Washington, D.C. 20549

 

FORM 10-QSB

 

(Mark One)
ý	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
o	TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                    to                    

 

Commission file number  000-30497

 

CORNERSTONE BANCHSHARES, INC.

(Exact name of small business issuer as specified in its charter)

 

 

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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  ý  No  o

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

The aggregate market value of the Registrant’s outstanding Common Stock held by nonaffiliates of the Registrant on March 31, 2004 was approximately $27,981,383.  There were 1,243,617 shares of Common Stock outstanding as of March 31, 2004.

 

Transitional Small Business Disclosure Format (check one) :

Yes           o

No     ý

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

CORNERSTONE BANCSHARES, INC.

 

PRESENTATION OF FINANCIAL INFORMATION

 

The 2004 financial information in this report has not been audited.  The information included herein should be read in conjunction with the notes to the consolidated financial statements included in the 2003 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone Bancshares, Inc. (“Cornerstone”) in March 2004.  The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices.

 

Consolidation

 

The accompanying consolidated financial statements include the accounts of Cornerstone and its subsidiary Cornerstone Community Bank (the “Bank”).

 

Substantially all intercompany transactions, profits and balances have been eliminated.

 

Accounting Policies

 

During interim periods, Cornerstone follows the accounting policies set forth in its 10-KSB for the year ended December 31, 2003, as filed with the Securities and Exchange Commission. Since December 31, 2003, there have been no changes in any accounting principles or practices, or in the method of applying any such principles or practices.

 

Interim Financial Data (Unaudited)

 

In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the consolidated financial condition, the consolidated results of operations, and consolidated cash flows for the interim period.  Results for interim periods are not necessarily indicative of the results to be expected for a full year.

 

Earnings Per Common Share

 

Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the number of common shares outstanding (denominator).  Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted number of shares outstanding (denominator).  The adjusted number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

 

Forward-Looking Statements

 

Certain written and oral statements made by or with the approval of an authorized executive officer of Cornerstone may constitute “forward-looking statements” as defined under the Private Securities Litigation Reform Act of 1995.  Words or phrases such as “should result,” “are expected to,” “we anticipate,” “we estimate,” “we project” or similar expressions are intended to identify forward-looking statements.  These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from Cornerstone’s historical experience and its present expectations or projections.  These risks and uncertainties include, but are not limited to, unanticipated economic changes, interest rate fluctuations and the impact of competition.  Caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date they are made.

 

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PART I — FINANCIAL INFORMATION

 

Item 1.    Financial Statements

 

CONSOLIDATED BALANCE SHEET

 

		Unaudited						Unaudited
		March 31, 2004			December 31, 2003			March 31, 2003
ASSETS
Cash and due from banks		$	4,970,773		$	7,071,075		$	4,616,885
Due from banks time deposits		—			—			—
Federal funds sold		1,705,000			3,060,000			1,400,000
Investment securities available for sale		22,581,474			24,825,961			27,431,351
Investment securities held to maturity		583,527			640,651			914,160
Federal Home Loan Bank stock		675,900			582,300			511,800
Loans, less allowance for loan loss		167,233,011			155,278,321			128,587,738
Premises and equipment, net		4,858,170			4,292,566			3,913,296
Accrued interest receivable		854,661			938,763			792,109
Excess cost over fair value of assets acquired		2,541,476			2,541,476			2,541,476
Other assets		1,654,628			1,765,604			1,562,426
Total assets		$	207,658,620		$	200,996,717		$	172,271,241
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Noninterest-bearing		$	27,360,070		$	22,326,841		$	18,652,731
NOW accounts		25,964,903			28,513,598			23,673,583
Savings deposits and money market accounts		31,191,877			27,712,339			25,792,789
Time deposits of $100,000 or more		22,206,569			22,264,211			19,686,146
Time deposits of less than $100,000		56,643,884			58,535,286			52,812,799
Total deposits		163,367,303			159,352,275			140,618,048
Federal funds purchased and securites sold under agreement to repurchase		3,108,218			6,084,078			1,045,745
Federal Home Loan Bank advance and note payable		22,400,000			17,400,000			14,000,000
Accrued interest payable		97,211			102,163			123,105
Other liabilities		1,222,992			1,154,700			989,144
Total Liabilities		190,195,724			184,093,216			156,776,042
Stockholders’ Equity
Common stock		1,243,617			1,243,167			1,233,167
Additional paid-in capital		12,193,318			12,183,868			12,093,868
Retained Earnings		3,819,230			3,295,884			1,940,354
Accumulated other comprehensive income		206,731			180,582			227,810
Total Stockholders’ Equity		17,462,896			16,903,501			15,495,199
Total liabilities and stockholders equity		$	207,658,620		$	200,996,717		$	172,271,241

 

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CONSOLIDATED STATEMENTS OF INCOME

 

		Unaudited
		Three months ended March 31,
		2004			2003
INTEREST INCOME
Interest and fees on loans		$	2,844,788		$	2,385,208
Interest on investment securities		231,109			236,100
Interest on federal funds sold		1,571			13,486
Interest on other earning assets		428			5,180
Total interest income		3,077,896			2,639,974
INTEREST EXPENSE
Now accounts		23,588			18,873
Money market accounts		82,953			68,237
Savings accounts		9,033			16,431
Time deposits of less than $100,000		373,840			417,336
Time deposits of  $100,000 or more		138,303			160,740
Federal funds purchased		4,286			4,399
Securities sold under agreements to repurchase		3,515			4,041
Federal Home Loan Bank Advance		169,197			122,075
Other Borrowings		2,742			—
Total interest expense		807,457			812,131
Net interest income before the provision for loan losses		2,270,439			1,827,843
Provision for loan losses		160,000			105,000
Net interest income after the provision for loan losses		2,110,439			1,722,843
NONINTEREST INCOME
Service charges on deposit accounts		165,403			145,504
Net securities gains (losses)		—			—
Other income		182,212			140,007
Total noninterest income		347,615			285,511
NONINTEREST EXPENSE
Salaries and employee benefits		910,709			744,041
Occupancy and equipment expense		233,126			163,050
Other operating expense		460,373			446,601
Total noninterest expense		1,604,208			1,353,692
Income before provision for income taxes		853,846			654,662
Provision for income taxes		330,500			252,649
NET INCOME		$	523,346		$	402,013
Basic net income per common share		$	0.42		$	0.32
Diluted net income per common share		0.39			0.32
Dividends declared per common share		—			—

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS

 

For the Three Months Ended March 31

 

		2004			2003
Cash flows from operating activities:
Net income		$	523,346		$	402,013
Adjustments to reconcile net income to net cash provided by operating actvities:
Provision for loan losses		$	160,000		$	105,000
Net Charge-offs		(57,399		)	(4,614		)
Depreciation and amortization		86,408			82,527
Accrued interest receivable		84,102			(112,511		)
Accrued interest payable		(4,952		)	1,835
Changes in other assets and liabilities		179,268			279,370
Net cash provided by (used in) operating activities		970,773			753,618
Cash flows from investing activities:
Purchase of investment securities: AFS		(1,412,145		)	(10,181,233		)
Purchase of investment securities: HTM		—			—
Proceeds from security transactions:  AFS		3,599,446			3,860,104
Proceeds from security transactions:  HTM		56,744			110,074
Purchase of due from banks time deposits		—			—
Net increase in loans		(12,057,291		)	(5,591,546		)
Purchase of bank premises and equipment		(661,897		)	(36,543		)
Net cash provided by (used in) investing activities		(10,475,143		)	(11,839,144		)
Cash flows from financing activities:
Net increase in deposits		4,015,028			10,171,724
Net increase in securities sold under agreements to repurchase		(2,975,860		)	(2,457,394		)
Net increase of FHLB advances		5,000,000			4,000,000
Issuance of common stock		9,900			—
Net cash provided by (used in) financing activities		6,049,068			11,714,330
Net increase (decrease) in cash and cash equivalents		(3,455,301		)	628,805
Cash and cash equivalents beginning of period		10,131,075			5,388,080
Cash and cash equivalents end of period		$	6,675,773		$	6,016,885

 

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Cornerstone Bancshares, Inc and Subsidiary

Consolidated Statement of Changes in Stockholders’ Equity

March 31, 2004

 

		Comprehensive Income		Common Stock		Additional Paid-in Capital		Retained Earnings (Deficit)		Accumulated Other Comprehensive Income		Total Stockholders’ Equity
BALANCE, December 31, 2003				1,243,167		12,183,868		3,295,884		180,582		16,903,501
Redemption of Common Stock				—		—						—
Issuance of Common Stock				450.00		9,450.00						9,900.00
Comprehensive Income:
Net Income		523,346						523,346				523,346
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		26,149								26,149		26,149
Total comprehensive income		469,782
BALANCE, March 31, 2004				1,243,617		12,193,318		3,819,230		206,731		17,462,896

 

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Item 2.                                                           Management’s Discussion and Analysis or Plan of Operation.

 

Overview

 

Cornerstone Bancshares, Inc. (“Cornerstone”) ended the first three months of 2004 with total assets of $208 million, a 3.3% increase from December 31, 2003 and a 20.5% increase from March 31, 2003.  Cornerstone reported net income the for three months ending March 31, 2004 of $523,346, or $0.42 basic earnings per share, compared to $402,013, or $0.32 basic earnings per share, for the same period in 2003.  The increase in earnings represents a 30.2% increase from the first three months of 2003 compared to the first three months of 2004.

 

The increase in net income from the first three months of 2004 to the first three months of 2003 is due primarily to one factor.  The Bank’s net-interest income increased $443 thousand or 24.2% over the same period in 2003.  The Bank accomplished this by increasing the total average earning assets of the Bank by $34.3 million or 22.3% over the first quarter of 2003, while only increasing average non-earning assets by $1.8 million or 14.3% compared with the first quarter of 2003.  In addition, the Bank’s ability to collect loan fees and sell loans while maintaining servicing fees increased non-interest income and offset generally low market rates.  This additional income helped the Bank to be ranked at the 91^st percentile in an interest income comparison of our peer banks.  Concurrently, the Bank was able to increase its deposits as well as use alternative sources of funds to improve the Bank’s interest rate risk exposure while decreasing the overall cost of funds.  Interest expense decreased $4 thousand for the first three months of 2004 compared to the same period in 2003.  This reduction was the result of an increase in the percentage of transaction accounts in relationship to total deposits.  Average transaction accounts represented 64.7% of average total deposits during the first quarter of 2004 compared with 52.4% during the first quarter of 2003.  These accounts are less expensive for the Bank and allowed the Bank to grow average total deposits 16.8% while reducing actual interest expense.  The Bank took advantage of attractive non-traditional funding sources during the first quarter of 2004.  Cornerstone increased its Federal Home Loan Bank borrowings by $5 million and selected longer-term maturities to reduce the Bank’s general interest rate risk.  In addition, the Bank actively used its federal funds lines of credit as an inexpensive source of funds.  The Bank expects to raise additional deposits to fund future loan and investment securities growth and anticipates deposit growth in both transaction deposits and certificates of deposit during the second and third quarters of 2004.  Non-interest income increased 21.6% for the first three months of 2004 compared with the same period in 2003.  This increase was broad based, but had a large contribution from the electronic payments activity sponsored by the Bank.  On the qualitative side, the Bank improved its asset quality, which is quantified by the Bank’s below peer bank average of past due loans to net loans ratio of 0.17% and a below peer bank average non-performing asset ratio of 0.03%.  This was accomplished in a time period during which regional banks struggled to maintain net interest margin and had a general deterioration of loan quality.  For the first three months of 2004, the Bank’s net interest margin was 4.92% compared with 4.82% for the same time period in 2003.  The Bank’s management expects the Bank’s net interest margin to decrease slightly over the remainder of 2004.  The Board firmly believes that the earnings estimate of $2,341,000 for net income in 2004 and expected earnings per share to $1.88 basic earnings per share are achievable.  This would represent a 24% increase of basic earnings per share and the Company believes that it is a reasonable expectation of earnings given the Bank’s growth in the Chattanooga MSA.

 

During the first quarter of 2004, the Bank saw exceptional loan growth with normal

 

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deposit growth with the exception of the Bank’s non-interest bearing demand deposits, which also saw exceptional growth.  The loan growth was mostly concentrated in commercial real estate and one to four family residential construction loans.  One other area of interest related to loan growth was the Bank’s continued growth of asset based lending and related services.  The Bank was able to add more customers to accounts receivable and inventory borrowing and lock box services and due to the nature of the business line, the loans and depository accounts should be long-term relationships.  The Bank continues to sell electronic business services such as merchant card processing, payroll card, stored value card, and ACH origination processing, all of which help increase the Bank’s non-interest income and diversifies the Bank’s revenue.  Management believes this area has the brightest outlook for future revenue growth within the Federal Reserve’s permissible activities.  The Bank hired two relationship managers in February, one of whom will operate in the Ooltewah area and it is intended that the second will improve the Bank’s commercial lending capability in the Hixson area.  Attracting talented employees is key to the Bank’s success and has been and will continue to be management’s top priority for the foreseeable future.  The Ooltewah branch nears completion and should be completed in mid-May and be operational in early June.  The branch plans to have a grand opening with an appropriate marketing effort in August or September.  This branch opening brings the total number of branches to five.

 

The Bank, pursuant to its strategic plan, intends to continue to focus on providing a competitive footprint (convenient branches) to the Chattanooga Metropolitan Statistical Area allowing Cornerstone to compete with the three major regional banks located in the area.  The Bank also intends to focus its efforts in the suburban branch network and not on a central hub bank located in downtown Chattanooga.  It is also intended that special emphasis will be placed on providing services specifically targeted to small businesses and individual consumers.

 

Financial Condition

 

Earning Assets. Average earning assets for the three months ending March 31, 2004, increased by $34.3 million or 22.8% compared to the three months ending March 31, 2003, while actual earning assets increased $33.9 million or 21.4% during the same period. The average and actual balance increases were due to strong loan demand throughout 2003 and the first three months of 2004.  Average earning assets would have been larger if Management allowed the investment portfolio to grow proportionally, but due to an unfavorable investment risk versus return relationship the investment portfolio was maintained at the minimum amount needed to satisfy pledging requirements and liquidity needs.  Management expects average earning assets to grow at a slower pace during the remainder of 2004.

 

Loan Portfolio. The Bank’s average loans for the first three months of 2004 were $163 million, an increase of $35.5 million or 27.9% compared to the first three months of 2003, while actual balances increased to $169.3 million, an increase of 30.0% above the $130.3 million in loans as of March 31, 2003.  Management anticipates slower loan growth for the remainder of the year in both average and actual balances.

 

Investment Portfolio.  The Bank’s average investment securities portfolio increased by 12.8% or $2.8 million for the three months ending March 31, 2004 compared to the three months ending March 31, 2003, while actual balances decreased $5.0 million, a decrease of 18.2%.  The decrease is a result of strong loan growth and unusually low interest rates.  The low interest rates have caused the Bank to be very cautious and consequently, the Bank closely monitors the risk versus return of each security purchase.  It is the Bank’s opinion that rates will increase in the near

 

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future and the Bank will retain its cautious position until the risk of interest rate increases diminishes.  The Bank is maintaining approximately $10 million in Agency CMO LIBOR floating rate securities which will protect the Bank from sudden increases in short term rates.  These investments adjust every thirty days and are tied to the 30-day LIBOR index plus a spread (typically 130 basis points), which acts as a leading indicator to rate increases or decreases.  The Bank expects to maintain an investment strategy of making prudent investment decisions with active management of the portfolio to optimize, within the constraints of established policies, an adequate return and value.  Investment objectives include, in order of priority, gap management, liquidity, pledging, return, and local community support.  The Bank maintains two classifications of investment securities: “Held to Maturity” (HTM) and “Available for Sale” (AFS).  The “Available for Sale” securities are carried at fair market value, whereas “Held to Maturity” securities are carried at book value. As of March 31, 2004, net unrealized gains in the “Available for Sale” portfolio amounted to $313,229, a 1.4% increase in value.

 

Deposits. The Bank’s average deposits increased by $24.9 million or 18.8% for the three-month period ending March 31, 2004 compared to the same period ending March 31, 2003, while actual deposit balances increased by $22.7 million or 16.2%.  The actual deposit growth was concentrated in non-interest bearing transaction accounts and money market accounts.  The checking account growth is a direct result of relationship building with small businesses while the money market account growth is tied to the premium rate paid to attract new money to the Bank.  Management intends to focus its efforts on attracting core deposits and expects both transaction accounts and certificates of deposit to increase over the remainder of 2004 as loan growth continues. The Bank intends to maintain as one of its highest priorities the continued solicitation of transaction accounts from new and existing customers, which should provide the Bank with an increased net interest margin.

 

Other Liabilities.  As of the end of the first quarter of 2004 the Bank had $22 million of Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings and the ability to borrow another $15 million.  The borrowings are designed with a maturity of 10 years with call and put options after a stated conversion date.  During the first quarter of 2004, the Bank borrowed $5 million with a three-year conversion date and an interest rate of 2.50% bringing the total Bank borrowings to $22 million. Management believes that FHLB borrowings provide an inexpensive method to reduce interest rate risks by obtaining longer term liabilities to match the typically longer term assets the Bank has on its balance sheet that are usually below the cost of certificates of deposit.  Cornerstone increased its guidance line with Fifth Third Bank to $5 million to give the company the ability to fund future capital needs in the Bank and take advantage of any opportunities for investment at the holding company.  The company presently has $400 thousand outstanding on the line of credit, which was used to inject capital into the Bank during the second quarter of 2003.  The injection was needed to maintain an 8.0% capital leverage ratio, which the regulators consider appropriate, given the size of the Bank.  The loan is priced at 30-day LIBOR index plus 150 basis points, which as of March 31 was 2.6%.  Cornerstone will either pay off the loan with dividends from the Bank or will issue stock to pay off the loan.

 

Capital Resources.  Average stockholders’ equity increased by $1.9 million or 12.4% to $17.3 million for the three months ending March 31, 2004 compared with $15.4 million during the three months ending March 31, 2003.  Actual equity increased by $1.9 million or 12.7% from March 31, 2003 to March 31, 2004.  This increase was primarily due to net income.

 

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CONSOLIDATED AVERAGE BALANCE SHEET

INTEREST INCOME / EXPENSE AND YIELD / RATES

Taxable equivalent basis

(in thousands)

 

		Three months ended March 31,
		2004						2003
		Average Balance		Income / Expense		Yield / Rate		Average Balance		Income / Expense		Yield / Rate
Assets
Loans, net of unearned income		162,761		2,845		7.09	%	127,171		2,385		7.61	%
Investment securities		24,761		231		3.96	%	21,951		241		4.46	%
Other earning assets		648		2		1.25	%	4,776		13		1.10	%
Total earning assets		188,170		3,078		6.66	%	153,898		2,640		6.96	%
Allowance for loan losses		(2,073	)					(1,624	)
Cash and other assets		14,343						12,533
TOTAL ASSETS		200,440						164,807
Liabilities and Stockholders’ Equity
Interest bearing liabilities:
Interest bearing demand deposits		26,352		24		0.37	%	20,741		19		0.37	%
Savings deposits		29,328		92		1.27	%	23,468		84		1.45	%
Time deposits		57,341		374		2.65	%	52,467		417		3.23	%
Time deposits of $100,000 or more		22,266		138		2.51	%	19,100		161		3.42	%
Federal funds and securities sold under agreements to repurchase		3,451		11		1.29	%	2,808		8		1.16	%
Other borrowings		21,178		169		3.24	%	13,289		122		3.74	%
Total interest bearing liabilities		159,916		808		2.08	%	131,873		812		2.50	%
Net interest spread				2,270						1,828
Noninterest bearing demand deposits		21,898						16,486
Accrued expenses and other liabilities		1,342						1,065
Stockholders’ equity		17,284						15,383
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		200,440						164,807
Net interest margin on earning assets						4.92	%					4.82	%
Net interest spread on earning assets						4.58	%					4.46	%

 

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Results of Operations – Three months ended March 31, 2004 compared to three months ended March 31, 2003

 

Net Interest Income. Net interest income is the principal component of a financial institution’s income stream and represents the spread between interest and fee income generated from earning assets and the interest expense paid on deposits. The following discussion is on a fully taxable equivalent basis.

 

Net interest income before loan loss provision for the first three months of 2004 increased $442,596 or 24.2% above net interest income before loan loss provision for the first three months of 2003. The increase in net interest income as of March 31, 2004 was primarily due to the growth of earning assets and the collection of loan fees and servicing fees associated with SBA loans sold to the open market, while funding the larger portfolio with a slight decrease of interest expense.  This decrease was due to a mix change in the Bank’s deposits as transaction accounts increased as a percentage of total deposits.  As a result, the cost of funds decreased from 2.50% for the first three months of 2003 to 2.08% for the first three months of 2004.  The yield from earning assets decreased from 6.96% to 6.66% over the same time period.  The Bank’s increased average earning assets as a percentage of total earning assets increased to 93.8% for the first quarter of 2004 compared with 93.4% during the first quarter of 2003.  The Bank’s asset mix shifted as the percentage of average loans to average total assets was 81.2% for the first three months of 2004 compared to 77.2% for the first three months of 2003, providing the majority of the Bank’s asset growth in higher yielding assets.  Finally, SBA loan production that is not reflected in the average loan balances was sold to the secondary market for fee income.  Management foresees the net interest margin remaining at present levels for the remainder of 2004 with a slight compression as rates adjust during the second half of 2004.  The nominal dollar amount of the net interest margin should increase during the remainder of 2004 as rates increase and earning assets continue to grow.

 

Interest income increased $437,922 or 16.6% for the three-month period ended March 31, 2004 compared to the three month period ended March 31, 2003.  Interest income produced by the loan portfolio increased $459,580 or 19.3% for the three month period ended March 31, 2004 compared to three month period ended March 31, 2003, due to the increase in average loans outstanding and origination fees associated with loan growth for the period.  The increase of loan interest income was partially offset by the general repricing of the loan portfolio in a low interest rate environment.  Management estimates that the average balances will continue to increase but will restrain origination of these loans to insure that appropriate quality standards and documentation are maintained.  Interest income on investment securities, Federal Funds and other investments decreased $21,658 or 8.5% for the three month period ending March 31, 2004 compared to the three month period ended March 31, 2003, due primarily to a decrease in general market rates for a prolonged period of time.

 

Total interest expense decreased $4,674 or 0.6% from March 31, 2003 to March 31, 2004. The interest expense decrease from the first three months of 2003 to the first three months of 2004 is primarily due to a decrease in the rates of all deposits and an increase of transaction accounts as a percentage of total deposits, but was offset by an over 21.3% growth in average interest sensitive liabilities.

 

The trend in net interest income is commonly evaluated in terms of average rates using

 

11

 

the net interest margin and the interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average earning assets. This ratio represents the difference between the average yield on average earning assets and the average rate paid for all funds used to support those earning assets. The net interest margin for the first three months of 2004 was 4.92%.  The yield on earning assets decreased 30 basis points to 6.66% for the three month period ended March 31, 2004, compared to 6.96% for the three month period ended March 31, 2003.

 

The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing sources of funds. The interest rate spread eliminates the impact of non-interest bearing funds and gives a direct perspective on the effect of market interest rate movements.  As the Bank attracted more transaction accounts and interest expense decreased, the interest rate spread increased to 4.58% for the three-month period ending March 31, 2004 compared to 4.46% for the three-month period ending March 31, 2003, an increase of 12 basis points.

 

Allowance for Loan Losses. The allowance for possible loan losses represents management’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for possible loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the $2.1 million allowance for loan losses as of March 31, 2004 reflects the full known extent of credit exposure. Cornerstone made a $160,000 provision during the first quarter of 2004 and anticipates that it will make similar provisions in the future as the loan portfolio grows.  No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

 

 Non-performing Assets. Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. The Bank’s policy is to place a loan on non-accrual status when payment of principal or interest is contractually 90 or more days past due. At the time a loan is placed on non-accrual status, interest previously accrued but not collected may be reversed and charged against current earnings. As of March 31, 2004, the Bank had $38,356 in non-accrual loans and $44,021 in non-performing assets.

 

Non-interest Income.  Non-interest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and profits, commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of residential mortgage loans are included in non-interest income.  As the result of a new product line offering operating leases to the Bank’s customers, the Bank’s lease income was $28,000 but is offset by asset depreciation of $21,000.  These numbers slightly inflate the income statement non-interest income and non-interest expense; the net increase to income is $7,000.  Total non-interest income increased by $62,104 or 21.8% from the first quarter of 2003 compared with the first quarter of 2004.  The Bank is optimistic that non-interest income will continue to grow at an above average rate for the foreseeable future as the Bank’s e-commerce products continue to grow.

 

Non-interest Expense.  Non-interest expense for the first three months of 2004 increased by $250,516 or 18.5% compared to the first three months of 2003.  Expenses for salaries and employee benefits increased by $166,668 or 22.4% for the three months ending March 31, 2004 over

 

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the three months ending March 31, 2003.  Occupancy and equipment expense as of March 31, 2004 increased by $70,076 or 43.0% over the same period in 2003.  Occupancy and equipment expense is inflated by $21,000 related to the new operating leases mentioned above.  All other non-interest expenses for the three-month period ended March 31, 2004 increased $13,72 or 3.1% over the non-interest expenses for the same period ended March 31, 2003.  The increase in all other non-interest expense is due primarily to the growth of the Bank and its needs to properly manage the growth.  The Bank added two talented lenders and has had to add two bank operations personnel to handle the increased volume of activity from the new transaction accounts opened over the last year.  In addition, the Bank’s data processing cost has grown concurrently with the Bank’s deposit growth.

 

ALLOWANCE FOR LOAN LOSSES

 

		2004		2003
Quarter Ending		March 31		December 31		September 30		June 30		March 31
Balance at beginning of period		2,011,329		2,090,751		1,827,734		1,691,538		1,591,152
Loans charged-off		(202,060	)	(220,401	)	(3,802	)	(43,095	)	(67,587	)
Loans recovered		144,662		5,978		11,819		129,291		62,973
Net charge-offs (recoveries)		57,399		214,423		(8,018	)	(86,196	)	4,614
Provision for loan losses charged to expense		160,000		135,000		255,000		50,000		105,000
Balance at end of period		2,113,930		2,011,329		2,090,751		1,827,734		1,691,538
Allowance for loan losses as a percentage of average loans outstanding for the period		1.299	%	1.311	%	1.439	%	1.339	%	1.330	%
Allowance for loan losses as a percentage of nonperforming assets and loans 90 days past due outstanding for the period		4802.094	%	696.646	%	482.654	%	761.543	%	639.283	%
Annualized QTD net charge-offs as a percentage of average loans outstanding for the period		0.141	%	0.559	%	-0.022	%	-0.253	%	0.015	%
Annualized YTD net charge-offs as a percentage of average loans outstanding for the period		0.141	%	0.088	%	-0.087	%	-0.124	%	0.015	%
YTD Average Outstanding Loans		162,760,681		141,586,000		137,585,459		131,848,342		127,172,057
QTD Average Outstanding Loans		162,760,681		153,454,946		148,873,000		136,473,429		127,172,057
Nonperforming assets and loans 90 days past due		44,021		288,716		433,178		240,004		264,599

 

Item 3.    Controls and Procedures

 

(a)           Evaluation of Disclosure Controls and Procedures.  The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”).  Based on such evaluation, such officers have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic filings under the Exchange Act.

 

(b)           Changes in Internal Controls.  Since the Evaluation Date, there have not been any significant changes in the Company’s internal controls or in other factors that could significantly affect such controls.

 

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PART II – OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank’s business.  In the opinion of Management, no material loss is expected from any of such pending claims or lawsuits.

 

Item 2.  Changes in Securities and Small Business Issuer Purchases of Equity Securities

 

On April 27, 2004 the Company filed its First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. with the Secretary of State of the State of Tennessee increasing the number of authorized shares of its common stock from 2,000,000 shares to 10,000,000 shares.  Upon the issuance of additional shares of common stock the common stock holders’ interest in the Company will be diluted.

 

Item 6.  Exhibits and Reports on Form 8-K

 

(a)		Exhibits
		Exhibit Number		Description
		3		First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc.
		31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
		32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

 

(b)                                 Reports on Form 8-K

 

(1)          Form 8-K filed on April 15, 2004, disclosing press release related to first quarter earnings.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	Cornerstone Bancshares, Inc.
Date:  May 14, 2004	/s/ Gregory B. Jones
	Gregory B. Jones,
	Chairman and Chief Executive Officer
Date:  May 14, 2004	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes
	President and Chief Financial Officer

 

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EXHIBIT INDEX

 

Exhibit Number		Description
3		First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc.
31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

 

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