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PACIFIC FINANCIAL CORP - Quarter Report: 2006 March (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

  [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006

OR

  [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ____________

Commission File Number 000-29829

PACIFIC FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

Washington 91-1815009
(State or other jurisdiction of
incorporation or organization)
(IRS Employer Identification No.)

1101 S. Boone Street
Aberdeen, Washington 98520-5244
(360) 533-8870

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

300 East Market Street
Aberdeen, Washington 98520-5244
(Former address, if changed since last report)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ]

        Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer or non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

            Large accelerated filer [ ]             Accelerated Filer [X]             Non-accelerated filer [ ]

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [X]

        The number of shares of the issuer’s common stock, par value $1.00 per share, outstanding as of April 28, 2006, was 6,480,362 shares.

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TABLE OF CONTENTS
PART I FINANCIAL INFORMATION 3
ITEM 1. FINANCIAL STATEMENTS 3
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, 2006 AND DECEMBER 31, 2005
3
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED MARCH 31, 2006 AND 2005
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, 2006 AND 2005
5
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
THREE MONTHS ENDED MARCH 31, 2006 AND 2005
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
12
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
18
ITEM 4. CONTROLS AND PROCEDURES 18
PART II OTHER INFORMATION 19
ITEM 5. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 19
ITEM 6. EXHIBITS 19
SIGNATURES 19

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PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Balance Sheets

(Dollars in thousands)

March 31, 2006
(Unaudited)
December 31, 2005
Assets      
   Cash and due from banks  $   12,829   $   11,223  
   Interest bearing balances with banks  173   283  
   Federal funds sold  15,865    
   Investment securities available for sale  29,363   29,748  
   Investment securities held-to-maturity  6,418   6,504  
   Federal Home Loan Bank stock, at cost  1,858   1,858  
   Loans held for sale  11,069   10,111  
   Loans  392,790   398,870  
   Allowance for credit losses  5,202   5,296  


   Loans, net  387,588   393,574  

   Premises and equipment
 
10,739
 
10,085
 
   Foreclosed real estate  37   37  
   Accrued interest receivable  2,364   2,364  
   Cash surrender value of life insurance  9,476   9,394  
   Goodwill  11,282   11,282  
   Other intangible assets  709   745  
   Other assets  2,374   2,201  


Total assets  $502,144   $489,409  

Liabilities and Shareholders' Equity
 
   Deposits: 
     Non-interest bearing  $   81,402   $   86,264  
     Interest bearing  337,076   313,462  


   Total deposits  418,478   399,726  

   Accrued interest payable
  628   547  
   Secured borrowings  1,951   2,150  
   Short-term borrowings    3,985  
   Long-term borrowings  24,500   24,500  
   Junior subordinated debentures  5,155   5,155  
   Other liabilities  3,072   6,746  


   Total liabilities  453,784   442,809  

Shareholders' Equity
 
   Common Stock (par value $1); 25,000,000 shares authorized; 
     6,480,362 shares issued and outstanding at March 31, 2006 
     and 6,464,536 at December 31, 2005  6,480   6,464  
   Additional paid-in capital  25,618   25,386  
   Retained earnings  16,663   15,073  
   Accumulated other comprehensive loss  (401 ) (323 )


   Total shareholders' equity  48,360   46,600  

Total liabilities and shareholders' equity
 
$502,144

 

$489,409
 

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PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Income

Three months ended March 31, 2006 and 2005
(Dollars in thousands, except per share)
(Unaudited)

2006 2005
Interest and dividend income      
Loans  $       7,691   $       6,124  
Investment securities and FHLB dividends  360   450  
Deposits with banks and federal funds sold  75   72  


Total interest and dividend income   8,126   6,646  

Interest Expense
 
Deposits  2,123   1,304  
Other borrowings  370   215  


Total interest expense   2,493   1,519  

Net Interest Income
 
5,633
 
5,127
 
Provision for credit losses    300  


Net interest income after provision for   5,633   4,827  
   credit losses  

Non-interest Income
 
Service charges on deposits  376   321  
Gain on sales of loans  380   279  
Gain on sale of investments available for sale    9  
Gain on sale of premises and equipment  2   80  
Other operating income  188   197  


Total non-interest income   946   886  

Non-interest Expense
 
Salaries and employee benefits  2,531   2,414  
Occupancy and equipment  531   467  
Other  1,252   998  


Total non-interest expense   4,314   3,879  

Income before income taxes
  2,265   1,834  
Provision for income taxes  675   545  



Net Income
  $       1,590   $       1,289  

Comprehensive Income
  $       1,512   $          992  

Earnings per common share:
 
   Basic  $         0.25   $         0.20  
   Diluted  0.24   0.20  
Average shares outstanding:  
   Basic  6,478,188   6,421,396  
   Diluted  6,574,831   6,525,848  

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PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Cash Flows

Three months ended March 31, 2006 and 2005
(Dollars in thousands)
(Unaudited)

2006 2005
OPERATING ACTIVITIES            
Net income   $ 1,590   $ 1,289  
Adjustments to reconcile net income to net cash provided by  
    (used in) operating activities:  
   Provision for credit losses        300  
   Depreciation and amortization    293    268  
   Origination of loans held for sale    (20,830 )  (25,426 )
   Proceeds of loans held for sale    20,252    19,634  
   Gain on sales of loans    (380 )  (279 )
   Gain on sale of investment securities        (9 )
   Gain on sale of premises and equipment    (2 )  (80 )
   Increase in accrued interest receivable        (56 )
   Increase in accrued interest payable    81    6  
   Other    742    (87 )


   Net cash provided by (used in) operating activities     1,746    (4,440 )

INVESTING ACTIVITIES
  
   Net increase in federal funds    (15,865 )  (6,451 )
   (Increase) decrease in interest bearing deposits with banks    110    (3,206 )
   Purchase of securities available for sale    (362 )  (2,715 )
   Proceeds from maturities of investments held to maturity    84    157  
   Proceeds from sales of securities available for sale        1,100  
   Proceeds from maturities of securities available for sale    586    2,076  
   Net increase in loans    6,059    5,370  
   Additions to premises and equipment    (848 )  (226 )
   Proceeds from sales of premises and equipment    4    104  


   
Net cash used in investing activities
    (10,232 )  (3,791 )

FINANCING ACTIVITIES
  
   Net increase in deposits    18,752    18,284  
   Net decrease in short-term borrowings    (3,985 )    
   Net decrease in secured borrowings    (199 )  (156 )
   Proceeds from issuance of long-term borrowings    2,000      
   Repayments of long-term borrowings    (2,000 )  (2,000 )
   Issuance of common stock    243      
   Payment of cash dividends    (4,719 )  (4,624 )



   Net cash provided by financing activities
    10,092    11,504  

   Net increase in cash and due from banks
    1,606    3,273  

CASH AND DUE FROM BANKS
  
   Beginning of period    11,223    10,213  

   End of period
   $ 12,829   $ 13,486  

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
  
   Cash payments for:  
     Interest   $ 2,412   $ 1,513  
     Income Taxes        375  

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING ACTIVITIES
  
   Change in fair value of securities available for sale, net of tax    (78 )  (297 )

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PACIFIC FINANCIAL CORPORATION
Condensed Consolidated Statements of Shareholders’ Equity
Three months ended March 31, 2006
and 2005 (Dollars in thousands) (Unaudited)

COMMON
STOCK
ADDITIONAL
PAID-IN
CAPITAL
RETAINED
EARNINGS
ACCUMULATED
OTHER
COMPREHENSIVE
INCOME
(LOSS)
TOTAL
Balance December 31, 2004     $ 6,421   $ 25,003   $ 13,746   $ 133   $ 45,303  
Other comprehensive income:  
   Net income            1,289        1,289  
   Change in fair value of securities                (297 )  (297 )
      available for sale, net  
   Comprehensive income                
   992  






Balance March 31, 2005
   $ 6,421   $ 25,003   $ 15,035    ($ 164 ) $ 46,295  

Balance December 31, 2005
   $ 6,464   $ 25,386   $ 15,073    ($ 323 ) $ 46,600  
Other comprehensive income:  
   Net income            1,590        1,590  
   Change in fair value of securities                (78 )  (78 )
      available for sale, net  
   Comprehensive income                    1,512  
Issuance of common stock    16    227            243  
Stock compensation expense        5            5  





Balance March 31, 2006    $ 6,480   $ 25,618   $ 16,663    ($ 401 ) $ 48,360  

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PACIFIC FINANCIAL CORPORATION
Notes to Condensed Consolidated Financial Statements

Nine months ended September 30, 2005 and 2004
(unaudited)

Note 1 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared by Pacific Financial Corporation (“Pacific” or the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2006, are not necessarily indicative of the results anticipated for the year ending December 31, 2006. Certain information and footnote disclosures included in the Company’s consolidated financial statements for the year ended December 31, 2005, have been condensed or omitted from this report. Accordingly, these statements should be read with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

All dollar amounts in tables, except earnings per share tables and per share information, are stated in thousands.

Note 2 – Earnings per Share

The following table illustrates the computation of basic and diluted earnings per share.

Three months ended March 31,

2006 2005
Basic:            
Net income   $ 1,590,000   $ 1,289,000  
Weighted average shares outstanding  
     6,478,188    6,421,396  
Basic earnings per share   $ 0.25   $ 0.20  
Diluted:  
Net income   $ 1,590,000   $ 1,289,000  
Weighted average shares outstanding  
     6,478,188    6,421,396  
Effect of dilutive stock options    96,643    104,452  
Weighted average shares outstanding  
assuming dilution    6,574,831    6,525,848  
Diluted Earnings Per Share   $ 0.24   $ 0.20  



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As of March 31, 2006 and 2005, there were 272,600 and 93,600 shares, respectively, subject to outstanding options to acquire common stock with exercises prices in excess of the current market value. These shares are not included in the table above, as exercise of these options may not be considered dilutive to shareholders.

Note 3 – Investment Securities

Investment securities consist principally of short and intermediate term debt instruments issued by the U.S. Treasury, other U.S. government agencies, state and local government units, and other corporations.

Securities Held to Maturity AMORTIZED
COST
UNREALIZED
GAINS
UNREALIZED
LOSSES
FAIR
VALUE

March 31, 2006
                   
U.S. Government Securities   $ 1,122   $ 1   $ 7   $ 1,116  
State and Municipal Securities    5,296    29    49    5,276  




      Total    $ 6,418   $ 30   $ 56   $ 6,392  


Securities Available for Sale AMORTIZED
COST
UNREALIZED
GAINS
UNREALIZED
LOSSES
FAIR
VALUE

March 31, 2006
                   
U.S. Government Securities   $ 12,277   $ 24   $ 325   $ 11,976  
State and Municipal Securities    12,586    71    199    12,458  
Corporate Securities    2,066    3    55    2,014  
Mutual Funds    3,041        126    2,915  




      Total    $ 29,970   $ 98   $ 705   $ 29,363  

For all the above investment securities, the unrealized losses are generally due to changes in interest rates and, as such, are considered to be temporary by management. The Company has evaluated the securities shown above and anticipates full recovery of amortized cost with respect to these securities at maturity or sooner in the event of a more favorable market interest rate environment. The Company regularly reviews its investment portfolio to determine whether any of its securities are other than temporarily impaired. In addition to accounting and regulatory guidance, in determining whether a security is other than temporarily impaired, the Company considers duration and amount of each unrealized loss, the financial condition of the issuer, and the prospects for a change in market or net asset value within a reasonable period of time. We also consider that the contractual cash flow of certain mortgage backed securities are guaranteed by an agency of the United States Government.

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Note 4 – Allowance for Credit Losses

THREE MONTHS
ENDED
MARCH 31,
TWELVE MONTHS
ENDED
DECEMBER 31,
2006 2005 2005

Balance at beginning of period
    $ 5,296   $ 4,236   $ 4,236  

Provision for credit losses
        300    1,100  

Charge-offs
    (100 )      (65 )
Recoveries    6    8    25  



Net (charge-offs) recoveries    (94 )  8    (40 )

Balance at end of period
   $ 5,202   $ 4,544   $ 5,296  

Ratio of net charge-offs to
  
   average loans outstanding    .02 %  .00 %  .01 %

Note 5 – Stock Based Compensation

Prior to January 1, 2006, the Company accounted for stock option plans under recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost was reflected in net income for previous awards, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Effective January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment”, which requires measurement of compensation cost for all stock based awards based on the grant date fair value and recognition of compensation cost over the service period of stock based awards. The Company has adopted SFAS No. 123R using the modified prospective method, which provides for no restatement of prior periods and no cumulative adjustment to equity accounts. It also provides for expense recognition for both new and existing unvested stock-based awards. Stock based compensation expense during the three months ended March 31, 2006 was $5,000, ($3,000 net of tax benefit). Future compensation expense for unvested awards outstanding as of March 31, 2006 is estimated to be $32,000 recognized over a weighted average period of 3.5 years. Cash received from the exercise of stock options during the three months ended March 31, 2006 and 2005, respectively, totaled $10,000 and $0.

The fair value of stock options is determined using the Black-Scholes option pricing model, which is consistent with the Company’s methodology previously utilized for options in footnote disclosures. Expected volatilies are based on historical volatility of the Company’s common shares. The expected term of stock options granted will be based on the simplified method, which is the simple average between contractual term and vesting period. The risk-free rate is based on the expected term of stock options and the applicable U.S. Treasury yield in effect at the time of grant. There were no options granted during the quarter ended March 31, 2006. The following assumptions were used for valuing option grants made during the three months ended March 31, 2005: dividend yield – 4.43%, expected life – 10 years, risk-free interest rate – 4.48%, expected volatility – 17.27%. Applying the model, the weighted average grant date fair value of stock options granted during the three months ended March 31, 2005 was $4.52.

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A summary of stock option activity under the stock option plans as of March 31, 2006 and changes during the three months ended March 31, 2006 and 2005, are presented below:

March 31, 2006 Shares Weighted Average
Exercise Price
Weighted Average
Remaining
Contractual Term
( Years)
Aggregate
Instrinsic Value

Outstanding beginning of period
     687,674   $ 13.28          
Exercised    (900 )  11.11        
Forfeited                  




Outstanding end of period     686,774   $ 13.28    6.4   $ 1,350  

Exercisable end of period
    611,968   $ 13.33    5.2   $ 1,176  


March 31, 2005 Shares Weighted Average
Exercise Price
Weighted Average
Remaining
Contractual Term
( Years)
Aggregate
Instrinsic Value

Outstanding beginning of period
     619,794   $ 12.51          
Exercised    115,500    16.25      
Forfeited    (10,000 )  17.13          




Outstanding end of period     725,294   $ 13.04    7.4   $ 2,002  

Exercisable end of period
    329,269   $ 10.74    7.1   $ 1,666  

A summary of the status of the status of the Company's nonvested options as of March 31, 2006 and 2005, and changes during the three months then ended is presented below:

2006

Shares
Weighted Average
Fair Value
2005

Shares
Weighted
Average Fair
Value

Non-vested beginning of period
  144,006   $2.00   362,104   3.30  
Granted      115,500   4.52  
Vested  (69,200 ) 1.22   (71,579 ) 1.32  
Forfeited      (10,000 ) 5.13  




Non-vested end of period   74,806   $2.72   396,025   $3.96  

The total intrinsic value of stock options exercised during the three months ended March 31, 2006 was $4,000. There is no instrinsic value for options granted and exercised during the three months ended March 31, 2005 as the shares are anti-dilutive.

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The following table illustrates the effect on net income and earnings per share had the Company applied the fair value recognition provisions of SFAS No. 123R to the prior year’s quarter ended March 31, 2005.

Net Income, as reported     $ 1,289,000  

Less total stock-based compensation expense
  
   determined under fair value method for all  
   qualifying awards, net of tax    54,000  

Pro forma net income
    1,235,000  

Earnings per share basic - as reported
   $ 0.20  
Earnings per share basic - pro forma    0.19  
Earnings per share diluted - as reported    0.20  
Earnings per share diluted - pro forma    0.19  

Note 7 – Operating Segments

The Company has operating segments which have been aggregated into one reporting segment as provided in SFAS No. 131 "Disclosures About Segments of an Enterprise and Related Information."

Note 7 – Subsequent event

In April 2006, the Company entered into a contract to construct a new branch in the Barkley district of Bellingham, Washington. Construction costs are estimated at $2,000,000.

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

A Warning About Forward-Looking Information

        This document contains forward-looking statements that are subject to risks and uncertainties. These statements are based on the beliefs and assumptions of our management, and on information currently available to them. Forward-looking statements include the information concerning our possible future results of operations set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and statements preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions.

        Any forward-looking statements in this document are subject to risks relating to, among other things, the following:

    1.                      competitive pressures among depository and other financial institutions may impede our ability to attract and retain borrowers, depositors and other customers, retain key employees, and maintain our interest margins and fee income;


    2.                      changes in the interest rate environment may reduce margins or decrease the value of our securities;


    3.                      our growth strategy, particularly if accomplished through acquisitions, may not be successful if we fail to accurately assess market opportunities, asset quality, anticipated cost savings, and transaction costs, or experience significant difficulty integrating acquired businesses or assets;


    4.                      general economic or business conditions, either nationally or in the regions in which we do business, may be less favorable than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; and


    5.                      a lack of liquidity in the market for our common stock may make it difficult or impossible for you to liquidate your investment in our stock or lead to distortions in the market price of our stock.


        Our management believes the forward-looking statements in this report are reasonable; however, you should not place undue reliance on them. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Many of the factors that will determine our future results and share value are beyond our ability to control or predict. We undertake no obligation to update forward-looking statements.

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Overview

Pacific Financial Corporation is a bank holding company headquartered in Aberdeen, Washington. The Company’s wholly-owned subsidiary, The Bank of the Pacific (the “Bank”), is a state chartered bank, also located in Washington. The Company also has one wholly-owned subsidiary trust known as of PFC Statutory Trust I (the “Trust”) that was formed in connection with the issuance of pooled trust preferred securities in December 2005. The Company was incorporated in the State of Washington on February 12, 1997, pursuant to a holding company reorganization of the Bank.

The Company conducts its banking business through the Bank, which operates 17 branches located in communities in Grays Harbor, Pacific, Whatcom, and Wahkiakum counties in the state of Washington and one loan production office in Clatsop County, Oregon. A full service branch located in Anacortes, Washington is expected to open in May 2006. In addition, the Bank has entered into a contract to construct a new branch in the Barkley district of Bellingham, Washington, and the Bank has entered into a deposit transfer and assumption agreement with an Oregon bank that will, subject to regulatory approvals, enable the Bank to establish its first full-service branch in Oregon. The Bank provides loan and deposit services to customers, who are predominantly small and middle-market businesses and middle-income individuals.

Results of Operations

Net income. For the three months ended March 31, 2006, Pacific’s net income was $1,590,000 compared to $1,289,000 for the same period in 2005. Increases in net income for the three month period resulted from an increase in net interest income for the period, as described below, and no provision for credit loss in the period, as well as increases in non-interest income arising from greater service charge revenues and gain on sales of loans, as compared to the same period in 2005. These increases were partially offset by increased non-interest expense for the period arising out of greater staffing and benefit expenses, increased professional fees, and increased supplies expense.

Net interest income. Net interest income for the three months ended March 31, 2006 increased $506,000, or 9.87%, compared to the same period in 2005. The increase is primarily related to the increase in interest income as a result of the rise in short-term interest rates and increased balances of interest earning assets. See the table on the following page and discussion thereafter for further information on interest income and expense. The net interest margin (net interest income divided by average earning assets) decreased to 4.99% for March 31, 2006 from 5.05% for the same period last year. The slight decline in net interest margin is due primarily to an increase in cost of funds from 1.89% to 2.78% for the three months ended March 31, 2005 and 2006, respectively. We have, however, been able to maintain a stable net interest margin in part due to our continued focus on variable rate loans and fixed rate loan terms of not longer than three years.

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The following table sets forth information with regard to average balances of the interest earnings assets and interest bearing liabilities and the resultant yields or cost, net interest income, and the net interest margin on a tax equivalent basis. Loans held for sale and non-accrual loans are included in total loans.

Three Months Ended March 31,

(dollars in thousands) Average
Balance

2006
Interest
Income
(Expense)

Avg
Rate

Average
Balance

2005
Interest
Income
(Expense)

Avg
Rate


Interest Earnings Assets
                               
     Loans (1)   $406,300 $7,708 * 7.59 % $349,625 $ 6,133 * 7.02 %
     Taxable Securities   20,960    202    3.85    26,407    284    4.30  
     Tax-Exempt Securities    15,862    239 *  6.04    15,779    252 *  6.38  
     Federal Home Loan Bank Stock    1,858          1,850    
     Interest earnings deposits with banks    6,570    75    4.57    12,705    72    2.27  

Total interest earning assets
   $ 451,550   $ 8,224    7.29 % $ 406,366   $ 6,741    6.63 %

    Cash and due from banks
    11,282        8,888    
    Bank premises and equipment (net)    10,387        6,883    
    Other assets    24,960        24,836    
    Allowance for credit losses    (5,296 )      (4,369 )    

Total assets
   $ 492,883       $442,604      

Interest Bearing Liabilities
  
     Savings and interest bearing demand   $ 197,769   $ (984 )  1.99 % $ 185,829   $ (619 )  1.33 %
     Time deposits    125,780    (1,139 )  3.62    111,365    (685 )  2.46  
     Total deposits     323,549    (2,123 )  2.62    297,194    (1,304 )  1.76  

     Short-term borrowings
    2,898    (36 )  4.97            
     Long-term borrowings    24,500    (215 )  3.51    20,098    (154 )  3.06  
     Secured borrowings    2,051    (39 )  7.61    3,655    (61 )  6.68  
     Junior subordinated debentures    5,155    (80 )  6.21            
     Total borrowings     34,604    (370 )  4.28    23,753    (215 )  3.62  

Total interest-bearing liabilities
   $ 358,153   $ (2,493 )  2.78 % $ 320,947   $ (1,519 )  1.89 %
     
Demand deposits
    82,834        73,698    
     Other liabilities    4,570        3,129    
     Shareholders' equity    47,326        44,830    

Total liabilities and shareholders' equity
   $ 492,883       $442,604      

Net interest income
     $5,731 *       $5,222 *    

Net interest spread
        5.08 %      5.14 %
Net interest margin         4.99 %      5.05 %
>

* Tax equivalent basis – 34% tax rate used

(1)     Interest income on loans include loan fees of $278,000, and $521,000 in 2006 and 2005, respectively.

Interest and dividend income for the three months ended March 31, 2006, increased $1,480,000, or 22.3%, compared to the same period in 2005. Loans averaged $406.3 million with an average yield of 7.59% for the three months ended March 31, 2006 compared to average loans of $349.6 million with an average yield of 7.02% for the same period in 2005. The Company experienced significant loan growth during the year ended December 31, 2005, with a slight reduction in loans during the current period.

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Interest expense for the three months ended March 31, 2006 increased $974,000, or 64.1%, compared to the same periods in 2005. The increase is primarily attributable to increased deposit balances and rates paid on certain deposits, as well as expense related to Pacific’s junior subordinated debentures and higher interest rates. Average interest-bearing deposit balances for the three months ended March 31, 2006 and March 31, 2005 were $323,549,000 and $297,194,000, respectively, with an average cost of 2.62% and 1.76%, respectively.

Average secured borrowings for the three months ended March 31, 2006 and March 31, 2005 were $2,051,000 and $3,655,000, respectively. The secured borrowings represent borrowings collateralized by participation interests in loans originated by the Company. These borrowings are repaid as payments are made on the underlying loans, bearing interest rates ranging from 6.5% to 8.5%. Average long and short term borrowings for the three months ended March 31, 2006 were $27,398,000 with an average cost of 3.66% compared to $20,098,000 with an average cost of 3.06% for the same period in 2005.

Provision and allowance for credit losses. The allowance for credit losses reflects management’s current estimate of the amount required to absorb losses on existing loans and commitments to extend credit.  Loans deemed uncollectible are charged against and reduce the allowance. Periodically, a provision for credit losses is charged to current expense. This provision acts to replenish the allowance for credit losses and to maintain the allowance at a level that management deems adequate.

There is no precise method of predicting specific credit losses or amounts that ultimately may be charged off on segments of the loan portfolio. The determination that a loan may become uncollectible, in whole or in part, is a matter of judgment. Similarly, the adequacy of the allowance for credit losses can be determined only on a judgmental basis, after full review, including (a) consideration of economic conditions and the effect on particular industries and specific borrowers; (b) a review of borrowers’ financial data, together with industry data, the competitive situation, the borrowers’ management capabilities and other factors; (c) a continuing evaluation of the loan portfolio, including monitoring by lending officers and staff credit personnel of all loans which are identified as being of less than acceptable quality; (d) an in-depth appraisal, on a monthly basis, of all loans judged to present a possibility of loss (if, as a result of such monthly appraisals, the loan is judged to be not fully collectible, the carrying value of the loan is reduced to that portion considered collectible); and (e) an evaluation of the underlying collateral for secured lending, including the use of independent appraisals of real estate properties securing loans. A formal analysis of the adequacy of the allowance is conducted quarterly and is reviewed by the Board of Directors. Based on this analysis, management considers the allowance for credit losses to be adequate at March 31, 2006.

Periodic provisions for credit losses are made to maintain the allowance for credit losses at an appropriate level. The provisions are based on an analysis of various factors including historical loss experience based on volumes and types of loans, volumes and trends in delinquencies and non-accrual loans, trends in portfolio volume, results of internal and independent external credit reviews, and anticipated economic conditions. For additional information, please see the discussion under the heading “Critical Accounting Policy” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2005.

During the three months ended March 31, 2006, no loan loss provision was provided for possible credit losses, compared to $300,000 for the same period in 2005. For the three months ended March 31, 2006, net charge-offs were $94,000 compared to $8,000 of net recoveries for the same period in 2005.

At March 31, 2006, the allowance for credit losses stood at $5,202,000 compared to $5,296,000 at December 31, 2005, and $4,544,000 at March 31, 2005. The increase over March 31, 2005 was attributable to the additions in loan loss provision that was allocated to the allowance for credit losses as a result of continued growth in the loan portfolio during 2005. The slight decrease in 2006 is related

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primarily to one charge-off amount totaling $100,000. The ratio of the allowance to total loans outstanding including loans held for sale was 1.29%, 1.29% and 1.30%, respectively, at March 31, 2006, December 31, 2005, and March 31, 2005.

Non-performing assets and foreclosed real estate owned. Non-performing assets totaled $6,406,000 at March 31, 2006. This represents 1.59% of total loans including loans held for sale, compared to $6,769,000 or 1.66% at December 31, 2005, and $7,746,000 or 2.22% at March 31, 2005. Non-accrual loans at March 31, 2006 totaled $6,324,000. This relates primarily to one borrower involved in the forest products industry. Although the borrower is continuing operations and making principle and interest payments as agreed, the deteriorating financial condition of the borrower creates the potential the Company may not be able to collect all principal and interest according to the terms of the loan. Of the non-accrual loans outstanding, $3,484,000 are guaranteed by the United States Department of Agriculture representing 55.09% of non-accrual loans outstanding. Based on current analysis, management has made provisions in the loan loss reserves for potential losses associated with non-accrual loans. Foreclosed real estate consists of two properties secured by real estate with no individual material balances.

ANALYSIS OF NON-PERFORMING ASSETS

(in thousands) MARCH 31,
2006
DECEMBER 31,
2005
MARCH 31,
2005

Accruing loans past due 90 days or more
    $ 45   $ 82   $ 6  

Non-accrual loans
    6,324    6,650    7,706  

Foreclosed real estate
    37    37    40  

TOTAL
   $ 6,406   $ 6,769   $ 7,752  

Non-interest income and expense. Non-interest income for the three months ended March 31, 2006 increased $60,000 compared to the same period in 2005. The primary reason for the increase was gain on sale of loans. Gain on sale of loans totaled $380,000 and $279,000, respectively, for the three months ended March 31, 2006 and 2005. This increase is attributable to increased pricing of loans sold in the secondary market over the prior year. Commitment to sell and sale price is established at the time of origination of loans to limit any potential price risk. Management expects flat growth in mortgage banking activity for the remainder of the year. Additionally, during the three months ended March 31, 2005, the Company recognized a one-time gain on sale of fixed assets totaling $80,000.

Non-interest expense for the three months ended March 31, 2006 increased $435,000 compared to the same period in 2005. Increased staffing, benefits and professional fees were the major contributing factors to increased non-interest expense, as well as other operating expenses incurred in the opening of the Raymond, Washington branch in January 2006. Full time equivalent employees at March 31, 2006 were 185 compared to 163 at March 31, 2005.

Income taxes. The federal income tax provision for the three months ended March 31, 2006 was $675,000, an increase of $130,000 compared to the same period in 2005. The effective tax rate for the three months ended March 31, 2006 was 29.8%.

Financial Condition

Assets. Total assets were $502,144,000 at March 31, 2006, an increase of $12,735,000, or 2.6%, over year-end 2005. Loans, including loans held for sale, were $403,859,000 at March 31, 2006, a decrease of

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$5,122,000, or 1.25%, over year-end 2005. The decrease in the portfolio was primarily a result of two significant payoffs in commercial real estate loans. Total deposits were $418,478,000 at March 31, 2006, an increase of $18,752,000, or 4.7%, compared to December 31, 2005. The $18,752,000 increase is comprised of a $4,862,000 decrease in non-interest bearing accounts, $3,420,000 increase in NOW accounts, $8,893,000 increase in money market accounts, $79,000 increase in savings accounts and a $11,222,000 increase in certificates of deposits.

Loans. Loan detail by category, including loans held for sale, as of March 31, 2006 and December 31, 2005 follows:

March 31,
2006
December 31,
2005

Commercial and industrial
    $ 113,034   $ 101,327  
Agricultural    24,497    25,359  
Real estate mortgage    175,736    183,353  
Real estate construction    78,240    87,621  
Installment    9,283    8,487  
Credit cards and other    3,069    2,834  


Total Loans    403,859    408,981  
Allowance for credit losses    (5,202 )  (5,296 )


Net Loans   $ 398,657   $ 403,685  

Liquidity.     Adequate liquidity is available to accommodate fluctuations in deposit levels, fund operations, and provide for customer credit needs and meet obligations and commitments on a timely basis. The Bank’s primary sources of funds are customer deposits, maturities of investment securities, sales of securities available for sale, loan sales, loan repayments, net income and other borrowings. When necessary, liquidity can be increased by taking advances available from the Federal Home Loan Bank of Seattle. The Bank maintains credit facilities with correspondent banks totaling $37,000,000, none of which were used at March 31, 2006. In addition, the Bank has a credit line with the Federal Home Loan Bank of Seattle for up to 20% of assets, $24,500,000 of which was used at March 31, 2006. For its funds, the Company relies on dividends from the Bank, proceeds from the exercise of stock options, and proceeds from the issuance of trust preferred securities, all of which are used for various corporate purposes.

Capital.     Total shareholders’ equity was $48,360,000 at March 31, 2006, an increase of $1,760,000, or 3.8%, compared to December 31, 2005. Tangible book value per share was $5.61 at March 31, 2006 compared to $5.35 at December 31, 2005. Tangible book value is calculated by dividing total equity capital minus goodwill and other intangibles, by total shares outstanding.

The Federal Reserve and the Federal Deposit Insurance Commission have established minimum guidelines that mandate risk-based capital requirements for bank holding companies and member banks. Under the guidelines, risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Regulatory minimum risk-based capital guidelines require Tier 1 capital to risk-weighted assets of 4% and total capital to risk-weighted assets of 8%. The Company’s Tier 1 and Total Risk Based Capital ratios were 10.03% and 11.28%, respectively, at March 31, 2006 compared with 9.44% and 10.69%, respectively at December 31, 2005.

Additionally, to qualify as “well-capitalized”, the Bank must have a Tier 1 risk based capital ratio of at least 6%, total risk based capital of at least 10%, and a leverage ratio of a least 5%. The Bank qualified as “well-capitalized” at March 31, 2006.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate, credit, and operations risks are the most significant market risks which affect the Company’s performance. The Company relies on loan review, prudent loan underwriting standards and an adequate allowance for possible credit losses to mitigate credit risk.

An asset/liability management simulation model is used to measure interest rate risk. The model produces regulatory oriented measurements of interest rate risk exposure. The model quantifies interest rate risk by simulating forecasted net interest income over a 12-month time period under various interest rate scenarios, as well as monitoring the change in the present value of equity under the same rate scenarios. The present value of equity is defined as the difference between the market value of assets less current liabilities. By measuring the change in the present value of equity under various rate scenarios, management is able to identify interest rate risk that may not be evident from changes in forecasted net interest income.

The Company is currently asset sensitive, meaning that interest earning assets mature or re-price more quickly than interest-bearing liabilities in a given period. Therefore, a significant increase in market rates of interest could improve net interest income. Conversely, a decreasing rate environment may adversely affect net interest income.

It should be noted that the simulation model does not take into account future management actions that could be undertaken should actual market rates change during the year. Also, the model simulation results are not exact measures of the Company’s actual interest rate risk. They are rather only indicators of rate risk exposure, based on assumptions produced in a simplified modeling environment designed to heighten sensitivity to changes in interest rates. The rate risk exposure results of the simulation model typically are greater than the Company’s actual rate risk. That is due to the conservative modeling environment, which generally depicts a worst-case situation. Management has assessed the results of the simulation reports as of March 31, 2006, and believes that there has been no material change since December 31, 2005.

ITEM 4. CONTROLS AND PROCEDURES

The Company’s disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (CEO) and chief financial officer (CFO), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosures.

No change in the Company’s internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II – OTHER INFORMATION

ITEM 5. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Pacific held its Annual Meeting of Shareholders on April 19, 2006, at which the shareholders of the Company voted on the election of five Class A directors (Edwin Ketel, Dennis A. Long, Joseph A. Malik, Randy Rust, Robert J. Worrell) for a three year term.

        The voting with respect to the election of directors was as follows:

NAME          FOR           WITHHELD

Edwin Ketel
     3,628,430    24,410  
Dennis A. Long    3,647,750    5,090  
Joseph A. Malik    3,509,860    142,980  
Randy Rust    3,628,430    24,410  
Robert J. Worrell    3,440,800    212,040  

ITEM 6. EXHIBITS

        See Exhibit Index immediately following signatures below.

SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


PACIFIC FINANCIAL CORPORATION

DATED: May 9, 2006

By:  /s/ Dennis A. Long
       Dennis A. Long
       Chief Executive Officer

By:  /s/ Denise Portmann
        Denise Portmann
        Chief Financial Officer

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EXHIBIT INDEX

EXHIBIT NO. EXHIBIT

10.1

Employment Agreement dated December 20, 2005, between the registrant and Philippe S. Swaab.*
31.1 Certification of CEO under Rule 13a - 14(a) of the Exchange Act.
31.2 Certification of CFO under Rule 13a - 14(a) of the Exchange Act.
32 Certification of CEO and CFO under 18 U.S.C. Section 1350.

*Mr. Swaab was named an Executive Vice President of the registrant at the annual meeting of directors of the Company on April 19, 2006.






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