 388 Time deposits (97 ) (137 ) 40 Repurchase agreements & other (3 ) (4 ) 1 Advances from FHLB 327 286 41 Trust preferred securities 162 - 162 Subordinated debt 316 316 - Total interest expense 1,150 518 632 Net interest income $ 1,515 $ 549 $ 966 1 Interest on non-taxable securities and loans has been adjusted to fully tax equivalent The maturity distribution and weighted-average interest rates of debt securities available-for-sale at December 31, 2022, are set forth in the table below. The weighted-average interest rates are based on coupon rates for securities purchased at par value and on effective interest rates considering amortization or accretion if the securities were purchased at a premium or discount: Maturing ($ in thousands) Within 1 Year Weighted Average Yield 1-5 Years Weighted Average Yield 5-10 Years Weighted Average Yield After 10 Years Weighted Average Yield Total Weighted Average Yield Available for sale: U.S. Treasury and Government agencies $ 243 0.64 % $ 1,022 2.45 % $ 5,499 1.78 % $ - $ 6,764 1.84 % Mortgage-backed securities - 1,827 2.74 % 29,142 1.65 % 174,866 1.36 % 205,835 1.41 % State and political subdivisions 837 3.38 % 792 2.85 % 1,893 4.37 % 7,581 2.64 % 11,103 2.97 % Other corporate securities - - 15,078 3.69 % - 15,078 3.69 % Total securities by maturity $ 1,080 2.76 % $ 3,641 2.68 % $ 51,612 2.36 % $ 182,447 1.41 % $ 238,780 1.64 % 1 Yields are presented on a tax-equivalent basis. 38 ($ in thousands) Years Ended December 31, Total loans 2022 2021 % Change Commercial business & agriculture $ 192,478 $ 179,653 7.1 % Commercial real estate 412,635 381,168 8.3 % Residential real estate 291,512 206,424 41.2 % Consumer & other 65,005 55,156 17.9 % Total loans 961,630 822,401 16.9 % Net deferred costs (fees) 445 313 42.2 % Total loans, net deferred costs (fees) 962,075 822,714 16.9 % Loans held for sale $ 2,073 $ 7,472 -72.3 % Total deposits 2022 2021 % Change Noninterest bearing demand $ 256,799 $ 247,044 3.9 % Interest-bearing demand 191,719 195,464 -1.9 % Savings & money market 447,267 514,033 -13.0 % Time deposits 190,880 156,504 22.0 % Total deposits 1,086,665 1,113,045 -2.4 % Total shareholders’ equity $ 118,428 $ 144,929 -18.3 % Loans held for investment increased $139.4 million, or 16.9 percent, to $962.1 million at December 31, 2022, which was due to an increase in residential and commercial real estate lending during 2022. The Company booked a much higher portion of residential real estate production on the balance sheet as saleable pricing was not competitive during much of 2022. Concentrations of Credit Risk : The Company makes commercial, real estate and installment loans to customers located mainly in the Tri-State region of Ohio, Indiana and Michigan. Commercial loans include loans collateralized by commercial real estate, business assets and, in the case of agricultural loans, crops and farm equipment and the loans are expected to be repaid from cash flow from operations of businesses. As of December 31, 2022, commercial business and agricultural loans made up approximately 29.6 percent of the loans held for investment (“HFI”) loan portfolio while commercial real estate loans accounted for approximately 42.5 percent of the HFI loan portfolio. Residential first mortgage loans made up approximately 20.9 percent of the HFI loan portfolio and are secured by first mortgages on residential real estate, while consumer loans to individuals made up approximately 7.0 percent of the HFI loan portfolio and are primarily secured by consumer assets. Maturities and Sensitivities of Loans to Changes in Interest Rates: The following table shows the maturity distribution of loans outstanding as of December 31, 2022. The amounts have been categorized between loans with a fixed or floating interest rate (floating rate loans have an adjustable interest rate that changes in accordance to a rate index). 39 Maturities and Sensitivities of Loans to Changes in Interest Rates As of December 31, 2022 ($ in thousands) Within one year After one, but within five years After five, but within fifteen years After fifteen years Total Loans with fixed interest rates: Commercial & industrial $ 1,527 $ 20,613 $ 28,442 $ 21 $ 50,603 Commercial real estate - owner occupied 461 3,662 7,822 - 11,945 Commercial real estate - nonowner occupied 3,181 19,356 13,257 142 35,936 Agricultural 131 4,214 9,341 1,595 15,281 Residential real estate 893 801 18,066 32,078 51,838 HELOC - - - - - Consumer 3,544 9,195 3,362 76 16,177 Total $ 9,737 $ 57,841 $ 80,290 $ 33,912 $ 181,780 Loans with floating interest rates: Commercial & industrial $ 32,554 $ 9,351 $ 35,159 $ 423 $ 77,487 Commercial real estate - owner occupied 2,642 12,108 44,116 40,037 98,903 Commercial real estate - nonowner occupied 3,596 35,334 110,556 116,365 265,851 Agricultural 189 6,440 18,689 23,789 49,107 Residential real estate 7,920 364 12,962 218,428 239,674 HELOC 112 262 32,710 11,977 45,061 Consumer 335 3,432 - - 3,767 Total $ 47,348 $ 67,291 $ 254,192 $ 411,019 $ 779,850 Total loans: Commercial & industrial $ 34,081 $ 29,964 $ 63,601 $ 444 $ 128,090 Commercial real estate - owner occupied 3,103 15,770 51,938 40,037 110,848 Commercial real estate - nonowner occupied 6,777 54,690 123,813 116,507 301,787 Agricultural 320 10,654 28,030 25,384 64,388 Residential real estate 8,813 1,165 31,028 250,506 291,512 HELOC 112 262 32,710 11,977 45,061 Consumer 3,879 12,627 3,362 76 19,944 Total loans $ 57,085 $ 125,132 $ 334,482 $ 444,931 $ 961,630 Deposits decreased $26.4 million, or 2.4 percent, to $1.09 billion at December 31, 2022. Deposits declined in 2022 after experiencing over $200 million in growth during 2021. Increased inflation and interest rates resulted in clients seeking higher returns on their deposit accounts. As a result, during 2022, we experienced a shift in the mix of our deposit balances as more of our clients moved balances to long-term time deposit accounts. Specifically, during 2022, time deposits increased $34.4 million, or 22 percent, while other deposits decreased $60.8 million, or 6 percent. The average amount of deposits and weighted-average rates paid are summarized as follows for the years ended December 31: 2022 2021 2020 Average Average Average Average Average Average ($ in thousands) Amount Rate Amount Rate Amount Rate Savings and interest bearing demand deposits $ 693,271 0.33 % $ 672,296 0.27 % $ 492,267 0.64 % Time deposits 159,401 0.76 % 177,918 0.74 % 247,955 1.18 % Non interest bearing demand deposits 252,899 - 255,908 - 211,004 - Totals $ 1,105,571 0.31 % $ 1,106,122 0.28 % $ 951,226 0.64 % Time deposits that exceeded the FDIC insurance limit of $250,000 are summarized as follows: ($ in thousands) 2022 2021 Three months or less $ 6,992 $ 1,033 Over three months through six months 102 415 Over six months and through twelve months 1,330 3,083 Over twelve months 6,949 238 Total $ 15,373 $ 4,769 40 Shareholders’ equity at December 31, 2022, was $118.4 million or 8.9 percent of total assets compared to $144.9 million or 10.9 percent of total assets at December 31, 2021. Retained earnings increased during the year due to earnings of $12.5 million less dividends paid to common shareholders of $3.4 million and repurchases of Company common shares of $5.8 million. The fair market value of the bond portfolio regressed during 2022 due to the valuation adjustment on the portfolio, which resulted in a decline in accumulated other comprehensive income (“AOCI”) of $30.3 million. The Company continued to repurchase its own stock during the year. Specifically, the Company repurchased approximately 317,000 shares during 2022 at an average price of $18.43 per share. As of December 31, 2022, the Company had 480,682 shares remaining of the 500,000 shares authorized for repurchase under the Company’s existing share repurchase program, which was authorized on December 21, 2022 and expires December 31, 2024. Asset Quality Years Ended December 31, ($ in thousands) 2022 2021 % Change Nonaccruing loans $ 3,682 $ 3,652 0.8 % Accruing restructured loans (TDRs) 654 725 -9.8 % Foreclosed assets and other assets held for sale, net 777 2,104 -63.1 % Nonperforming assets 5,113 6,481 -21.1 % Net recoveries (13 ) (181 ) -92.8 % Loan loss provision - 1,050 -100.0 % Allowance for loan losses 13,818 13,805 0.1 % Nonaccruing loans/total loans 0.38 % 0.44 % -13.8 % Allowance/nonaccruing loans 375.29 % 378.01 % -0.7 % Nonperforming assets/total assets 0.38 % 0.49 % -21.4 % Net charge offs/average loans 0.00 % -0.02 % -95.0 % Allowance/loans 1.44 % 1.68 % -14.4 % Allowance/nonperforming loans 318.68 % 315.40 % 1.0 % Nonperforming assets consisting of loans, Other Real Estate Owned (“OREO”) and accruing TDRs totaled $5.1 million, or 0.38 percent of total assets at December 31, 2022, a decrease of $1.4 million, or 21.1 percent from 2021. The Company had total net recoveries on loans in both 2022 and 2021, with $13,000 in net recoveries in 2022, following $181,000 in net recoveries for all of 2021. The Company’s allowance for loan losses at December 31, 2022, now covers nonperforming loans at 319 percent, up from 315 percent at December 31, 2021. 41 The following schedule presents an analysis of the allowance for loan losses, average loan data and related ratios at December 31 for the years indicated: ($ in thousands) Provision for Loan Loss Net (Chargeoffs) Recoveries Average Loans Ratio of annualized net (chargeoffs) recoveries to average loans December 31, 2022 Commercial & industrial $ (227 ) $ - $ 126,496 0.00 % Commercial real estate - owner occupied (135 ) - 122,031 0.00 % Commercial real estate - nonowner occupied (366 ) - 276,805 0.00 % Agricultural 12 - 58,745 0.00 % Residential real estate 923 - 239,162 0.00 % HELOC (84 ) - 43,210 0.00 % Consumer (123 ) 13 14,039 0.09 % Total $ - $ 13 $ 880,488 0.00 % December 31, 2021 Commercial & industrial $ (1,411 ) $ 227 $ 160,267 0.14 % Commercial real estate - owner occupied 505 - 118,713 0.00 % Commercial real estate - nonowner occupied 825 - 264,980 0.00 % Agricultural 103 - 53,122 0.00 % Residential real estate 975 6 195,277 0.00 % HELOC (16 ) - 43,488 0.00 % Consumer 69 (52 ) 11,546 -0.45 % Total $ 1,050 $ 181 $ 847,393 0.02 % December 31, 2020 Commercial & industrial $ 1,757 $ (566 ) $ 198,991 -0.28 % Commercial real estate - owner occupied 721 - 104,856 0.00 % Commercial real estate - nonowner occupied 1,128 - 269,924 0.00 % Agricultural 62 - 51,840 0.00 % Residential real estate 373 (42 ) 185,311 -0.02 % HELOC 203 (8 ) 47,227 -0.02 % Consumer 256 (65 ) 11,595 -0.56 % Total loans $ 4,500 $ (681 ) $ 869,744 -0.08 % The allowance for loan losses balance and the provision for loan losses are determined by management based upon periodic reviews of the loan portfolio. In addition, management considers the level of charge offs on loans, as well as the fluctuations of charge offs and recoveries on loans, in the factors which caused these changes. Estimating the risk of loss and the amount of loss is necessarily subjective. Accordingly, the allowance is maintained by management at a level considered adequate to cover losses that are currently anticipated based on past loss experience, economic conditions, information about specific borrower situations, including their financial position and collateral values, and other factors and estimates which are subject to change over time. The Company has substantially increased the reserve level over the last several years. Specifically, since December 31, 2019 the allowance for loan losses balance has increased from $8.8 million to $13.8 million at December 31, 2022, which is an increase of $5.0 million or 59 percent. This increase was the result of $5.6 million in provision expense during the period ($4.5 million in 2020 and $1.1 million in 2021) and minimal charge-offs, which were just $0.5 million over the two-year period. The reserve has remained flat in 2022 as a result of increased loan growth that has been offset by improving economic conditions. 42 The following schedule provides a breakdown of the allowance for loan losses allocated by type of loan and related ratios at December 31 for the years indicated: Allowance Amount Percentage of Loans In Each Category to Total Loans Allowance Amount Percentage of Loans In Each Category to Total Loans Allowance Amount Percentage of Loans In Each Category to Total Loans ($ in thousands) 2022 2021 2020 Commercial & industrial $ 1,663 12.0 % $ 1,890 14.9 % $ 3,074 23.4 % Commercial real estate - owner occupied 1,696 12.3 % 2,588 14.5 % 2,059 12.9 % Commercial real estate - nonowner occupied 4,584 33.2 % 4,193 31.9 % 3,392 29.5 % Agricultural 611 4.4 % 599 7.0 % 496 6.3 % Residential real estate 4,438 32.1 % 3,515 25.1 % 2,534 20.8 % Home equity line of credit (HELOC) 547 4.0 % 631 5.1 % 647 5.3 % Consumer 279 2.0 % 389 1.6 % 372 1.7 % $ 13,818 100.0 % $ 13,805 100.0 % $ 12,574 100.0 % As detailed in the risk factors, the CARES Act provided for significant consumer and small business relief due to the impact of the COVID-19 pandemic. The Company provided payment relief to a number of consumer and small business customers throughout 2020 and 2021, which we believe was successful and enabled our clients to weather the pandemic effectively. All such COVID-related payment deferrals had expired or been removed by December 31, 2021 and all clients were back to contractual terms at such date. Regulatory capital reporting is required for State Bank only, as the Company is currently exempt from quarterly regulatory capital level measurement pursuant to the Small Bank Holding Company Policy Statement. As of December 31, 2022, State Bank met all regulatory capital levels required to be considered well-capitalized (see Note 16 to the Consolidated Financial Statements). On May 27, 2021, the Company issued and sold $20.0 million in aggregate principal amount of its 3.65% Fixed to Floating Rate Subordinated Notes due 2031 in a private placement exempt from the registration requirements under the Securities Act of 1933, as amended. The Subordinated Notes bear interest at a fixed rate of 3.65% through May 31, 2026. From June 1, 2026 to the maturity date or earlier redemption of the Subordinated Notes, the interest rate will reset quarterly to an interest rate per annum, equal to the then-current-three-month Secured Overnight Financing Rate (“SOFR”) provided by the Federal Reserve Bank of New York plus 296 basis points. The proceeds from the Subordinated Notes will be used to assist the Company in meeting various corporate obligations, including share buyback, acquisition costs and organic asset growth. The Subordinated Notes have a maturity of 10 years. Earnings Summary – 2022 vs. 2021 Net income for 2022 was $12.5 million, or $1.77 per diluted share, compared with net income of $18.3 million, or $2.56 per diluted share, for 2021. State Bank reported net income for 2022 of $13.4 million, which was down from the $18.6 million in net income in 2021. SBFG Title reported net income for 2022 of $0.4 million, which was down from net income of $0.5 million in 2021. Positive results for 2022 included loan growth of $141.4 million when excluding the impact of the PPP initiative, while deposits were slightly lower by $26.4 million. The Company completed the final forgiveness in December of 2022 from the nearly 1,200 PPP loans processed during 2020 and 2021. The mortgage banking business line, despite the headwinds from rapidly rising rates, continued to contribute in both balance growth and gain on sale. For the full year of 2022, residential real estate loan production was $313.0 million, with $4.3 million of revenue from gains on sale. The level of mortgage origination was down from the $600.0 million in 2021. The Company’s loans serviced for others ended the year at $1.35 billion, down slightly from $1.36 billion at December 31, 2021. Operating revenue decreased by $11.0 million, or 3.9 percent, from $68.6 million in 2021 to $57.6 million in 2022 due to decreased PPP fees, OMSR recapture and significantly lower mortgage gain revenue. SBFG Title increased revenue by $0.1 million to $2.2 million for 2022. 43 Operating expense decreased by $2.5 million, or 5.6 percent, from $44.8 million in 2021 to $42.3 million in 2022, due to lower incentive and commission levels, which were offset by higher medical costs and increased spending on technology. Results of Operations Years Ended December 31, ($ in thousands, except per share data) 2022 2021 % Change Total assets $ 1,335,633 $ 1,330,854 0.4 % Total investments 238,780 263,259 -9.3 % Loans held for sale 2,073 7,472 -72.3 % Loans, net of unearned income 962,075 822,714 16.9 % Allowance for loan losses 13,818 13,805 0.1 % Total deposits 1,086,665 1,113,045 -2.4 % Total operating revenue 1 $ 57,630 $ 68,581 -16.0 % Net interest income 39,399 37,884 4.0 % Loan loss provision - 1,050 -100.0 % Noninterest income 18,231 30,697 -40.6 % Noninterest expense 42,314 44,808 -5.6 % Net income 12,521 18,277 -31.5 % Diluted earnings per share 1.77 2.56 -30.9 % 1 Operating revenue equals net interest income plus noninterest income. Net interest income was $39.4 million for 2022 compared to $37.9 million for 2021, an increase of $1.5 million or 4.0 percent. Despite the reduction in PPP fees of $3.6 million compared to 2021, 2022 margin revenue was able to grow due to a favorable shift in mix on the balance sheet. Average earning assets decreased slightly to $1.23 billion in 2022, compared to $1.24 billion in 2021, due lower cash and securities, partially offset by the increase in our loan portfolio. The consolidated 2022 full year net interest margin on an FTE basis increased 16 basis points to 3.22 percent compared to 3.06 percent for the full year of 2021. The Company benefited from the Federal Reserve’s seven interest rate increases in 2022, which increased margin revenue from our variable rate loans and securities. Zero provision for loan losses was taken in 2022 compared to $1.0 million taken for 2021. For 2022, net recoveries totaled $0.01 million, compared to net recoveries of $0.18 million or (0.02) percent of average loans, for 2021. Noninterest Income Years Ended December 31, ($ in thousands) 2022 2021 % Change Wealth management fees $ 3,728 $ 3,814 -2.3 % Customer service fees 3,378 3,217 5.0 % Gains on sale of residential loans & OMSR’s 4,298 17,255 -75.1 % Mortgage loan servicing fees, net 2,964 2,940 -0.8 % Gain on sale of non-mortgage loans 566 158 258.2 % Title insurance income 2,229 2,089 6.7 % Other 1,068 1,224 -12.7 % Total noninterest income $ 18,231 $ 30,697 -40.6 % 44 Total noninterest income was $18.2 million for 2022 compared to $30.7 million for 2021, representing a decrease of $12.5 million, or 40.6 percent, year-over-year. Mortgage gain on sale was down significantly from the record year in 2021 by $13.0 million. The Company sold $184.8 million of originated mortgages into the secondary market in 2022, which due to being less than the amortization on the serviced portfolio, reduced the size of our serviced loan portfolio to $1.35 billion at December 31, 2022 from $1.36 billion at December 31, 2021. Sales of non-mortgage loans (small business and farm credits) increased in 2022 as compared to 2021, as SBA activity returned to normal production. The Company saw its wealth management assets under management decline by $111.2 million to $507.13 million, however price increases and higher brokerage activity held the revenue decline for the year to only 2.3 percent. Noninterest Expense Years Ended December 31, ($ in thousands) 2022 2021 % Change Salaries & employee benefits $ 24,142 $ 26,838 -10.0 % Net occupancy expense 2,993 3,048 -1.8 % Equipment expense 3,616 3,281 10.2 % Data processing fees 2,510 2,579 -2.7 % Professional fees 3,214 3,027 6.2 % Marketing expense 911 784 16.2 % Telephone and communications 474 581 -18.4 % Postage and delivery expense 422 414 1.9 % State, local and other taxes 1,082 1,175 -7.9 % Employee expense 613 663 -7.5 % Other expense 2,337 2,418 (3.3 %) Total noninterest expense $ 42,314 $ 44,808 -5.6 % Total noninterest expense was $42.3 million for 2022 compared to $44.8 million for 2021, representing a $2.5 million, or 5.6 percent, decrease year-over-year. Total full-time equivalent employees ended 2022 at 269, which was down one from year end 2021. Earnings Summary – 2021 vs. 2020 Net income for 2021 was $18.3 million, or $2.56 per diluted share, compared with net income of $14.9 million, or $1.96 per diluted share, for 2020. State Bank reported net income for 2021 of $18.6 million, which was up from the $16.0 million in net income in 2020. SBFG Title reported net income for 2021 of $0.5 million, which was down from net income of $0.6 million in 2020. Positive results for 2021 included loan growth of $18.5 million when excluding the impact of the PPP initiative, and deposit growth of $64.0 million. The Company fully participated in both phases of PPP, with a total of $111.4 million in loans to over 1,100 clients with revenue of $3.4 million for 2021 compared to $1.4 million for 2020. The mortgage banking business line continued to contribute significant revenues, with residential real estate loan production of $600.0 million for the year, resulting in $17.3 million of revenue from gains on sale. The level of mortgage origination was down from the $694.2 million in 2020. The Company’s loans serviced for others ended the year at $1.36 billion, up from $1.30 billion at December 31, 2020. Operating revenue increased by $2.6 million, or 3.9 percent, from $66.0 million in 2021 to $68.6 million in 2020 due to increased PPP fees and OMSR recapture which offset lower mortgage gain revenue. SBFG Title increased revenue by $0.1 million to $2.1 million for 2022. Operating expense increased by $1.7 million, or 4.0 percent, from $43.1 million in 2021 to $44.8 million in 2020, due to compensation and fringe benefit cost increases and higher spend on technology/digital initiatives. These expense increases were offset by lower mortgage commission expense due to lower volume. 45 Goodwill, Intangibles and Capital Purchases The Company completed its most recent annual goodwill impairment review as of December 31, 2022. At December 31, 2022, the Company concluded that it was more likely than not that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment. The Company’s goodwill is further discussed in Note 6 to the Consolidated Financial Statements. Management plans to continue from time to time to purchase additional premises and equipment and improve current facilities to meet the current and future needs of the Company’s customers. These purchases will include buildings, leasehold improvements, furniture and equipment. Management expects that cash on hand and cash generated from current operations will fund these capital expenditures and purchases. Liquidity Liquidity relates primarily to the Company’s ability to fund loan demand, meet deposit customers’ withdrawal requirements and provide for operating expenses. Sources used to satisfy these needs consist of cash and due from banks, interest-bearing deposits in other financial institutions, securities available-for-sale, loans held for sale and borrowings from various sources. These assets, excluding the borrowings, are commonly referred to as liquid assets. Liquid assets were $270.8 million at December 31, 2022, compared to $422.9 million at December 31, 2021. The Company does not have material cash requirements for capital expenditures over the next year. Any cash needs for capital requirements would be funded by cash existing at the Company. It is not anticipated that the Company will be required to initiate external borrowings in order to fund ongoing operations. The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolio of $768.5 million at December 31, 2022, can and is readily used to collateralize borrowings, which is an additional source of liquidity. Management believes the Company’s current liquidity level, without these borrowings, is sufficient to meet its current and anticipated liquidity needs. At December 31, 2022, all eligible commercial real estate, residential first, multi-family mortgage and agricultural loans were pledged under a Federal Home Loan Bank (“FHLB”) blanket lien. Significant additional off-balance-sheet liquidity is available in the form of FHLB advances, unused federal funds lines from correspondent banks and the national certificate of deposit market. Management expects the risk of changes in off-balance-sheet arrangements to be immaterial to earnings. Based on the current collateralization requirements of the FHLB, approximately $80.9 million of additional borrowing capacity existed at December 31, 2022. At December 31, 2022 and 2021, the Company had $56.0 million in federal funds lines available. The Company also had $166.5 million in unpledged securities at December 31, 2022 available for additional borrowings. The cash flow statements for the periods presented provide an indication of the Company’s sources and uses of cash as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for 2022 and 2021 follows: The Company experienced positive cash flows from operating activities in 2022 and 2021. Net cash from operating activities was $25.6 million and $17.3 million for the years ended December 31, 2022 and 2021, respectively. Significant operating items for 2022 included gain on sale of loans of $4.9 million and net income of $12.5 million. Cash provided by the sale of loans held for sale were $189.5 million. Cash used in the origination of loans held for sale were $181.2 million. The Company experienced negative cash flows from investing activities in 2022 and 2021. Net cash used in investing activities was $165.7 million and $72.0 million for the years ended December 31, 2022 and 2021, respectively. The changes for 2022 include the purchase of available-for-sale securities of $50.6 million, and net increase in loans of $139.7 million. The changes for 2021 include the purchase of available- for-sale securities of $170.7 million and net decrease in loans of $48.5 million. The Company had proceeds from repayments, maturities, sales and calls of securities of $35.9 million and $50.5 million in 2022 and 2021, respectively. 46 The Company experienced positive cash flows from financing activities in 2022 and 2021. Net cash from financing activities was $18.4 million and $63.6 million for the years ended December 31, 2022 and 2021, respectively. Negative cash flows of $26.4 million and positive cash flows of $64.0 million is attributable to the change in deposits for 2022 and 2021, respectively. The Company uses an Economic Value of Equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The results of this analysis are reflected in the following table. Economic Value of Equity December 31, 2022 ($ in thousands) Change in rates $ Amount $ Change % Change +400 basis points $ 264,361 $ (61,360 ) -18.84 % +300 basis points 284,602 (41,120 ) -12.62 % +200 basis points 303,265 (22,457 ) -6.89 % +100 basis points 319,473 (6,249 ) -1.92 % Base Case 325,722 - - -100 basis points 321,550 (4,172 ) -1.28 % -200 basis points 305,242 (20,480 ) -6.29 % -300 basis points 293,718 (32,004 ) -9.83 % -400 basis points 271,404 (54,318 ) -16.68 % Economic Value of Equity December 31, 2021 ($ in thousands) Change in rates $ Amount $ Change % Change +400 basis points $ 278,254 $ 35,684 14.71 % +300 basis points 273,190 30,620 12.62 % +200 basis points 265,711 23,142 9.54 % +100 basis points 256,110 13,540 5.58 % Base Case 242,570 - - -100 basis points 217,281 (25,289 ) -10.43 %