PROSPERITY BANCSHARES INC - Quarter Report: 2005 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER: 000-25051

PROSPERITY BANCSHARES, INC.^®

(Exact name of registrant as specified in its charter)

Prosperity Bank Plaza

4295 San Felipe

Houston, Texas 77027

(Address of principal executive offices, including zip code)

(713) 693-9300

(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  x    No  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 2, 2005, there were 27,562,518 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

INDEX TO FORM 10-Q

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PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(Table continued on following page)

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See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(UNAUDITED)

1. BASIS OF PRESENTATION

The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc. ^®(the “Company”) and its wholly-owned subsidiaries, Prosperity Bank ^®(the “Bank”) and Prosperity Holdings of Delaware, L.L.C. All significant inter-company transactions and balances have been eliminated.

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 and Amendment No. 1 to the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004. Operating results for the nine month period ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

2. EARNINGS PER SHARE

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

There were no stock options exercisable at September 30, 2005 and 2004 that would have had an anti-dilutive effect on the above computation.

3. NEW ACCOUNTING STANDARDS

SFAS No. 154, “Accounting Changes and Error Corrections” — Statement of Financial Accounting Standards (“SFAS”) No. 154 eliminates the requirement in APB Opinion No. 20, Accounting Changes, to include the cumulative effect of a change in accounting principle in the income statement in the period of change. Instead, to enhance the comparability of prior period financial statements, SFAS 154 requires that a change in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented as if that principle had always been used. The cumulative effect of the change is reflected in the carrying value of assets and liabilities as of the first period presented and the offsetting adjustments are recorded to opening retained earnings. Each period presented is adjusted to reflect the period specific effects of applying the change. Although retrospective application is similar to restating prior periods, SFAS 154 gives the treatment a new name to

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PROSPERITY BANCSHARES, INC.^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(UNAUDITED)

differentiate it from restatement for the correction of an error. Only direct effects of the change will be included in the retrospective application; all indirect effects will be recognized in the period of change. If it is impracticable to determine the cumulative effect for all prior periods, the new accounting principle should be applied as if it were adopted prospectively from the earliest date practicable. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not expected to have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

SFAS No. 123(R), “Share-Based Payment (Revised 2004).” SFAS 123(R) establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123(R) eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. The effective date for adoption of SFAS 123R was deferred by the Securities and Exchange Commission (“SEC”) in April 2005. SFAS 123R is now effective for the beginning of the next fiscal year that begins after June 15, 2005.

On March 29, 2005, the SEC issued SAB 107 to provide public companies additional guidance in applying the provisions of SFAS 123(R), Share-Based Payment. Among other things, SAB 107 describes the SEC staff’s expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of SFAS 123(R) with certain existing SEC guidance. The guidance is also beneficial to users of financial statements in analyzing the information provided under SFAS 123(R). The SAB will be applied upon the adoption of SFAS 123(R).

In March 2004, the Emerging Issues Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This Issue provides guidance for determining when an investment is other-than-temporarily impaired. It specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-1 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments within the scope of this Issue. In June 2005, the Financial Accounting Standards Board (“FASB”) directed its staff to prepare FSP EITF Issue 03-1-a, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments which will supercede EITF 03-1. FSP EITF Issue 03-1-a is expected to be effective for impairment analyses conducted in periods beginning after September 15, 2005 and should clarify that impairment losses be recognized no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. The disclosure requirements originally included in EITF 03-1 are expected to be included in the final guidance.

4. RECENT DEVELOPMENTS

On September 12, 2005, the Company announced the signing of a definitive agreement with Grapeland Bancshares, Inc. (“Grapeland”), Grapeland, Texas. Under the terms of the agreement, Grapeland will merge into the Company and subsequently, Grapeland’s wholly owned subsidiary, First State Bank, will merge into the Bank. The Company will issue approximately 242,000 shares of its common stock, subject to adjustment, for all of the issued and outstanding capital stock of Grapeland.

Grapeland is privately held and operates two (2) banking offices in Grapeland and Crockett, Texas. As of September 30, 2005, Grapeland had, on a consolidated basis, total assets of $72.2 million, loans of $43.7 million, deposits of $46.6 million and shareholders’ equity of $3.8 million. The acquisition is expected to close in the fourth quarter of 2005 and is subject to the approval of Grapeland’s shareholders and customary regulatory approvals.

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PROSPERITY BANCSHARES, INC. ^® AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(UNAUDITED)

5. GOODWILL AND CORE DEPOSIT INTANGIBLES

Changes in the carrying amount of the Company’s goodwill and core deposit intangibles (CDI) for nine months ended September 30, 2005 were as follows:

The Company initially records the total premium paid on acquisitions at management’s best estimate of goodwill and CDI. Subsequent to the acquisition, a third party valuation of CDI is performed. Adjustments to CDI, if necessary, are appropriately reclassified within goodwill. The reclassifications have no effect on total assets, liabilities, shareholder’s equity or cash flows. Net income is decreased by the amortization of CDI which is amortized at an accelerated rate over an eight year period from the acquisition date. Adjustments to estimates of deferred taxes that relate to goodwill are made after reconciliations of the final tax returns are prepared.

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

Special Cautionary Notice Regarding Forward-Looking Statements

Statements and financial discussion and analysis contained in this quarterly report on Form 10-Q that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and are including this statement for purposes of invoking these safe harbor provisions. These forward-looking statements include information about possible or assumed future results of the Company’s operations or performance. By using any of the words “believe,” “expect”, “anticipate”, “estimate”, “continue”, “intend”, “may”, “will”, “should”, or similar expressions, the Company identifies these forward-looking statements. Many possible factors or events could affect the future financial results and performance of the Company and could cause those financial results or performance to differ materially from those expressed in the forward-looking statement. These possible events or factors include, without limitation:

A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable.

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However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.

RECENT DEVELOPMENTS

On September 12, 2005, the Company announced the signing of a definitive agreement with Grapeland Bancshares, Inc. (“Grapeland”), Grapeland, Texas. Under the terms of the agreement, Grapeland will merge into the Company and subsequently, Grapeland’s wholly owned subsidiary, First State Bank, will merge into the Bank. The Company will issue approximately 242,000 shares of its common stock, subject to adjustment, for all of the issued and outstanding capital stock of Grapeland.

Grapeland is privately held and operates two (2) banking offices in Grapeland and Crockett, Texas. As of September 30, 2005, Grapeland had, on a consolidated basis, total assets of $72.2 million, loans of $43.7 million, deposits of $46.6 million and shareholders’ equity of $3.8 million. The acquisition is expected to close in the fourth quarter of 2005 and is subject to the approval of Grapeland’s shareholders and customary regulatory approvals.

OVERVIEW

The Company was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank^® (“Prosperity Bank^®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. The Bank operates eighty-three (83) full-service banking locations; with thirty-three (33) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), seventeen (17) in eleven contiguous counties situated south and southwest of Houston and extending into South Texas, six (6) in the Austin, Texas area, sixteen (16) in the Corpus Christi, Texas area and eleven (11) in the Dallas/Fort Worth, Texas area. The Greater Houston CMSA includes Austin, Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery, San Jacinto and Waller counties. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybanktx.com.

The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are offset by interest expense paid on deposits and other borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin. The Company has recognized increased net interest income due to the yield earned on interest-earning assets increasing at a greater rate that the increase in rates paid on interest bearing liabilities and an increase in the volume of interest-earning assets.

Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and strategic merger transactions. The Company focuses on continual internal growth. Each Banking Center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking Center Presidents and Managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan application processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek strategic expansion opportunities. On August 1, 2004, the Company acquired Village Bank and Trust, ssb (the “Village acquisition”) and Liberty Bancshares, Inc. (the “Liberty acquisition”), which added six (6) banking centers in the Austin, Texas area and on March 1, 2005, the Company acquired First Capital Bankers, Inc. (the “First Capital acquisition”), which added twenty-seven (27) banking centers.

Total assets were $3.49 billion at September 30, 2005 compared with $2.70 billion at December 31, 2004, an increase of $796.7 million or 29.5%. Total loans were $1.51 billion at September 30, 2005 compared with $1.04 billion at December 31, 2004, an increase of $478.7 million or 46.2%. Total deposits were $2.88 billion at September 30, 2005 compared with $2.32 billion at December 31, 2004, an increase of $562.2 million, or 24.3%. Shareholders’ equity increased $171.1 million or 62.1%, to $446.7 million at September 30, 2005 compared with $275.6 million at December 31, 2004. These increases were primarily the result of the First Capital acquisition.

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CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Amendment No. 1 to the Annual Report on Form 10-K/A for the year ended December 31, 2004. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:

Allowance for Credit Losses - The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS 118, and allowance allocations determined in accordance with SFAS No. 5, “Accounting for Contingencies.”

Valuation of Securities – The Company’s available for sale securities portfolio is reported at fair value. When the fair value of a security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. Available for sale and held to maturity securities are analyzed quarterly for possible other-than-temporary impairment. The analysis considers the financial condition and near-term prospects of the issuer, as well as the value of any security we may have in the investment. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the security may be different than previously estimated, which could have a material effect on the Company’s results of operations and financial condition.

RESULTS OF OPERATIONS

Net income available to common shareholders was $12.5 million ($0.45 per common share on a diluted basis) for the quarter ended September 30, 2005 compared with $8.9 million ($0.40 per common share on a diluted basis) for the quarter ended September 30, 2004, an increase in net income of $3.5 million, or 39.4%. The Company posted returns on average common equity of 11.28% and 14.42%, returns on average assets of 1.43% and 1.37% and efficiency ratios of 48.82% and 48.55% for the quarters ended September 30, 2005 and 2004, respectively. The efficiency ratio is not calculated on a tax equivalent basis.

For the nine months ended September 30, 2005, net income available to common shareholders was $35.2 million ($1.32 per common share on a diluted basis) compared with $25.4 million ($1.18 per common share on a diluted basis) for the same period in 2004, an increase in net income of $9.9 million or 38.9%. The Company posted returns on average common equity of 11.73% and 14.49%, returns on average assets of 1.42% and 1.36% and efficiency ratios of 49.54% and 49.29% for the nine months ended September 30, 2005 and 2004, respectively. The efficiency ratio is not calculated on a tax equivalent basis.

Net Interest Income

Net interest income was $28.9 million for the quarter ended September 30, 2005 compared with $21.1 million for the quarter ended September 30, 2004, an increase of $7.9 million, or 37.3%. Net interest income increased as a result of an increase in average interest-earning assets to $3.05 billion for the quarter ended September 30, 2005 from $2.35 billion for the quarter ended September 30, 2004, an increase of $696.1 million, or 29.6%. The increase in average earning assets is primarily attributable to increases in average loans and securities in the quarter ended September 30, 2005 compared to the quarter ended September 30, 2004 resulting from the First Capital acquisition in the first quarter of 2005.

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The net interest margin on a tax equivalent basis increased to 3.81% for the quarter ended September 30, 2005 compared with 3.62% for the quarter ended September 30, 2004. The rate paid on interest-bearing liabilities increased 63 basis points from 1.65% for the quarter ended September 30, 2004 compared with 2.28% for the quarter ended September 30, 2005 while the yield on earning assets increased 70 basis points from 4.85% for the quarter ended September 30, 2004 compared with 5.55% for the quarter ended September 30, 2005. The average of interest-bearing liabilities increased $543.6 million and the average of interest earning assets increased $696.1 million for the same periods.

Net interest income increased $22.1 million, or 37.0%, to $81.9 million for the nine months ended September 30, 2005 compared with $59.8 million for the same period in 2004. This increase is mainly attributable to higher average interest-earning assets resulting from an increase in average loans. The net interest margin on tax equivalent basis increased to 3.81% compared with 3.62% for the same periods principally due to a 59 basis point increase in the yield on earning assets from 4.83% for the nine months ended September 30, 2004 compared with 5.42% for the nine months ended September 30, 2005, partially offset by a 47 basis point increase in the rate paid on interest-bearing liabilities from 1.62% for the nine months ended September 30, 2004 compared with 2.09% for the nine months ended September 30, 2005.

The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”

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The following tables set forth, for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the quarters ended September 30, 2005 and 2004 and the nine months ended September 30, 2005 and 2004. The tables also set forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.