SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2004 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-QSB

 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2004

 

OR

 

o 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 000-27719

 

Greenville First Bancshares, Inc.

(Exact name of registrant as specified in its charter)

 

 

864-679-9000

(Telephone Number)

 

Not Applicable

(Former name, former address

and former fiscal year,

if changed since last report)

 

Check whether the issuer (1) has 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

 

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:

2,647,994 shares of common stock, $.01 par value per share, issued and outstanding as of November 8, 2004.

 

Transitional Small Business Disclosure Format (check one):  YES o NO ý

 

 

GREENVILLE FIRST BANCSHARES, INC.

 

PART I.  FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

The financial statements of Greenville First Bancshares, Inc. and Subsidiary are set forth in the following pages.

 

2

 

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 

		September 30, 2004			December 31, 2003
		(Unaudited)			(Audited)
Assets
Cash and due from banks		$	3,098,173		$	4,104,697
Federal funds sold		473,819			2,842,594
Investment securities available for sale		2,950,185			3,628,996
Investment securities held to maturity- (market value $13,648,242 and $9,761,305)		13,696,642			9,834,324
Other investments, at cost		3,886,150			2,296,150
Loans, net		264,258,625			206,076,833
Accrued interest		996,672			756,905
Property and equipment, net		1,736,579			824,259
Other real estate owned		305,485			—
Other assets		1,538,766			476,463
Total assets		$	292,941,096		$	230,841,221
Liabilities
Deposits		$	183,232,228		$	168,963,595
Official checks outstanding		2,045,465			1,575,357
Federal funds purchased and repurchase agreements		13,805,000			9,296,999
Federal Home Loan Bank advances		60,610,000			32,500,000
Junior subordinated debentures		6,186,000			6,186,000
Accrued interest payable		679,283			572,272
Accounts payable and accrued expenses		895,510			560,030
Total liabilities		267,453,486			219,654,253
Shareholders’ equity
Preferred stock, par value $.01 per share, 10,000,000 shares authorized, no shares issued		—			—
Common stock, par value $.01 per share
Authorized, 10,000,000 shares; issued 2,527,994 and 1,724,994 at September 30, 2004 and December 31, 2003, respectively		25,280			17,250
Additional paid-in capital		23,650,354			10,629,450
Accumulated other comprehensive income		59,998			96,997
Retained earnings		1,751,978			443,271
Total shareholders’ equity		25,487,610			11,186,968
Total liabilities and shareholders’ equity		$	292,941,096		$	230,841,221

 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 

3

 

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

 

		For the three months ended September 30,
		2004			2003
		(Unaudited)			(Unaudited)
Interest income
Loans		$	3,404,077		$	2,352,898
Investment securities		224,993			139,249
Federal funds sold		6,184			2,957
Total interest income		3,635,254			2,495,104
Interest expense
Deposits		943,048			685,441
Borrowings		501,075			246,944
Total interest expense		1,444,123			932,385
Net interest income before provision for loan losses		2,191,131			1,562,719
Provision for loan losses		375,000			250,000
Net interest income after provision for loan losses		1,816,131			1,312,719
Noninterest income
Loan fee income		33,860			50,446
Service fees on deposit accounts		71,977			67,838
Write-down on real estate owned		—			(70,000		)
Other income		78,584			67,034
Total noninterest income		184,421			115,318
Noninterest expenses
Compensation and benefits		612,118			494,979
Professional fees		41,711			56,947
Marketing		61,985			44,128
Insurance		33,006			28,171
Occupancy		153,580			141,899
Data processing and related costs		208,452			169,240
Telephone		6,454			5,517
Other		65,464			55,733
Total noninterest expenses		1,182,770			996,614
Income before income tax expense		817,782			431,423
Income tax expense		310,876			163,941
Net income		$	506,906		$	267,482
Earnings per common share:
Basic		$	0.28		$	0.16
Diluted		$	0.25		$	0.14
Weighted average common shares outstanding
Basic		1,788,864			1,724,994
Diluted		2,044,963			1,886,399

 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 

4

 

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

 

		For the nine months ended September 30,
		2004			2003
		(Unaudited)			(Unaudited)
Interest income
Loans		$	9,092,541		$	6,660,548
Investment securities		670,171			338,362
Federal funds sold		15,477			14,625
Total interest income		9,778,189			7,013,535
Interest expense
Deposits		2,511,334			2,097,817
Borrowings		1,182,294			587,338
Total interest expense		3,693,628			2,685,155
Net interest income before provision for loan losses		6,084,561			4,328,380
Provision for loan losses		1,025,000			750,000
Net interest income after provision for loan losses		5,059,561			3,578,380
Noninterest income
Loan fee income		100,684			154,112
Service fees on deposit accounts		211,705			191,134
Write-down on real estate owned		—			(170,000		)
Other income		234,932			171,178
Total noninterest income		547,321			346,424
Noninterest expenses
Compensation and benefits		1,811,640			1,462,821
Professional fees		141,526			131,506
Marketing		187,943			122,873
Insurance		94,668			81,436
Occupancy		443,479			441,261
Data processing and related costs		605,227			456,770
Telephone		19,760			16,704
Other		191,623			140,688
Total noninterest expenses		3,495,866			2,854,059
Income before income tax expense		2,111,016			1,070,745
Income tax expense		802,309			406,882
Net income		$	1,308,707		$	663,863
Earnings per common share:
Basic		$	0.75		$	0.38
Diluted		$	0.65		$	0.35
Weighted average common shares outstanding
Basic		1,746,617			1,724,994
Diluted		2,013,727			1,874,780

 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 

5

 

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

(Unaudited)

 

										Accumulated						Total
							Additional			other			Retained			share-
		Common stock					paid-in			comprehensive			earnings			holders’
		Shares		Amount			capital			income			(deficit)			equity
December 31, 2002		1,150,000		$	11,500		$	10,635,200		$	147,733		$	(562,644	)	$	10,231,789
Net income		—		—			—			—			663,863			663,863
Comprehensive loss, net of tax -
Unrealized holding gain on securities available for sale		—		—			—			(68,408		)	—			(68,408		)
Comprehensive income		—		—			—			—			—			595,455
September 30, 2003		1,150,000		$	11,500		$	10,635,200		$	79,325		$	101,219		$	10,827,244
December 31, 2003		1,724,994		$	17,250		$	10,629,450		$	96,997		$	443,271		$	11,186,968
Net income		—		—			—			—			1,308,707			1,308,707
Comprehensive income, net of tax -
Unrealized holding loss on securities available for sale		—		—			—			(36,999		)	—			(36,999		)
Comprehensive income		—		—			—			—			—			1,271,708
Proceeds from sale of common stock, net		800,000		8,000			13,000,924			—			—			13,008,924
Exercise of warrants		3,000		30			19,980			—			—			20,010
September 30, 2004		2,527,994		$	25,280		$	23,650,3549		$	59,998		$	1,751,978		$	25,487,6101

 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 

6

 

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		For the nine months ended September 30,
		2004			2003
		(Unaudited)			(Unaudited)
Operating activities
Net income		$	1,308,707		$	663,863
Adjustments to reconcile net income to cash provided by operating activities:
Provision for loan losses		1,025,000			750,000
Depreciation and other amortization		117,663			109,904
Accretion and amortization of securities discounts and premiums, net		58,692			77,309
Increase in other assets, net		(1,302,070		)	(389,226		)
Increase (decrease) in other liabilities, net		931,660			(84,229		)
Net cash provided by operating activities		2,139,652			1,127,621
Investing activities
Origination of loans, net		(59,512,277		)	(38,560,872		)
Purchase of property and equipment		(1,029,983		)	(122,082		)
Purchase of investment securities:
Held to maturity		(5,585,719		)	(10,158,438		)
Other investments		(3,585,000		)	(2,971,150		)
Payments and maturity of investment securities:
Available for sale		601,689			10,484,108
Held to maturity		1,685,772			129,365
Other investments		1,995,000			1,205,000
Net cash used for investing activities		(65,430,518		)	(39,994,069		)
Financing activities
Increase in deposits, net		14,268,633			22,530,448
Increase (decrease) in short-term borrowings		4,508,000			(9,107,000		)
Increase (decrease) in other borrowings		—			(2,500,000		)
Proceeds from junior subordinate debentures		—			6,186,000
Proceeds from issuances of common stock, net		13,008,924			—
Proceeds from exercise of stock warrants, net		20,010			—
Increase in Federal Home Loan Bank advances		28,110,000			27,000,000
Net cash provided by financing activities		59,915,567			44,109,448
Net increase (decrease) in cash and cash equivalents		(3,375,299		)	5,243,000
Cash and cash equivalents at beginning of the period		6,947,291			4,471,026
Cash and cash equivalents at end of the period		$	3,571,992		$	9,714,026
Supplemental information
Cash paid for
Interest		$	3,586,617		$	2,766,333
Income taxes		$	1,780,005		$	37,188
Schedule of non-cash transactions
Foreclosure of real estate		$	305,485		$	—
Unrealized loss on securities, net of income taxes		$	(36,999	)	$	(120,119	)

 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 

7

 

GREENVILLE FIRST BANCSHARES, INC.  AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1 – Nature of Business and Basis of Presentation

 

Business activity

 

Greenville First Bancshares, Inc.  (the “company”) is a South Carolina corporation that owns all of the capital stock of Greenville First Bank, N.A.  (the “bank”) and all of the stock of Greenville First Statutory Trust I (the “Trust”).  The bank is a national bank organized under the laws of the United States located in Greenville County, South Carolina.  The bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the Federal Deposit Insurance Corporation, and providing commercial, consumer and mortgage loans to the general public.  The Trust is a special purpose subsidiary for the sole purpose of issuing trust preferred securities.

 

Basis of Presentation

 

The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-QSB.  Accordingly, they do not include all 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, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company’s Form 10-KSB (Registration Number 000-27719) as filed with the Securities and Exchange Commission.  The consolidated financial statements include the accounts of Greenville First Bancshares, Inc., and its wholly owned subsidiary Greenville First Bank, N.A.  As discussed in Note 7, the financial statements related to the special purpose subsidiary, Greenville First Statutory Trust I, have not been consolidated in accordance with FASB Interpretation No. 46.

 

Cash and Cash Equivalents

 

For purposes of the Consolidated Statement of Cash Flows, cash and federal funds sold are included in “cash and cash equivalents.”  These assets have contractual maturities of less than three months.

 

Note 2 – Reclassifications

 

Certain amounts, previously reported, have been reclassified to state all periods on a comparable basis that had no effect on shareholders’ equity or net income.

 

Note 3 – Stock Split

 

On November 17, 2003, shareholders of record as of November 3, 2003, received one additional share of stock for every two shares of stock owned prior to the 3 for 2 stock split.  All factional shares were paid in cash.  The earnings per share amounts for all periods shown have been adjusted to reflect the 3 for 2 split.

 

Note 4 – Secondary Offering

 

On September 24, 2004, the company received $14.3 million from the sale of 800,000 shares of common stock at a price of $17.875.  On October 15, 2004, the company’s underwriter exercised its option to purchase an additional 120,000 shares at the same price.  The total gross proceeds were $16.4 million.  The net proceeds to the company after offering costs and underwriter’s discount were approximately $15.0 million.

 

Note 5 – Note Payable

 

At September 30, 2004, the company had an unused $4.5 million revolving line of credit with another bank.  This line of credit has a maturity of March 20, 2005. At December 31, 2003, the outstanding balance was $3.0 million.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at September 30, 2004 was 4.02%.  The company has pledged the stock of the bank as collateral for this line of credit. The line of credit agreement contains various covenants related to earnings and asset quality.  As of September 30, 2004, the company believes it is in compliance with all covenants.

 

8

 

Note 6 – Earnings per Share

 

The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three months and nine months ended September 30, 2004 and 2003.  Dilutive common shares arise from the potentially dilutive effect of Greenville First Bancshares, Inc.’s stock options and warrants that are outstanding.  The assumed conversion of stock options and warrants can create a difference between basic and dilutive net income per common share.  The average dilutive shares have been computed utilizing the “treasury stock” method.  The number of shares and the earnings per share have been adjusted for the 3 for 2 stock split.

 

		Three months ended September 30,
		2004			2003
Basic Earnings Per Share
Average common shares		1,788,864			1,724,994
Net income		$	506,906		$	267,482
Earnings per share		$	0.28		$	0.16
Diluted Earnings Per Share
Average common shares outstanding		1,788,864			1,724,994
Average dilutive common shares		256,099			161,405
Adjusted average common shares		2,044,963			1,886,399
Net income		$	506,906		$	267,482
Earnings per share		$	0.25		$	0.14

 

		Nine months ended September 30,
		2004			2003
Basic Earnings Per Share
Average common shares		1,746,617			1,724,994
Net income		$	1,308,707		$	663,863
Earnings per share		$	0.75		$	0.38
Diluted Earnings Per Share
Average common shares outstanding		1,746,617			1,724,994
Average dilutive common shares		267,110			149,786
Adjusted average common shares		2,013,727			1,874,780
Net income		$	1,308,707		$	663,863
Earnings per share		$	0.65		$	0.35

 

Note 7 – Accounting for Variable Interest Entities

 

Effective January 1, 2004, the company adopted FASB Interpretation No. 46, (“FIN 46”), “Consolidation of Variable Interest Entities.” In accordance with FIN 46, the $186,000 investment by the parent company, Greenville First Bancshares, Inc, in the special purpose subsidiary, Greenville First Statutory Trust I, results in the special purpose subsidiary being treated as a “variable interest entity” as defined in FIN 46.  Therefore, in accordance with the revised rules, the company did not consolidate its special purpose trust subsidiary.  Prior to the January 1, 2004, the effective date on the adoption of FIN 46, the company had consolidated the special purpose subsidiary.  The 2003, consolidated financial statements have been restated, resulting in the “deconsolidation” of this wholly-owned subsidiary.  The deconsolidation of this wholly-owned subsidiary, increased both the company’s other assets by $186,000, and the debt associated with the junior subordinated debentures.  The company’s maximum exposure to loss is the $186,000 invested in the special purpose subsidiary.  In addition to the loss exposure related to the investment in the special purpose subsidiary, the company has a full and unconditional guarantee for the $6,000,000 junior subordinate debentures that were issued.  The special purpose subsidiary was formed for the sole purpose of issuing the junior subordinate debentures.

 

9

 

Note 8 – Stock Based Compensation

 

The company has a stock-based employee compensation plan.  The company accounts for the plan under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net income, as all stock options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

 

		For the three months ended September 30,
		2004			2003
Net income, as reported		$	506,906		$	267,482
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(20,719		)	(19,613		)
Pro forma net income		$	486,187		$	247,869
Earnings per common share-adjusted for 3 for 2 stock split:
Basic - as reported		$	0.28		$	0.16
Basic - pro forma		$	0.27		$	0.14
Diluted - as reported		$	0.25		$	0.14
Diluted – pro-forma		$	0.24		$	0.13

 

		For the nine months ended September 30,
		2004			2003
Net income, as reported		$	1,308,707		$	663,863
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(62,157		)	(58,839		)
Pro forma net income		$	1,246,550		$	605,024
Earnings per common share-adjusted for 3 for 2 stock split:
Basic - as reported		$	0.75		$	0.38
Basic - pro forma		$	0.71		$	0.35
Diluted - as reported		$	0.65		$	0.35
Diluted – pro-forma		$	0.62		$	0.32

 

The fair value of the option grant is estimated on the date of grant using the Black-Scholes option-pricing model.  The following assumptions were used for grants: expected volatility of 10% for 2004 and 2003, risk-free interest rate of 3.00% for 2004 and 2003 respectively, expected lives of the options 10 years, and the assumed dividend rate was zero.

 

10

 

Item 2.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

The following discussion reviews our results of operations and assesses our financial condition.  You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunction with the discussion of forward-looking statements, the financial statements and the related notes and the other statistical information included in this report.

 

DISCUSSION OF FORWARD-LOOKING STATEMENTS

 

This report contains “forward-looking statements” relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management.  The words “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” and “intend,” as well as other similar words and expressions of the future, are intended to identify forward-looking statements.  Our actual results may differ materially from the results discussed in the forward-looking statements, and our operating performance each quarter is subject to various risks and uncertainties that are discussed in detail in our filings with the Securities and Exchange Commission, including, without limitation:

 

•                  significant increases in competitive pressure in the banking and financial services industries;

•                  changes in the interest rate environment which could reduce anticipated or actual margins;

•                  changes in political conditions or the legislative or regulatory environment;

•                  general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a deterioration in credit quality;

•                  changes occurring in business conditions and inflation;

•                  changes in technology;

•                  changes in monetary and tax policies;

•                  the level of allowance for loan loss;

•                  the rate of delinquencies and amounts of charge-offs;

•                  the rates of loan growth;

•                  adverse changes in asset quality and resulting credit risk-related losses and expenses;

•                  loss of consumer confidence and economic disruptions resulting from terrorist activities;

•                  changes in the securities markets; and

•                  other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

 

Overview

 

We were incorporated in March 1999 to organize and serve as the holding company for Greenville First Bank, N.A.  Since we opened our bank in January 2000, we have experienced consistent growth in total assets, loans, deposits, and shareholders’ equity, which has continued during the first nine months of 2004.

 

On September 24, 2004 and October 15, 2004, the company sold 800,000 and 120,000 shares, respectively, of common stock.  The net proceeds were approximately $15.0 million.

 

Like most community banks, we derive the majority of our income from interest received on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread.

 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We maintain this allowance by charging a provision for loan losses against our operating earnings for each period.  We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

 

11

 

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers.  We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense.

 

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the Securities and Exchange Commission.

 

Critical Accounting Policies

 

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2003, as filed in our annual report on Form 10-KSB.

 

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

 

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 

Effect of Economic Trends

 

During the three years ended December 31, 2003, and the first six months of 2004, our rates on both short-term or variable rate earning assets and short-term or variable rate interest-bearing liabilities declined primarily as a result of the actions taken by the Federal Reserve.  Our rates on both short-term or variable earning assets and short-term or variable rate interest-bearing liabilities began to increase in the third quarter of 2004, as a result of actions taken by the Federal Reserve to increase short-term rates.

 

During most of 2001 and during 2002, the United States experienced an economic decline.  During this period, the economy was affected by lower returns of the stock markets.  Economic data led the Federal Reserve to begin an aggressive program of reducing rates that moved the Federal Funds rate down 11 times during 2001 for a total reduction of 475 basis points.  During the fourth quarter of 2002 and the first nine months of 2003, the Federal Reserve reduced the Federal Funds rate down an additional 75 basis points, bringing the Federal Funds rate to its lowest level in 40 years.

 

Despite sharply lower short-term rates, stimulus to the economy during 2003 was muted and consumer demand and business investment activity remained weak.  During all of 2003 and substantially all of the nine months ended September 30, 2004, the financial markets operated under historically low interest rates. As a result of these unusual conditions, Congress passed an economic stimulus plan in 2003.  During the first nine months of 2004, many economists believed the economy began to show signs of strengthening and at the end of the second quarter and near the end of the third quarter, the Federal Reserve increased the short-term interest rate each time by 25 basis points.  Many economists believe that the Federal Reserve will continue to increase rates during the remainder of 2004 and during most of 2005.  However, no assurance can be given that the Federal Reserve will take such action.

 

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Results of Operations

 

Income Statement Review

 

Summary

 

Three months ended September 30, 2004 and 2003

 

Our net income was $506,906 and $267,482 for the three months ended September 30, 2004 and 2003, respectively, an increase of $239,424, or 89.5%.  Our income was fully taxable in both three month periods.  The $239,424 increase in net income resulted primarily from increases of $628,412 in net interest income and $69,103 in noninterest income.  These increases were partly offset by $186,156 of additional noninterest expense, a $125,000 increase in provisions for loan losses, and a $146,935 increase in income tax expense.  Our efficiency ratio has continued to improve because we have been earning more income without substantially increasing our overhead expenses.  Our efficiency ratio was 49.79% and 59.39% for the three months ended September 30, 2004 and 2003, respectively.

 

Nine months ended September 30, 2004 and 2003

 

Our net income was $1.3 million and $663,863 for the nine months ended September 30, 2004 and 2003, respectively, an increase of $644,844, or 97.1%.  Our income was fully taxable in both nine month periods.  The $644,844 increase in net income resulted primarily from increases of $1.8 million in net interest income and $200,897 in noninterest income.  These increases were partly offset by $641,807 of additional noninterest expense, a $275,000 increase in provisions for loan losses, and a $395,427 increase in income tax expense.  Our efficiency ratio has continued to improve because we have been earning more income without substantially increasing our overhead expenses.  Our efficiency ratio was 52.71% and 61.05% for the nine months ended September 30, 2004 and 2003, respectively.

 

Net Interest Income

 

Our level of net interest income is determined by the level of earning assets and the management of our net interest margin.  The continuous growth in our loan portfolio is the primary driver of the increase in net interest income.  During the three months ended September 30, 2004, our loan portfolio had increased an average of $19.8 million compared to the second quarter of 2004.  The growth in the first nine months of 2004 was $58.2 million.  We anticipate the growth in loans will continue to drive the growth in assets and the growth in net interest income.  However, no assurance can be given that we will be able to continue to increase loans at the same levels we have experienced in the past.

 

Our decision to grow the loan portfolio at the current pace created the need for a higher level of capital and the need to increase deposits and borrowings.  This loan growth strategy also resulted in a significant portion of our assets being in higher earning loans than in lower yielding investments.  At September 30, 2004, loans represented 90.2% of total assets, while investments and federal funds sold represented 7.2% of total assets.  While we plan to continue our focus on increasing the loan portfolio, as rates on investment securities begin to rise and additional deposits are obtained, we also anticipate increasing the size of the investment portfolio.

 

The historically low interest rate environment in the last three years allowed us to obtain short-term borrowings and wholesale certificates of deposit at rates that were lower than certificate of deposit rates being offered in our local market.  Therefore, we decided not to begin our retail deposit office expansion program until the beginning of 2005.  This funding strategy allowed us to continue to operate in one location, maintain a smaller staff, and not incur marketing costs to advertise deposit rates, which in turn allowed us to focus on the fast growing loan portfolio.  At September 30, 2004, retail deposits represented $114.3 million, or 39.0% of total assets, borrowings represented $80.6 million, or 27.5% of total assets, and wholesale out-of-market deposits represented $70.0 million, or 23.5% of total assets.

 

In anticipation of rising interest rates, we are planning to open two retail deposit offices, one in the first quarter of 2005 and the other in the third quarter of 2005.  We plan to focus our efforts in these two locations to obtain low cost transaction accounts that are less affected by rising rates.  Also, in anticipation of rising rates, during the first nine months of 2004 we offered aggressive promotional rates on new checking accounts and new money market accounts.  The promotional rates offered are 2.00% on checking accounts and 2.25% on money market accounts and are guaranteed until January 31, 2005.  Based on prior experience, we anticipate the majority of these funds to be retained at the end of the promotion.  Our goal is to increase both the percentage of assets being funded by “in market” retail deposits and to

 

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increase the percentage of low-cost transaction accounts to total deposits.  No assurance can be given that these objectives will be achieved; however, we anticipate that the two additional retail deposit offices will assist us in meeting these objectives.  We also anticipate the current deposit promotion and the opening of the two new offices will have a negative impact on earnings in the years ending 2004 and 2005.  However, we believe that these two strategies will provide additional clients in our local market and will provide a lower alternative cost of funding in a higher or rising interest rate environment, which we believe will increase earnings in future periods.

 

As more fully discussed in the – “Market Risk” and – “Liquidity and Interest Rate Sensitivity” sections below, at September 30, 2004, 68.1% of our loans had variable rates.  Given our high percentage of rate-sensitive loans, our primary focus during the three years ended December 31, 2003 and for first nine months of 2004 has been to obtain short-term liabilities to fund our asset growth.  This strategy allows us to manage the impact on our earnings resulting from changes in market interest rates.  At December 31, 2003, 83.4% of interest-bearing liabilities had a maturity of less than one year.

 

In anticipation of rising rates, in May 2004 we extended the maturities on $25.0 million of short-term deposits and borrowings with a term of less than three months into $25.0 million of deposits and borrowings with a weighted average life of five years.  As of September 30, 2004, 80.0% of interest-bearing liabilities had a maturity of less than one year.  We believe that we are positioned to benefit from future increases in short-term rates.  At September 30, 2004, we had $13.9 million more assets than liabilities that reprice within the next three months.

 

We intend to maintain a capital level for the bank that exceeds the OCC requirements to be classified as a “well capitalized” bank.  To provide the additional capital needed to support our bank’s growth in assets, we issued $6.2 million in junior subordinated debentures in connection with our trust preferred securities offering in June 2003, and we borrowed during 2004, $3.0 million under a short-term holding company line of credit.  This holding company line of credit was repaid on September 24, 2004, utilizing $3.0 million of the proceeds from the secondary offering that was completed on September 24, 2004.  The company utilized $9.5 million of the proceeds to provide additional capital for the bank to support assets growth.  At September 30, 2004, the additional capital reduced outstanding borrowings.

 

In addition to the growth in both assets and liabilities, and the timing of repricing of our assets and liabilities, net interest income is also affected by the ratio of interest-earning assets to interest-bearing liabilities and the changes in interest rates earned on our assets and interest rates paid on our liabilities.

 

Our net interest income for the three months ended September 30, 2004 and the nine months ended September 30, 2004 increased because we had more interest-earning assets than interest-bearing liabilities.  For the three and nine months ended September 30, 2004, interest-earning assets exceeded interest-bearing liabilities by $7.9 million and $7.5 million, respectively.  The estimated $2.5 million cost of the two additional retail offices will reduce the amount by which interest-earning assets exceed interest-bearing liabilities.

 

During the nine months ended September 30, 2004, our rates on both short-term or variable rate earning-assets and short-term or variable rate interest-bearing liabilities declined primarily as a result of the actions taken by the Federal Reserve in 2003 to lower short-term rates.

 

The impact of the Federal Reserve’s actions resulted in a decline in both the yields on our variable rate assets and the rates that we paid for our short-term deposits and borrowings.  Our net interest spread and net interest margins also declined since more of our rate sensitive assets repriced sooner than our rate sensitive liabilities during the nine month periods ending September 30, 2004.  Our net interest margin for the nine month period was 3.15%.

 

We anticipate that the three 25 basis point increases in short-term rates will result in an increase in loan yields and deposit and borrowing costs.  Accordingly, we believe that our net interest margin may increase if further action is taken by the Federal Reserve to increase short-term rates.

 

We have included a number of tables to assist in our description of various measures of our financial performance.  For example, the “Average Balances” tables show the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during both the three months ended September 30, 2004 and 2003 and the first nine months of 2004 and 2003.  A review of these tables shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we direct a substantial percentage of our earning assets into our loan portfolio.  Similarly, the “Rate/Volume Analysis” tables help demonstrate the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown.  We also track the sensitivity of our various categories of assets and liabilities to changes in

 

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interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning accounts and interest-bearing accounts.  Finally, we have included various tables that provide detail about our investment securities, our loans, our deposits, and other borrowings.

 

The following tables set forth information related to our average balance sheets, average yields on assets, and average costs of liabilities.  We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities.  We derived average balances from the daily balances throughout the periods indicated.  During the nine months ended September 30, 2004 and 2003, all investments were taxable.  During the same period, we had no interest-bearing deposits in other banks or any securities purchased with agreements to resell.  All investments were owned at an original maturity of over one year.  Nonaccrual loans are included in the following tables.  Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status.  The net of capitalized loan costs and fees are amortized into interest income on loans.

 

 

		Average Balances, Income and Expenses, and Rates For the Three Months Ended September 30,
		2004								2003
		Average Balance			Income/ Expense			Yield/ Rate(1)		Average Balance			Income Expense			Yield/ Rate(1)
		(In thousands)
Earnings
Federal funds sold		$	1,760		$	6		1.36	%	$	1,182		$	3		1.01	%
Investment securities		20,883			225			4.29	%	13,392			139			4.12	%
Loans		253,807			3,404			5.34	%	181,401			2,353			5.15	%
Total earning-assets		276,450			3,635			5.23	%	195,975			2,495			5.05	%
Non-earning assets		7,903								6,541
Total assets		$	284,353							$	202,516
Interest-bearing liabilities:
NOW accounts		$	41,097		$	97		0.94	%	$	31,015		$	33		0.42	%
Savings & money market		48,971			196			1.59	%	23,608			36			0.60	%
Time deposits		92,828			650			2.79	%	93,464			617			2.62	%
Total interest-bearing deposits		182,896			943			2.05	%	148,087			686			1.84	%
FHLB advances		63,071			346			2.18	%	28,458			158			2.20	%
Other borrowings		22,573			155			2.73	%	12,814			88			2.72	%
Total interest-bearing liabilities		268,540			1,444			2.14	%	189,359			932			1.95	%
Non-interest bearing liabilities		2,384								2,302
Shareholders’ equity		13,429								10,855
Total liabilities and shareholders’ equity		$	284,353							$	202,516
Net interest spread								3.09	%							3.10	%
Net interest income / margin					$	2,191		3.15	%				$	1,563		3.16	%

 

(1) Annualized for the three month period.

 

Our net interest spread was 3.09% for the three months ended September 30, 2004, compared to 3.10% for the three months ended September 30, 2003.

 

Our net interest margin for the three months ended September 30, 2004 was 3.15%, compared to 3.16% for the three months ended September 30, 2003.  During the three months ended September 30, 2004, earning assets averaged $276.5 million, compared to $196.0 million in the three months ended September 30, 2003.

 

The higher yields on loans for the three months ended September 30, 2004 compared to the three months ended September 30, 2003 resulted primarily from a 75 basis point increase in the prime rate.  The deposit cost increased as a result of our decision to aggressively market interest-bearing transaction accounts by paying an above market rate.  Also, we extended the maturity dates on various jumbo time deposits and FHLB advances.  These decisions were intended to compensate for anticipated higher rates in the future.

 

Net interest income, the largest component of our income, was $2.2 million and $1.6 million for the three months ended September 30, 2004 and 2003, respectively.  The significant increase in 2004 related to higher levels of both average earning assets and interest-bearing liabilities, offset by a slightly lower net interest margin.  Average earning assets increased

 

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