FIRST CAPITAL INC - Quarter Report: 2003 June (Form 10-Q)

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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended JUNE 30, 2003

OR

For the transition period from                      to                     

Commission File No. 0-25023

First Capital, Inc.

(Exact name of registrant as specified in its charter)

220 Federal Drive NW, Corydon, Indiana 47112

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code 1-812-738-2198

Not applicable

Former name, former address and former fiscal year, if changed since last report

Indicate by check mark whether the registrant (1) has filed all required 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 check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    NO  x

APPLICABLE ONLY TO CORPORATE ISSUERS; Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 2,825,777 shares of common stock were outstanding as of July 31, 2003.

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FIRST CAPITAL, INC.

INDEX

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PART I - FINANCIAL INFORMATION

FIRST CAPITAL, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to consolidated financial statements.

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PART I - FINANCIAL INFORMATION

FIRST CAPITAL, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

See accompanying notes to consolidated financial statements.

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PART I - FINANCIAL INFORMATION

FIRST CAPITAL, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to consolidated financial statements.

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FIRST CAPITAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

First Capital, Inc. (“Company”) is the holding company for First Harrison Bank (“Bank”). The information presented in this report relates primarily to the Bank’s operations.

In the opinion of management, the unaudited consolidated financial statements include all normal adjustments considered necessary to present fairly the financial position as of June 30, 2003, and the results of operations for the three months and six months ended June 30, 2003 and 2002 and cash flows for the six months ended June 30, 2003 and 2002. All of these adjustments are of a normal, recurring nature. Such adjustments are the only adjustments included in the unaudited consolidated financial statements. Interim results are not necessarily indicative of results for a full year.

The accompanying unaudited consolidated financial statements and notes have been prepared in accordance with generally accepted accounting principles for interim financial statements and are presented as permitted by the instructions to Form 10-Q. Accordingly, they do not contain certain information included in the Company’s annual audited consolidated financial statements and related footnotes for the year ended December 31, 2002 included in the Form 10-KSB.

The unaudited consolidated financial statements include the accounts of the Company, the Bank and the Bank’s wholly owned subsidiary, First Harrison Financial Services, Inc. All material intercompany balances and transactions have been eliminated in consolidation.

Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income for the Company includes net income and other comprehensive income representing the net unrealized gains and losses on securities available for sale. The following tables set forth the components of other comprehensive income and the allocated tax amounts for the three and six months ended June 30, 2003 and 2002:

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FIRST CAPITAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

On March 20, 2003, the Company consummated its acquisition of Hometown Bancshares, Inc. (Hometown), a bank holding company located in New Albany, Indiana, pursuant to an Agreement and Plan of Merger dated September 25, 2002. Hometown is the parent company of Hometown National Bank, which was merged with and into the Bank. The acquisition was made for the purpose of expanding the Company’s presence in the New Albany and Floyd County, Indiana market area and the Company expects to benefit from growth in this market area as well as from expansion of the banking services provided to the existing customers of Hometown.

Pursuant to the terms of the merger agreement, Hometown stockholders who elected to receive Company stock received 2.487 shares of Company common stock and Hometown shareholders who elected to receive cash received $46.50 in cash for each share of Hometown common stock. Hometown stockholders who did not submit properly completed election forms within the required timeframe received 0.773 shares of Company common stock and $32.05 in cash for each share of Hometown common stock. The Company issued 285,446 shares of common stock and paid approximately $5.4 million in cash consideration to former Hometown stockholders. The value assigned to the common shares issued in the transaction was approximately $6.1 million determined by the average closing price of the Company’s common stock over a twenty day period ended March 17, 2003. The transaction was accounted for under the purchase method of accounting. Accordingly, the results of operations of Hometown have been included in the Company’s results of operations since the date of acquisition. Under the purchase method of accounting, the purchase price is allocated to the respective assets acquired and liabilities assumed based on their estimated fair values, net of applicable income tax effects. The excess of cost over the fair value of the net assets acquired of approximately $5.4 million has been recorded as goodwill.

The following unaudited pro forma information assumes that the acquisition was consummated on January 1, 2002:

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FIRST CAPITAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In addition to combining the historical results of operations, the pro forma calculations consider the purchase accounting adjustments and nonrecurring charges directly related to the acquisition and the related tax effects. The pro forma calculations do not include any anticipated cost savings as a result of the acquisition. The pro forma results of operations are not necessarily indicative of the actual results of operations that would have occurred had the Hometown acquisition actually been consummated on January 1, 2002, or results that may occur in the future.

The Company accounts for its stock option plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the stock option plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation.

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FIRST CAPITAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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PART I—ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

FIRST CAPITAL, INC. AND SUBSIDIARIES

Safe Harbor Statement for Forward Looking Statements

This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts, rather statements based on the Company’s current expectations regarding its business strategies and their intended results and its future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.

Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to the Company’s actual results, performance and achievements to be materially different from those expressed or implied by the forward-looking statements. Factors that may cause or contribute to these differences include, without limitation, general economic conditions, including changes in market interest rates and changes in monetary and fiscal policies of the federal government; legislative and regulatory changes; and other factors disclosed periodically in the Company’s filings with the Securities and Exchange Commission.

Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on them, whether included in this report or made elsewhere from time to time by the Company or on its behalf. Except as required by applicable law or regulation, the Company assumes no obligation to update any forward-looking statements.

Financial Condition

Total assets increased from $308.6 million at December 31, 2002 to $398.6 million at June 30, 2003. The increase in total assets includes the assets acquired in the merger with Hometown, which had assets of $90.5 million, excluding goodwill and other purchase accounting adjustments.

Net loans receivable were $216.0 million at December 31, 2002, compared to $285.8 million at June 30, 2003. Loans totaling $64.3 million were added in the acquisition of Hometown, consisting primarily of commercial mortgages and commercial loans.

Securities available for sale increased $8.4 million from $65.0 million at December 31, 2002 to $73.3 million at June 30, 2003. The increase was primarily due to purchases of $23.2 million and the acquisition of Hometown’s securities portfolio of $4.3 million, offset by maturities of $10.5 million, principal repayments of $6.1 million and sales of $2.5 million. The securities in Hometown’s portfolio classified as available for sale consisted of government agencies, mortgage-backed securities, notes and bonds.

Investment securities held-to-maturity increased $85,000 primarily as a result of $223,000 in municipal obligations acquired from Hometown, offset by maturities of $107,000 and principal repayments of $30,000.

Cash and short-term investments increased from $12.7 million at December 31, 2002 to $14.3 million at June 30, 2003. Hometown had $18.1 million in cash and short-term investments at the date of the acquisition. Cash consideration of $5.4 million was paid to Hometown shareholders in connection with the merger. The majority of the remainder of cash and short-term investments was used for the investment purchases previously mentioned.

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PART I—ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

FIRST CAPITAL, INC. AND SUBSIDIARIES

Total deposits increased 38.1%, from $216.2 million at December 31, 2002 to $298.7 million at June 30, 2003. Hometown had deposits of $84.7 million at the date of the acquisition, including time deposits of $63.3 million and checking and savings accounts $21.4 million.

Federal Home Loan Bank borrowings increased from $53.3 million at December 31, 2002 to $53.7 million at June 30, 2003. New advances of $4.6 million have been drawn during the six month period, primarily to take advantage of lower interest rates at favorable terms and replace maturing advances of $4.2 million.

Total stockholders equity increased from $36.3 million at December 31, 2002 to $43.5 million at June 30, 2003 primarily as a result of the issuance of common stock of $6.1 million related to the acquisition of Hometown and retained net income of $1.0 million.

Results of Operations

Net Income for the six month periods ended June 30, 2003 and 2002. Net income was $1.7 million ($.64 per share diluted) for the six months ended June 30, 2003 compared to $1.6 million ($.63 per share diluted) for the six months ended June 30, 2002. Net income increased due to increases in interest and noninterest income, partially offset by increases in the provision for loan losses and noninterest expenses.

Net Income for the three month periods ended June 30, 2003 and 2002. Net income was $1.0 million ($.36 per share diluted) for the three months ended June 30, 2003 compared to $774,000 ($.31 per share diluted) for the same period in 2002. Net income increased due to increases in interest and noninterest income, partially offset by increases in the provision for loan losses and noninterest expenses.

Net interest income for the six month periods ended June 30, 2003 and 2002. Net interest income increased 22.0% from $4.9 million in 2002 to $6.0 million in 2003 primarily as a result of an increase in interest-earning assets funded by growth in deposits and borrowings from the Federal Home Loan Bank.

Total interest income increased $949,000 during the six months ended June 30, 2003 compared to the same period in 2002. The average balance of interest-earning assets increased from $272.7 million to $335.9 million when comparing the same periods. The average tax-equivalent yield on interest-earning assets declined from 6.98% in 2002 to 6.24% in 2003, primarily due to the continued refinancing of residential mortgages and the repricing of the investment portfolio and adjustable rate loans at lower interest rates.

Total interest expense decreased $139,000 to $4.3 million during the six months ended June 30, 2003 compared to $4.5 million for the same period in 2002. Interest on deposits decreased $313,000 while interest on Federal Home Loan Bank borrowings increased $174,000 when comparing the two periods. The average balance of interest-bearing liabilities increased from $232.9 million in 2002 to $291.4 million in 2003 while the average rate on these same liabilities decreased from 3.82% in 2002 to 2.96% in 2003. This resulted in the Bank’s interest rate spread increasing to 3.28% during the first six months of 2003 from 3.16% for the same period in 2002.

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PART I—ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

FIRST CAPITAL, INC. AND SUBSIDIARIES

Net interest income for the three month periods ended June 30, 2003 and 2002. Net interest income increased from $2.5 million for the three months ended June 30, 2002 to $3.4 million for the same period in 2003 primarily due to the increase in interest-earning assets and an increase in the interest rate spread.

Total interest income increased $918,000 for the three months ended June 30, 2003 compared to the same period in 2002. The increase in the average balance of earning assets from $274.1 million in 2002 to $371.0 million in 2003 more than made up for the reduction in the average taxable-equivalent yield from 6.98% in 2002 to 6.15% in 2003.

Total interest expense increased $24,000 for the three months ended June 30, 2003 compared to the same period in 2002. The average balance of interest-bearing liabilities increased from $234.7 million in 2002 to $325.3 million in 2003. This was offset by the decrease in the average yield on these liabilities from 3.79% in 2002 to 2.77% in 2003. The result was an increase in the interest rate spread from 3.19% in 2002 to 3.38% in 2003.

Provision for loan losses. The provision for loan losses was $325,000 for the six month period ended June 30, 2003 as compared to $90,000 for the same period in 2002. During 2003, gross loans receivable increased $71.0 million. The acquisition of Hometown accounted for $65.4 million of that increase. The allowance for loan losses related to the acquired loans amounted to $1.1 million as of the acquisition date. However, the consistent application of management’s allowance methodology resulted in an increase in the provision for loan losses due to the higher levels of nonperforming loans as compared to the prior year and the general weakening of economic conditions.

Provisions for loan losses are charges to earnings to maintain the total allowance for loan losses at a level considered reasonable by management to provide for probable known and inherent loan losses based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specified impaired loans, and economic conditions. Although management uses the best information available, future adjustments to the allowance may be necessary due to changes in economic, operating, regulatory and other conditions that may be beyond the Bank’s control. While the Bank maintains the allowance for loan losses at a level that it considers adequate to provide for estimated losses, there can be no assurance that further additions will not be made to the allowance for loan losses and that actual losses will not exceed the estimated amounts.

The methodology used in determining the allowance for loan losses includes segmenting the loan portfolio by identifying risk characteristics common to groups of loans, determining and measuring impairment of individual loans based on the present value of expected future cash flows or the fair value of collateral, and determining and measuring impairment for groups of loans with similar characteristics by applying loss factors that consider the qualitative factors which may effect the loss rates.

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PART I—ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

FIRST CAPITAL, INC. AND SUBSIDIARIES

The allowance for loan losses was $2.4 million at June 30, 2003 compared to $1.2 million at December 31, 2002. As previously discussed, Hometown’s allowance for loan losses was $1.1 million at the date of acquisition. Management has deemed these amounts as adequate on those dates based on its best estimate of probable known and inherent loan losses. At June 30, 2003, nonperforming loans amounted to $4.0 million compared to $1.3 million at December 31, 2002. Loans acquired in the Hometown acquisition accounted for $2.3 million of the $4.0 million. Nonperforming loans at June 30, 2003 include $1.5 million in nonaccrual loans loans over 90 days past due, but still accruing interest, including nonresidential mortgages of $1.2 million, residential mortgages of $700,000, commercial loans of $500,000 and consumer loans of $150,000. These loans are still accruing interest as the collateral and collection efforts are deemed sufficient to ensure full recovery.

Noninterest income for the six month periods ended June 30, 2003 and 2002. Noninterest income increased 34.8% to $1.1 million for the six months ended June 30, 2003 compared to $819,000 for the six months ended June 30, 2002. Service charges on deposits increased $190,000, from $658,000 in 2002 to $848,000 in 2003, primarily due to an increase in the number of savings and checking accounts from 16,000 at June 30, 2002 to 21,800 at June 30, 2003. The Bank also recognized gains of $51,000 on the sale of securities during the first quarter of 2003. The Bank had a large amount of securities due to mature in the same time frame so a portion of these securities were sold to reduce the interest rate risk. No securities were sold during the same period in 2002.

Noninterest income for the three month periods ended June 30, 2003 and 2002. Noninterest income increased 40.7% to $595,000 for the three months ended June 30, 2003 compared to $423,000 for the same period in 2002. Again, this is primarily attributable to an increase in service charges on deposit accounts, which were $478,000 during the quarter ended June 30, 2003 and $347,000 during the same period in 2002. Also contributing to the positive trend was an increase of $29,000 in commission income, primarily attributable to commissions recognized by agents of First Harrison Financial Services, a subsidiary of the Bank.

Noninterest expense for the six month periods ended June 30, 2003 and 2002. Noninterest expense increased by $917,000, or 28.1%, for the six month period ended June 30, 2003 compared to the six months ended June 30, 2002. Increases in compensation and benefits, data processing fees and other operating expenses fueled this increase.

Compensation and benefits increased by $455,000 when making comparisons between the first six months of 2003 and 2002. The primary factor behind this increase is the addition of staff due to the Hometown acquisition and the opening of the new Jeffersonville, Indiana branch office in May of 2003. At June 30, 2002, the Bank had 102 full-time equivalent employees compared to 138 at June 30, 2003.

Data processing fees increased $232,000 when comparing the six months ended June 30, 2003 to the same period in 2002, primarily due to the conversion of the Hometown accounts to the Bank’s computer system and the additional depreciation on the new equipment to serve the three additional offices. Other operating expenses were $230,000 higher for the fist six months of 2003 compared to 2002. An increase of $116,000 in advertising expenses is the primary factor as the Bank adopted a more aggressive marketing campaign to target the new areas and incurred the costs associated with the grand opening of the Jeffersonville office.

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PART I—ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

FIRST CAPITAL, INC. AND SUBSIDIARIES

Noninterest expense for the three month periods ended June 30, 2003 and 2002. Noninterest expense increased 35.8% to $2.3 million for the quarter ended June 30, 2003 compared to $1.7 million for the same period in 2002. Costs associated with compensation and benefits due to the addition of staff were the primary factor, increasing by $308,000 when comparing the two periods. Other operating expenses accounted for $159,000 of the increase, with advertising expenses increasing $74,000.

Income tax expense. Income tax expense for the six month period ended June 30, 2003 was $907,000, compared to $840,000 for the same period in 2002. The effective tax rate decreased from 34.9% in 2002 to 34.5% in 2003. Income tax expense for the three month period ended June 30, 2003 was $541,000, compared to $428,000 for the same quarter in 2002. The effective tax rate for the three month period in 2003 was 35.1%, compared to 35.6% in 2002.

Liquidity and Capital Resources

The Bank’s primary sources of funds are customer deposits, proceeds from loan repayments, maturing securities and FHLB advances. While loan repayments and maturities are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, general economic conditions and competition. At June 30, 2003, the Bank had cash and interest-bearing deposits with banks of $14.3 million and securities available-for-sale with a fair value of $73.3 million. If the Bank requires funds beyond its ability to generate them internally, it has additional borrowing capacity with the FHLB of Indianapolis and collateral eligible for repurchase agreements.

The Bank’s primary investing activity is the origination of one-to-four family mortgage loans and, to a lesser extent, consumer, multi-family, commercial real estate and residential construction loans. The Bank also invests in U.S. Government and agency securities and mortgage-backed securities issued by U.S. Government agencies.

The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to support loan growth and deposit withdrawals, to satisfy financial commitments and to take advantage of investment opportunities. Historically, the Bank has been able to retain a significant amount of its deposits as they mature.

The Bank is required to maintain specific amounts of capital pursuant to Office of Thrift Supervision (OTS) requirements. As of June 30, 2003, the Bank was in compliance with all regulatory capital requirements, which were effective as of such date with tangible, core and risk-based capital ratios of 9.0%, 9.0% and 14.8%, respectively. The regulatory requirements at that date were 1.5%, 3.0% and 8.0%, respectively.

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PART I—ITEM 3

QUANTITATIVE AND QUALITATIVE DISCLOSURES

ABOUT MARKET RISK

FIRST CAPITAL, INC. AND SUBSIDIARIES

Qualitative Aspects of Market Risk. The Bank’s principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Bank has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the mismatch between asset and liability maturities and interest rates. In order to reduce the exposure to interest rate fluctuations, the Bank has developed strategies to manage its liquidity, shorten its effective maturities of certain interest-earning assets and decrease the interest rate sensitivity of its asset base. Management has sought to decrease the average maturity of its assets by emphasizing the origination of short-term commercial and consumer loans, all of which are retained by the Bank for its portfolio. The Bank relies on retail deposits as its primary source of funds. Management believes retail deposits, compared to brokered deposits, reduce the effects of interest rate fluctuations because they generally represent a more stable source of funds.

Quantitative Aspects of Market Risk. The Bank does not maintain a trading account for any class of financial instrument nor does the Bank engage in hedging activities or purchase high-risk derivative instruments. Furthermore, the Bank is not subject to foreign currency exchange rate risk or commodity price risk.

The Bank uses interest rate sensitivity analysis to measure its interest rate risk by computing changes in NPV (net portfolio value) of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. NPV represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or decrease in market interest rates with no effect given to any steps that management might take to counter the effect of that interest rate movement. Using data compiled by the OTS, the Bank receives a report that measures interest rate risk by modeling the change in NPV (net portfolio value) over a variety of interest rate scenarios. This procedure for measuring interest rate risk was developed by the OTS to replace the “gap” analysis (the difference between interest-earning assets and interest-bearing liabilities that mature or reprice within a specific time period).

The following tables are provided by the OTS and set forth the change in the Bank’s NPV at December 31, 2002 and March 31, 2003, based on OTS assumptions that would occur in the event of an immediate change in interest rates, with no effect given to any steps that management might take to counteract that change. Due to the level of market interest rates over these time periods, the tables provide information for only a sustained 100 basis point decrease in market interest rates. Given the timing of the release of this information by the OTS, information as of June 30, 2003, is unavailable for inclusion in this report.

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PART I—ITEM 3

QUANTITATIVE AND QUALITATIVE DISCLOSURES

ABOUT MARKET RISK

FIRST CAPITAL, INC. AND SUBSIDIARIES