SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2006 March (Form 10-Q)

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.

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

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

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 GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME

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

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2006  AND 2005
(Unaudited)

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

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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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. is a South Carolina corporation that owns all of the capital stock of Greenville First Bank, N.A. and all of the stock of Greenville First Statutory Trust I and Trust II (collectively the "Trusts").  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 Trusts are special purpose subsidiaries 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-Q.  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 three-month period ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company's Form 10-K for the year ended December 31, 2005 (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 2, the financial statements related to the special purpose subsidiary, Greenville First Statutory Trust I and Trust II, have not been consolidated in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46.

Cash and Cash Equivalents

             For purposes of the Consolidated Statements 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 - Note Payable

The company has an unused $4.5 million revolving line of credit with another bank that matures on March 20, 2007.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at March 31, 2006 was 7.00%.  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 net income and asset quality.  As of March 31, 2006, the company believes it is in compliance with all covenants.

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Note 3 - Earnings per Share

             The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three months ended March 31, 2006 and 2005.  Dilutive common shares arise from the potentially dilutive effect of the company'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.

Note 4 - Stock Based Compensation

The company has a stock-based employee compensation plan.  On January 1, 2006, the company adopted the fair value recognition provisions of (R), Accounting for Stock-Based Compensation, to account for compensation costs under its stock option plan.  The company previously utilized the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (as amended) ("APB 25").  Under the intrinsic value method prescribed by APB 25, no compensation costs were recognized for the company's stock options because the option exercise price in its plans equals the market price on the date of grant.  Prior to January 1, 2006, the company only disclosed the pro forma effects on net income and earnings per share as if the fair value recognition provisions of SFAS No. 123(R) had been utilized. On December 20, 2005, the Board of Directors approved accelerating the vesting of 45,813 unvested stock options effective December 28, 2005.  The decision to accelerate vesting of these options was made so as to reduce compensation expense upon the adoption of SFAS No. 123(R) by approximately $68,000 and $52,000 in the years ended December 31, 2006 and 2007, respectively, and $4,000 in each of the years ended December 31, 2008 and 2009.

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               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 6.76% for 2006 and 2005, risk-free interest rate of 4.02% for 2006 and 2005, expected lives of the options 10 years, and the assumed dividend rate was zero.  No options were granted during the three months ended March 31, 2006.

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.

             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 and the lack of seasoning of our loan portfolio;

•    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.

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 three months of 2006.  To support this growth, we conducted an underwritten public offering of our common stock in September and October 2004.  On September 24, 2004 and October 15, 2004, we sold 800,000 and 120,000 shares, respectively, of common stock.  The net proceeds from this offering 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. 

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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.

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

             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, 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

Beginning in July of 2004 and through the first three months of 2006, our short-term or variable rate interest-bearing liabilities increased as the Federal Reserve began to increase short-term rates as the economy showed signs of strengthening following an economic decline and historically low interest rates.  During this period, the Federal Reserve increased rates 15 times for a total of 375 basis points.  Two of these rate increases occurred during the first quarter of 2006 for a total of 50 basis points.  Many economists believe that the Federal Reserve will continue to increase rates during 2006.  The following discussion includes our analysis of the effect we anticipate these rising interest rates will have on our financial condition.  However, no assurance can be given that the Federal Reserve will actually continue to raise interest rates or that the results we anticipate will actually occur.

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Results of Operations

Income Statement Review

Summary

                Our net income was $841,904 and $660,148 for the three months ended March 31, 2006 and 2005, respectively, an increase of $181,756, or 27.5%.  The $181,756 increase in net income resulted primarily from an increase of $679,213 in net interest income which was
partially offset by an increase of $55,000 in the provision for loan losses, a decrease of $57,800 in noninterest income, $305,333 of additional noninterest expense and a $79,324 increase in income tax expense.  Our efficiency ratio has continued to improve because our net interest income and other income continue to increase at a higher rate than the increases in our overhead expenses.  Our efficiency ratio was 50.9% and 51.3% for the three months ended March 31, 2006 and 2005, 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 March 31, 2006, our average loan portfolio increased $63.8 million compared to the average for the three months ended March 31, 2005.  The growth in the first three months of 2006 was $25.9 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 March 31, 2006, net loans represented 86.1% of total assets, while investments and federal funds sold represented 9.6% 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 until 2005, 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 March 31, 2006, retail deposits represented $206.4 million, or 49.4% of total assets, borrowings represented $106.6 million, or 25.5% of total assets, and wholesale out-of-market deposits represented $69.4 million, or 16.6% of total assets.

In anticipation of rising interest rates, we opened one retail deposit office in March of 2005 and a second in November 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.  Our goal is to increase both the percentage of assets being funded by "in market" retail deposits and to 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 deposit promotions and the opening of the two new offices will continue to have a negative impact on earnings in the year 2006.  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 March 31, 2006, 56.7% of our loans had variable rates.  Given our high percentage of rate-sensitive loans, our primary focus during the past three years has been to obtain short-term liabilities to fund our asset growth.  This strategy improves our ability to manage the impact on our earnings resulting from anticipated increases in market interest rates.

At March 31, 2006, 76.7% of interest-bearing liabilities had a maturity of less than one year.   Therefore, we believe that we are positioned to benefit from future increases in short-term rates.  At March 31, 2006, we had $12.9 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, in 2003 we issued $6.2 million in junior subordinated debentures in connection with our trust preferred securities offering.  During 2004, we issued 920,000 additional shares of common stock that resulted in $14.9 million of additional capital.  In 2005, we issued an additional $7.2 million in junior subordinated debentures in a second trust preferred securities offering.  The company also has a $4.5 million unused short-term holding company line of credit that could be utilized to provide additional capital for the bank if deemed necessary. As of March 31, 2006, the company's regulatory capital levels were over $14.4 million in excess of the various well capitalized requirements.

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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 margin for the three months ended March 31, 2006, exceeded our net interest spread because we had more interest-earning assets than interest-bearing liabilities.  Average interest-earning assets exceeded average interest-bearing liabilities by $46.5 million, and $41.4 million for the three months ended March 31, 2006 and 2005, respectively. 

During the three months ended March 31, 2006, our rates on both short-term or variable rate earning-assets and short-term or variable rate interest-bearing liabilities continued to increase primarily as a result of the actions taken by the Federal Reserve over the last twelve months to raise short-term rates.  The impact of the Federal Reserve's actions resulted in an increase 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 increased slightly since more of our rate sensitive assets repriced sooner than our rate sensitive liabilities during the 12 month period ending March 31, 2006.  We have chosen to limit our exposure to changes in short-term rates by increasing the amount of fixed rate loans in our loan portfolio and targeting to have a significant portion of our liabilities to reprice within a twelve month period. 

Our net interest spread for the three months ended March 31, 2006 was 3.03%.  Because we had more interest-earning assets than interest-bearing liabilities that repriced, our net interest spread increased 3 basis points in the three months ended March 31, 2006, compared to the same period in 2005.

For the three months ended March 31, 2006, our net interest margin was 3.48%.  The change in our net interest margin was 11 basis points higher than the change in net interest spread for the three month period ended March 31, 2006 when compared to the same period in 2005.  The additional 11 basis points resulted primarily because our interest-earning assets exceeded interest-bearing liabilities by $46.5 million for the three month period ended March 31, 2006, compared to $41.4 million for the same period in 2005. 

We have included a number of tables to assist in our description of various measures of our financial performance.  For example, the "Average Balances" table shows 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 the three months ended March 31, 2006 and 2005.  A review of this table 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" table demonstrates the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown.  A review of these tables shows that as short-term rates continue to rise, the increase in net interest income is more effected by the changes in rates than in prior years.  We also track the sensitivity of our various categories of assets and liabilities to changes in 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.

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The following table sets 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 three month periods ended March 31, 2006 and 2005, 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.

Our net interest spread was 3.03% for the three months ended March 31, 2006, compared to 3.00% for the three months ended March 31, 2005.  The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin for the three months ended March 31, 2006 was 3.48%, compared to 3.34% for the three months ended March 31, 2006.  During the three months ended March 31, 2006, interest-earning assets averaged $391.4 million, compared to $325.7 million in the three months ended March 31, 2005.  Interest earning assets exceeded interest bearing liabilities by $46.5 million and $41.4 million for the three month periods ended March 31, 2006 and 2005, respectively. 

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Our loan yield increased 122 basis points for the three months ended March 31, 2006 compared to the three months ended March 31, 2005 as a result of approximately 57% of the loan portfolio having variable rates, combined with the increase in prime rates over the twelve months ended March 31, 2006.  Offsetting the increase in our loan yield is a 106 basis point increase in the cost of our interest-bearing deposits for the first quarter of 2006 compared to the same period in 2005.  The increase in the rate on our time deposits is due to the renewal rates on time deposits being much higher than the original rates due to the number of increases in the prime rate in the past twenty-one months.  In addition, the cost of our savings and money market accounts has increased by 129 basis points as we have increased the rates we offer on these products in relation to the increase in short-term market rates to stay competitive.  The 102 basis point increase in FHLB advances and the 225 basis point increase in other borrowed funds in the first quarter of 2006 compared to the same period in 2005 resulted primarily from the impact of the 200 basis point increase in short-term market rates over the past twelve months.  As of March 31, 2006, approximately 46% of our FHLB advances had variable rates, while all of our other borrowings had variable rates.

Net interest income, the largest component of our income, was $3.4 million and $2.7 million for the three months ended March 31, 2006 and 2005, respectively.  The significant increase in the first quarter of 2006 related to higher levels of both average earning assets and interest-bearing liabilities.  Average earning assets were $65.7 million higher during the three months ended March 31, 2006 compared to the same period in 2005.

The $679,213 increase in net interest income for the three months ended March 31, 2006 compared to the same period in 2005 resulted primarily from a $534,000 increase in net interest income related to the impact of higher average earning assets and interest-bearing liabilities in the three months ended March 31, 2006 compared to the same period in 2005.  The remaining increase is largely a result of the impact of higher interest rates on both interest-earning assets and interest-bearing liabilities.

Interest income for the three months ended March 31, 2006 was $6.6 million, consisting of $6.1 million on loans, $431,690 on investments, and $48,391 on federal funds sold.  Interest income for the three months ended March 31, 2005 was $4.6 million, consisting of $4.2 million on loans, $405,090 on investments, and $5,811on federal funds sold.  Interest on loans for the three months ended March 31, 2006 and 2005 represented 92.8% and 91.0%, respectively, of total interest income, while income from investments and federal funds sold represented only 7.2% and 9.0% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 89.9% and 88.4% of average interest-earning assets for the three months ended March 31, 2006 and 2005, respectively.  Included in interest income on loans for the three months ended March 31, 2006 and 2005 was $140,197 and $118,797, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the three months ended March 31, 2006 was $3.3 million, consisting of $2.1 million related to deposits and $1.2 million related to borrowings.  Interest expense for the three months ended March 31, 2005 was $1.9 million, consisting of $1.2 million related to deposits and $746,886 related to borrowings.  Interest expense on deposits for the three months ended March 31, 2006 and 2005 represented 64.7% and 60.7%, respectively, of total interest expense, while interest expense on borrowings represented 35.3% and 39.3%, respectively, of total interest expense for the same three month periods.  During the three months ended March 31, 2006, average interest-bearing deposits increased by $53.4 million over the same period in 2005, while FHLB and other borrowing during the three months ended March 31, 2006 increased $7.2 million over the same period in 2005.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments. 

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Rate/Volume Analysis

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume.  The following table sets forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

Provision for Loan Losses

             We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statement of income.  We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.  Please see the discussion below under "Balance Sheet Review - Provision and Allowance for Loan Losses" for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

For the three months ended March 31, 2006 and 2005, there was a noncash expense related to the provision for loan losses of $400,000 and $345,000, respectively.  The additional provision which was partially offset by net loans charged-off added to our allowance for loan losses in the three months ended March 31, 2006and 2005.  The net increase in the allowance for loan losses was $25,616 and $356,793 for the three months ended March 31, 2006 and 2005, respectively.  The allowance for loan losses increased less than the provision for loan losses in the three months ended March 31, 2006 because we reported net charge-offs of $374,384 in the three month period. The $374,384 net charge-offs during the first quarter of 2006 represented 0.11% of the average outstanding loan portfolio for the three months ended March 31, 2006. The allowance for loan losses at March 31, 2005 increased more than the amount of the provision for loan losses as a result of a $11,793 recovery combined with no charge-offs in the three month period.  The $25,616 and the $356,793 increases in the allowance for the three months ended March 31, 2006 and 2005, respectively, related to our decision to increase the allowance in response to the $25.9 million and the $15.4 million growth in loans for the three months ended March 31, 2006 and 2005, respectively. 

During the first quarter of 2006, the decision was made not to increase the reserve at the same level as loan growth due to the amount of coverage we had against non-performing and charged-off loans.  At March 31, 2006, the allowance represented 4.2 times the amount of non-performing loans compared to 3.6 times at March 31, 2005.  In addition, the allowance represented 3.0 times the annualized charge-off amount at March 31, 2006, while there were no charge-offs at March 31, 2005.  Also, late in the quarter, we charged-off $340,000 related to a group of loans with a common interest.  This group of loans is secured by diversified real estate or vehicles.  The loan loss reserve was $4.5 million and $4.1 million as of March 31, 2006 and 2005, respectively.  The allowance for loan losses as a percentage of gross loans was 1.24% at March 31, 2006 and 1.38% at March 31, 2005, while the percentage of nonperforming loans to gross loans was 0.80% and 0.34% at March 31, 2006 and 2005, respectively.

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Noninterest Income

             The following table sets forth information related to our noninterest income. 

Noninterest income in the three month period ended March 31, 2006 was $155,575, a decrease of 27.1% over noninterest income of $213,375 in the same period of 2005. 

Loan fee income consists primarily of late charge fees, fees from issuance of letters of credit and mortgage origination fees we receive on residential loans funded and closed by a third party.  Loan fees were $30,801 and $46,624 for the three months ended March 31, 2006 and 2005, respectively.  The $15,823 decrease for the three months ended March 31, 2006 compared to the same period in 2005 related primarily to a $7,009 reduction in mortgage origination fees and a $12,513 decrease in fees received from the issuance of letters of credit which were offset by a $3,699 increase in late charge fees.  Mortgage origination fees were $2,885 and $9,893 for the three months ended March 31, 2006 and 2005, respectively, while income related to amortization of fees on letters of credit was $8,591 and $21,104 for the first quarter of 2006 and 2005, respectively.  Late charge fees were $19,325 and $15,626 for the three months ended March 31, 2006 and 2005, respectively. 

Service fees on deposits consist primarily of income from NSF fees and service charges on transaction accounts.  Service fees on deposits were $62,071 and $73,537 for the three months ended March 31, 2006 and 2005, respectively.  While the number of client accounts continues to grow, the $11,466 decrease is primarily related to the amount of NSF fees collected in the first quarter of 2006 compared to the same period in 2005.  NSF income was $36,925 and $45,123 for the three months ended March 31, 2006 and 2005, respectively, representing 59.5% of total service fees on deposits in the 2006 period compared to 61.4% of total service fees on deposits in the 2005 period.   In addition, service charges on deposit accounts decreased to $21,736 for the three months ended March 31, 2006 compared to $24,698 for the same period ended March 31, 2005.  The lower service charges are a result of an increase in the earnings credit paid on business checking accounts which offsets the service fees that would have been charged on these accounts.

Other income consisted primarily of fees received on debit card transactions and sale of customer checks.  Other income was $62,703 and $93,214 for the three months ended March 31, 2006 and 2005, respectively.  A significant portion of the $30,511 decrease is related to a change in merchant service providers whereby we now receive a net fee related to the service provided to our merchant clients.  In prior years, we received a substantially higher fee, but also incurred transaction costs.  Debit card transaction fees were $31,607 and $79,125 for the three months ended March 31, 2006 and 2005, respectively and represented 50.4% and 84.9% of total other income for the first quarters of 2006 and 2005, respectively.  The corresponding transaction costs associated with debit card transactions are included in noninterest outside service expense.  The debit card transaction costs were $23,198 and $64,642 for the three months ended March 31, 2006 and 2005, respectively.  The net impact of the fees received and the related cost of the debit card transactions on earnings for the three months ended March 31, 2006 and 2006 was $8,409 and $14,483, respectively.

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Noninterest expenses

The following table sets forth information related to our noninterest expenses. 

We incurred noninterest expenses of $1.8 million for the three months ended March 31, 2006 compared to $1.5 million for the three months ended March 31, 2005.  Average interest-earning assets increased 20.2% during this period, while general and administrative expense increased 20.6%.

For the three months ended March 31, 2006 compensation and benefits, occupancy, and data processing and related costs represented 78.6% of the total noninterest expense compared to 79.2% for the same period in 2005. 

The following table sets forth information related to our compensation and benefits. 

Compensation and benefits expense was $1,033,741 and $794,793 for the three months ended March 31, 2006 and 2005, respectively.   Compensation and benefits represented 57.8% and 53.5% of our total noninterest expense for the three months March 31, 2006 and 2005, respectively.  The $238,948 increase in compensation and benefits in the first quarter of 2006 compared to the same period in 2005 resulted from increases of $188,267 in base compensation,  $11,500 in additional incentive compensation, and $47,991 higher benefits expense.  These amounts were partly offset by an increase of $8,810 in loan origination compensation expense, which is required to be capitalized and amortized over the life of the loan as a reduction of loan interest income. 

The $188,267 increase in base compensation expense related to the cost of 16 additional employees as well as annual salary increases. Ten of the new employees relate to the staff that was hired for the new retail offices that opened in the first and third quarters of 2005.  The remaining six employees were hired primarily to support the growth in both loans and deposit operations.   Incentive compensation represented 13.7% and 16.4 % of total compensation and benefits for the three months ended March 31, 2006 and 2005, respectively.  The incentive compensation expense recorded for the first quarter of 2006 and 2005 represented an accrual of the portion of the estimated incentive compensation earned during the first quarter of the respective year.  Benefits expense increased $47,991 in the first quarter of 2006 compared to the same period in 2005.  Benefits expense represented 23.8% and 23.7% of the total compensation for the three months ended March 31, 2006 and 2005, respectively.

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The following tables set forth information related to our data processing and related costs. 

Data processing and related costs were $197,870 and $215,208 for the three months ended March 31, 2006 and 2005, respectively.   

During the three months ended March 31, 2006, our data processing costs for our core processing system were $127,086 compared to $112,373 for the three months ended March 31, 2005.   We have contracted with an outside computer service company to provide our core data processing services. 

Data processing costs increased $14,713, or 13.1%, for the three months ended March 31, 2006 compared to the same period in 2005.  The increases in costs were caused by the higher number of loan and deposit accounts.  A significant portion of the fee charged by the third party processor is directly related to the number of loan and deposit accounts and the related number of transactions. 

We receive income from debit card transactions performed by our clients.  Since we outsource this service, we are charged related transaction expenses from our merchant service provider.  Debit card transaction expense was $23,198 and $64,642 for the three months ended March 31, 2006 and 2005, respectively.    The decrease of $41,444 relates primarily to a change in merchant service card providers, whereby we now receive net fee income related to the service provided to our merchant clients.  In prior years, we received a substantially higher fee, but also incurred a higher transaction cost. 

Occupancy expense, which represented 9.8% and 11.2% of total noninterest expense for the three months ended March 31, 2006 and 2005, respectively, increased only $9,052, in spite of the addition of two new retail offices.  Occupancy expense was $174,777 and $165,725 for the three months ended March 31, 2006 and 2005, respectively.  The increase due to the additional costs of the two new retail offices was largely offset because we purchased our main retail office and headquarter building at the end of 2005.  The depreciation expense related to our main office and headquarter building is significantly less than the rent expense paid in prior years.   

The remaining $74,671 increase in noninterest expense for the three month period March 31, 2006 compared to the same period in 2005, resulted primarily from a $48,290 increase in marketing expenses and an additional $12,194 in professional fees.   The increase in marketing expenses relates to expanding our market awareness in the Greenville market, while the additional professional fees relates primarily to additional legal and accounting fees related to SEC reporting requirements and the overall growth of our company.  A significant portion of the increase in other expenses was due to increased costs of postage and office supplies, additional staff education and training, and higher dues and subscription costs. 

Income tax expense was $483,930 for the three months ended March 31, 2006 compared to $404,606 during the same period in 2005.   The increase related to the higher level of income before taxes.

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Balance Sheet Review

General

               At March 31, 2006, we had total assets of $417.8 million, consisting principally of $359.9 million in loans, $37.4 million in investments, $2.8 million in federal funds sold, and $5.5 million in cash and due from banks.  Our liabilities at March 31, 2006 totaled $386.5 million, which consisted principally of $275.8 million in deposits, $79.0 million in FHLB advances, $14.2 million in short-term borrowings, $2.1 million of official checks outstanding, and $13.4 million in junior subordinated debentures.  At March 31, 2006, our shareholders' equity was $31.3 million.

At December 31, 2005, we had total assets of $405.3 million, consisting principally of $334.0 million in loans, $36.1 million in investments, $19.4 million in federal funds sold, and $6.2 million in cash and due from banks.  Our liabilities at December 31, 2005 totaled $374.8 million, consisting principally of $254.1 million in deposits, $79.5 million in FHLB advances, $14.7 million of short-term borrowings, $7.8 million of official checks outstanding, and $13.4 million of junior subordinated debentures.  At December 31, 2005, our shareholders' equity was $30.5 million.

Federal Funds Sold

               At March 31, 2006, our federal funds sold were $2.8 million, or 0.7% of total assets.  At December 31, 2005, our $19.4 million in short-term investments in federal funds sold on an overnight basis comprised 4.8% of total assets.  Due to the large amount of official checks outstanding, our federal funds sold were higher than normal at December 31, 2005. 

Investments

                Contractual maturities and yields on our investments that are available for sale and are held to maturity at March 31, 2006 are shown in the following table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. 

             At March 31, 2006, our investments included securities issued by Federal Home Loan Bank, Federal Home Loan Mortgage Corporation, and Federal National Mortgage Association with carrying values of $1.0 million, $5.9 million, and $23.5 million, respectively.

The amortized costs and the fair value of our investments at March 31, 2006 and December 31, 2005 are shown in the following table.

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                Other investments totaled $5.7 million at March 31, 2006 and consisted of Federal Reserve Bank stock with a cost of $968,700, investments in Greenville First Statutory Trust I and Trust II of $186,000 and $217,000, respectively, and Federal Home Loan Bank stock with a cost of $4.4 million. 

At March 31, 2006, we had $37.4 million in our investment securities portfolio which represented approximately 9.0% of our total assets.  We held U.S. Government agency securities, municipal securities, and mortgage-backed securities with a fair value of $31.1 million and an amortized cost of $32.0 million for an unrealized loss of $908,290.  We believe, based on industry analyst reports and credit ratings that the deterioration in value is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary.  We have the ability and intent to hold these securities until such time as the value recovers or the securities mature.

At December 31, 2005, the $36.1 million in our investment securities portfolio represented approximately 8.9% of our total assets.  We held U.S. Government agency securities, municipal securities, and mortgage-backed securities with a fair value of $30.0 million and an amortized cost of $30.9 million for an unrealized loss of $864,088.  As a result of the strong growth in our loan portfolio and the historical low fixed rates that were available during the last two and one-half years, we have maintained a lower than normal level of investments.  As rates on investment securities rise and additional capital and deposits are obtained, we anticipate increasing the size of the investment portfolio. 

Contractual maturities and yields on our available for sale and held to maturity investments at December 31, 2005 are shown in the following table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  At December 31, 2005, we had no securities with a maturity of one to five years.

At December 31, 2005, our investments included securities issued by Federal Home Loan Bank, Federal Home Loan Mortgage Corporation, and Federal National Mortgage Association with carrying values of $1.1 million, $4.1 million, and $24.3 million, respectively.

Other investments totaled $5.5 million at December 31, 2005.  Other investments at December 31, 2005 consisted of Federal Reserve Bank stock with a cost of $863,700, investments in Greenville First Statutory Trust I and II of $186,000 and $217,000, respectively, and Federal Home Loan Bank stock with a cost of $4.2 million. 

Loans

                 Since loans typically provide higher interest yields than other types of interest earning assets, a substantial percentage of our earning assets are invested in our loan portfolio.  For the three months ended March 31, 2006 and 2005, average loans were $351.7 million and $287.9 million, respectively.  Before the allowance for loan losses, total loans outstanding at March 31, 2006 were $364.4 million.  Average loans for the year ended December 31, 2005 were $310.3 million.  Before the allowance for loan losses, total loans outstanding at December 31, 2005 were $338.5 million.

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The principal component of our loan portfolio is loans secured by real estate mortgages.    Most of our real estate loans are secured by residential or commercial property.  We do not generally originate traditional long term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit.  We obtain a security interest in real estate whenever possible, in addition to any other available collateral.  This collateral is taken to increase the likelihood of the ultimate repayment of the loan.  Generally, we limit the loan-to-value ratio on loans we make to 80%.  Due to the short time our portfolio has existed, the current mix may not be indicative of the ongoing portfolio mix.  We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral.

The following table summarizes the composition of our loan portfolio March 31, 2006 and December 31, 2005.

Maturities and Sensitivity of Loans to Changes in Interest Rates

              The information in the following tables is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity.  Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity.  Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

The following table summarizes the loan maturity distribution by type and related interest rate characteristics at March 31, 2006.