POTOMAC BANCSHARES INC - Quarter Report: 2004 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2004

Commission File Number 0-24958

POTOMAC BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

111 East Washington Street

PO Box 906

Charles Town WV 25414

(Address of principal executive offices) (zip code)

304-725-8431

(Registrant’s telephone number, including area code)

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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)    Yes  ¨    No  x

As of August 11, 2004, Potomac Bancshares, Inc. had 1,696,561 shares of common stock outstanding.

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POTOMAC BANCSHARES, INC.

FORM 10-Q

June 30, 2004

INDEX

FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 evidences Congress’ determination that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This Form 10Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risk and uncertainty. “Forward-looking statements” are easily identified by the use of words such “could,” “anticipate,” “estimate,” “believe,” and similar words that refer to a future outlook. To comply with the terms of the safe harbor, the company notes that a variety of factors could cause the company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the company’s forward-looking statements.

The risks and uncertainties that may affect the operations, performance, development and results of the company’s business include, but are not limited to, the growth of the economy, interest rate movements, the impact of competitive products, services and pricing, customer business requirements, Congressional legislation and similar matters. We caution readers of this report not to place undue reliance on forward-looking statements which are subject to influence by the named risk factors and unanticipated future events. Actual results, accordingly, may differ materially from management expectations.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

POTOMAC BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(000 OMITTED)

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(000 omitted except for per share data)

(Unaudited)

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(000 Omitted)

(Unaudited)

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(000 Omitted)

(Unaudited)

See Notes to Consolidated Financial Statements.

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POTOMAC BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003

The consolidated financial statements of Potomac Bancshares, Inc. (the company) and its wholly-owned subsidiary, Bank of Charles Town (the bank), include the accounts of both companies. All material intercompany balances and transactions have been eliminated in consolidation.

Certain reclassifications have been made to prior period amounts to conform to the current year presentation.

The company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the plan have 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 if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.

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There were no nonaccrual loans excluded from impaired loan disclosures under FASB 114 at June 30, 2004. At December 31, 2003 nonaccrual loans were $250,946.

Employer Contribution

Through the six months ended June 30, 2004, the company has contributed $255,754 to the pension plan, which is the entire contribution for 2004. The company has made payments of $11,575 for the postretirement benefits plan for the first six months of 2004.

The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock. Potential diluted common stock had no effect on earnings per share available to shareholders.

Shares outstanding have been restated to reflect the 200% stock dividend discussed in Note 3.

There were no recent accounting pronouncements since December 31, 2003.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

CRITICAL ACCOUNTING POLICIES

General

The company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

Our allowance for loan losses has two basic components: the formula allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the formula allowance.

FINANCIAL OVERVIEW

Between December 31, 2003 and June 30, 2004, total assets have increased 9% from $207 million to $226 million. Investments (securities purchased under agreements to resell, federal funds sold, securities held to maturity and securities available for sale) have increased $5 million and loans have increased $12 million since December 31, 2003. Loan growth has been in loans secured with construction, land development and other land and 1-4 family residential property, and in commercial and industrial loans. Loans secured by other real estate have decreased, and consumer borrowing for personal expenditures has continued to decline as it has since December 31, 2002.

Total deposits have increased $18 million or 10% at June 30, 2004 compared to December 31, 2003. Since December 31, 2003, noninterest-bearing demand deposits have increased $6 million and interest-bearing accounts have increased $12 million. Deposit growth is now in excess of the budgeted amount as of December 31, 2004.

The June 30, 2004 annualized return on average assets is 1.40% compared to 1.36% at December 31, 2003. At June 30, 2004 the annualized return on average equity is 14.19% compared to 12.57% at December 31, 2003. The leverage capital (equity to assets) ratio is 9.50% at June 30, 2004 compared to 10.20% at December 31, 2003.

The following table is an analysis of the company’s allowance for loan losses. Net charge-offs for the company have been very low when compared with the size of the total loan portfolio. Management monitors the loan portfolio on a continual basis with procedures that allow for problem loans and potential problem loans to be highlighted and watched. The loan policy regarding the grading and review system has recently been revised to enhance procedures for our growing portfolio of commercial loans as well as to update procedures for all other loans. Written reports are prepared on a quarterly basis for all loans. Information on commercial loans graded below a certain level is reported to the Board of Directors on a monthly basis. Based on experience, these loan policies and the Bank’s grading and review system, management believes the loan loss allowance is adequate.

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Loans are placed on nonaccrual status when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Following is a table showing the risk elements in the loan portfolio.

At June 30, 2004, other potential problem loans (excluding impaired loans) totalled $726,816. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis. Management has allocated a portion of the allowance for these loans.

The comparison of the income statements for the three months ended June 30, 2004 and 2003 and for the six months ended June 30, 2004 and 2003 shows similar differences between 2004 and 2003. At June 30, total interest and dividend income is up 5.5% in 2004 compared to June 30, 2003 primarily due to increased fee income as a result of loan growth. Interest income itself on loans in 2004 is only slightly above 2003 levels despite the loan growth since rates have remained low. Income on the securities portfolio is down 19% at June 30, 2004 compared to June 30, 2003 because of low interest rates even though the dollar volume of the portfolio has increased in 2004 compared to 2003. At the end of the first six months, interest expense is lower in 2004 than in 2003 due to continued low interest rates and the fact that a third of the deposit growth has been in the noninterest-bearing accounts. Net interest income has increased 8.6% in 2004 compared to 2003 with the increase in interest income and the decrease in interest expense.

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Noninterest income increased 10% for the six months ended June 30, 2004 compared to June 30, 2003. Trust and financial services income increased 55% at June 30, 2004 compared to June 30, 2003 due to increased estate fee accruals and the addition of brokerage fees and commissions from BCT Investments. Service charges on deposit accounts have increased 32.5% and credit and debit card fees have increased 56% at June 30, 2004 compared to the same time in 2003 primarily due to the growth in the deposit account base. Fees from production of secondary market loans have decreased 67% for the first six months of 2004 compared to the first six months of 2003 since secondary market rates have increased. Income from the increase in cash surrender value of life insurance has decreased 13.8% as of June 30, 2004 compared to June 30, 2003 due to decreased rates.

Other noninterest income has increased 10% as of June 30, 2004 compared to June 30, 2003. The most significant increase in this category is in the other fee income account as a result of fee increases effective March 1, 2003.

Noninterest expense increased 2.5% for the six months ended June 30, 2004 compared to the same period in 2003. Salaries and employee benefits for the first six months of 2004 are just slightly less than for the first six months of 2003 due to decreased group insurance expense. During the first quarter of 2003 fees were being paid to our previous group insurance vendor in addition to paying the expense of our current vendor. 401(k) expense in the first six months of 2004 is more than the same time period in 2003 due to increase in the number of participants and increased contributions by the participants which in turn increases the employer expense. The increase in 401(k) expense is positive position since management believes the plan is an incentive for good employees to remain at Bank of Charles Town. Stationery and supplies expense has decreased 33% at June 30, 2004 compared to June 30, 2003 due to fewer mass mailings and form changes in 2004 with the completion of the computer conversion. Advertising and marketing expenses have decreased in 2004 compared to 2003 as a result of intentional spending reductions. ATM and check card expenses have increased in the first six months of 2004 compared to the same time period in 2003 primarily due to growth in the deposit account base.

Other noninterest expenses have increased 24% at June 30, 2004 compared to June 30, 2003. Significant increases in this category include the following. Contributions have increased as a result of spreading the expense throughout the year rather than making all expenditures at year end. Fees for the overdraft protection program have increased due to deposit growth. Directors and committee fees have increased beginning in the second quarter with the election of two new directors in March 2004. In the trust department area a fee collected in a prior period in error was refunded with interest during the second quarter of 2004. Incurrence of a new expense item began in May 2004 for the outsourcing of investment review of certain trust department accounts

Liquid assets of the company include cash and due from banks, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s statement of cash flows details this liquidity. Net income after certain adjustments for noncash transactions provided $2.113 million in cash from operating activities. For the first six months of 2004, the primary operating activity requiring funds was the initial funding of loans held for sale. Funds totaling $15.002 million from maturity, sale and call of securities available for sale and from the maturity of securities held to maturity were used to fund investing activities. Investments made year to date in 2004 include the purchase of $23.498 million in securities available for sale, funding the net increase in loans in the amount of $12.550 million, and purchasing $179 thousand of bank premises and equipment. $19.232 million was provided through financing activities including increases in deposit account balances and increases in securities sold under agreements to repurchase. Financing activity expenditures included repaying $170 thousand of a Federal Home Loan Bank advance, paying $483 thousand in cash dividends to shareholders and repurchasing common stock for the treasury in the amount of $142 thousand. Cash and cash equivalents decreased during the first six months of 2004 by $675 thousand. The company has additional funding sources in the Federal Home Loan Bank, The Bankers Bank and Mercantile-Safe Deposit and Trust Company. Liquidity of the company is adequate to meet present and future financial obligations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The company’s market risk is composed primarily of interest rate risk. The company’s Asset and Liability Management Committee (ALCO) is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to this risk. The Board of Directors reviews and approves the guidelines established by ALCO.

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Interest rate risk is monitored through the use of three complimentary modeling tools: static gap analysis, earnings simulation modeling and economic value simulation (net present value estimation). Each of these models measure changes in a variety of interest rate scenarios. While each of the interest rate risk measures has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the company, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap which measures aggregate repricing values is less utilized since it does not effectively measure the investment options risk impact on the company and is not addressed here. But earnings simulation and economic value models which more effectively measure the cash flow impacts are utilized by management on a regular basis and are explained below.

Earnings Simulation Analysis

Management uses simulation analysis to measure the sensitivity of net income to change in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis such as the static gap analysis.

Assumptions used in this model, including loan and deposit growth rates, are derived from seasonal trends, economic forecasts and management’s outlook, as are the assumptions used to project yields and rates for new loans and deposits. Maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of repayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are accounted for in the different rate scenarios.

The most likely scenario represents the rate environment as management forecasts it to occur. From this base, rate shocks in 100 basis point increments are applied to see the impact on the company’s earnings. The following table represents the interest rate sensitivity on net income (fully tax equivalent basis) for the company using different rate scenarios as of June 30, 2004: