UWHARRIE CAPITAL CORP - Quarter Report: 2006 September (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2006

OR

For the transition period from              to             .

COMMISSION FILE NUMBER 000-22062

UWHARRIE CAPITAL CORP

(Exact name of registrant as specified in its charter)

Registrant’s Telephone number, including area code: (704) 983-6181

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

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

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date: 7,204,832 shares of common stock outstanding as of November 7, 2006.

Table of Contents

Table of Contents

-2-

Table of Contents

Uwharrie Capital Corp and Subsidiaries

Consolidated Balance Sheets

Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

See accompanying notes

-3-

Table of Contents

Uwharrie Capital Corp and Subsidiaries

Consolidated Statements of Operations (Unaudited)

See accompanying notes

-4-

Table of Contents

Uwharrie Capital Corp and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity (Unaudited)

See accompanying notes

-5-

Table of Contents

Uwharrie Capital Corp and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

-6-

Table of Contents

UWHARRIE CAPITAL CORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

Note 1 - Basis of Presentation

The financial statements and accompanying notes are presented on a consolidated basis including Uwharrie Capital Corp (the “Company”), its subsidiaries, Bank of Stanly (“Stanly”), Anson Bank & Trust Co. (“Anson”), Cabarrus Bank & Trust Company (“Cabarrus”), Strategic Investment Advisors, Inc., (“SIA”), and Uwharrie Mortgage Inc. Stanly consolidates its subsidiaries, the Strategic Alliance Corporation, BOS Agency, Inc. and Gateway Mortgage, Inc., each of which is wholly-owned by Stanly.

The information contained in the consolidated financial statements is unaudited. In the opinion of management, the consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and material adjustments necessary for a fair presentation of results of interim periods, all of which are of a normal recurring nature, have been made. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. Management is not aware of economic events, outside influences or changes in concentrations of business that would require additional clarification or disclosure in the consolidated financial statements. Certain prior period amounts have been reclassified to conform to current period classifications. These reclassifications had no effect on net income or shareholders’ equity as previously reported.

The organization and business of the Company, accounting policies followed by the Company and other information are contained in the notes to consolidated financial statements filed as part of the Company’s 2005 annual report on Form 10-K. This quarterly report should be read in conjunction with such annual report.

Note 2 – Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

-7-

Table of Contents

Note 3 – Per Share Data

On September 19, 2006, the Company’s Board of Directors declared a 3% stock dividend payable on November 14, 2006 to shareholders of record on October 20, 2006. All information presented in the accompanying interim consolidated financial statements regarding earnings per share and weighted average number of shares outstanding has been computed giving effect to this stock dividend. There were no anti-dilutive stock options outstanding during 2006 or 2005.

Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. The computation of basic and dilutive earnings per share is summarized below:

Note 4 – Loans

-8-

Table of Contents

Note 5 – Stock-Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R (revised 2004, “Share-Based Payment”, (“SFAS No. 123R”)) which was issued by the FASB in December 2004. SFAS No. 123R revises SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 “Accounting for Stock Issued to Employees” (APB No. 25) and its related interpretations. SFAS No. 123R requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (presumptively the vesting period). SFAS No. 123R also requires measurement of the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS No. 123R also amends SFAS No. 95 “Statement of Cash Flows”, to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.

The Company adopted SFAS No. 123R using the modified prospective application as permitted under SFAS No. 123R. Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Prior to the adoption of SFAS No. 123R, the Company used the intrinsic value method as prescribed by APB No. 25 and thus recognized no compensation expense for options granted with exercise prices equal to the fair market value of the common stock on the date of grant.

During 1996, the Company adopted the 1996 Incentive Stock Option Plan (“SOP”) and the Employee Stock Purchase Plan (“SPP”), under which options to purchase shares of the Company’s common stock may be granted to officers and eligible employees. Options granted under the SOP are exercisable in established increments according to vesting schedules, generally three to five years, and will expire if not exercised within ten years of the date of grant. Options granted under the SPP are fully vested at the date of grant and expire if not exercised within two years of the grant date. The compensation cost charged against income for those plans for the nine months ended September 30, 2006 was $47 thousand.

The fair market value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. There were no options granted during the nine months ended September 30, 2006. There was one grant for 37,046 shares during the nine months ended September 30, 2005 that has since been forfeited.

The following is a summary of stock option activity for the nine months ended September 30, 2006:

-9-

Table of Contents

A summary of the status of the Company’s non-vested stock options as of September 30, 2006, and changes during the quarter then ended is presented below:

The fair value of stock options vested over the nine months ended September 30, 2006 and 2005 was $37 thousand and $101 thousand respectively.

As of September 30, 2006, there was $128 thousand of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under all of the Company’s stock benefit plans. That cost is expected to be recognized over a weighted-average period of 2.3 years.

The Company funds the option shares from authorized but unissued shares. The Company does not typically purchase shares to fulfill the obligations of the stock benefit plans. Company policy does allow option holders to exercise options with seasoned shares.

The adoption of SFAS 123R and its fair value compensation cost recognition provisions are different from the non-recognition provisions under SFAS 123 and the intrinsic value method for compensation cost allowed under APB 25. The effect (increase/(decrease)) of the adoption of SFAS 123R is as follows:

For the nine months ended September 30, 2006, the intrinsic value of options exercised was $343 thousand and $46 thousand for the nine months ended September 30, 2005. For the three months ended September 30, 2006 there were no options exercised. The intrinsic value of the options exercised for the three months ended September 30, 2005 was $11 thousand.

-10-

Table of Contents

The following illustrates the effect on net income available to common stockholders if the Company had applied the fair value recognition provisions of SFAS No. 123 to the results for the three and nine months ended September 30, 2005 (in thousands, except per share data):

Note 6 - Commitments and Contingencies

The subsidiary banks are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of their customers. These financial instruments include commitments to extend credit, lines of credit and standby letters of credit. These instruments involve elements of credit risk in excess of amounts recognized in the accompanying financial statements.

The banks’ risk of loss with the unfunded loans and lines of credit or standby letters of credit is represented by the contractual amount of these instruments. The banks use the same credit policies in making commitments under such instruments as they do for on-balance sheet instruments. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Credit card commitments are unsecured. At September 30, 2006, outstanding financial instruments whose contract amounts represent credit risk were approximately (in thousands):

Note 7 – Recent Accounting Pronouncements

FAS 156

In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140” which is effective for fiscal years beginning after September 15, 2006. This statement was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement attributes. The Company is currently evaluating the new statement to determine the potential impact, if any, this would have on our financial results.

-11-

Table of Contents

FIN 48

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for the Company in the first quarter of fiscal 2007. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

SAB 108

In September 2006, the SEC staff issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements (SAB No. 108). SAB No. 108 addresses the diversity in practice by registrants when quantifying the effect of an error on the financial statements. SAB No. 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements and is effective for annual periods ending after November 15, 2006. The Company will be required to adopt the provisions of SAB No. 108 effective December 31, 2006. We currently believe that the adoption of SAB No. 108 will not have a material financial impact on our consolidated financial statements.

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

This Quarterly Report on Form 10-Q may contain certain forward-looking statements consisting of estimates with respect to the financial condition, results of operations and business of the Company that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values, and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, and technological factors affecting the Company’s operations, pricing, products and services.

Comparison of Financial Condition at September 30, 2006 and December 31, 2005.

During the nine months ended September 30, 2006, total assets increased $33.8 million or 9.7% from $350.2 million to $384.0 million. During the nine months, net loans receivable increased $18.2 million, or 6.7%, from $271.7 million at December 31, 2005 to $289.9 million at September 30, 2006. Liquid assets consisting of cash and due from banks, interest earning deposits with banks, federal funds sold and investment securities experienced an increase of $14.6 million. The growth in federal funds sold, increasing $9.9 million attributed to the increase in liquid assets.

Federal funds sold experienced an increase of $9.9 million for the period. During the first nine months, the growth in deposits has outpaced the loan growth. As a result, the Company has been investing the excess in short term federal funds sold.

As stated, net loans receivable increased $18.2 million to $289.9 million during the period ended September 30, 2006. The Company has experienced positive growth trends in its residential construction, commercial real estate and residential 1-4 family lending. These positive trends were impacted by decreases in the remaining areas of our loan portfolio. The allowance for loan losses was $3.2 million at September 30, 2006 which represents 1.09% of the loan portfolio.

-12-

Table of Contents

Federal Home Loan Bank(“FHLB”) stock decreased $92 thousand, or 4.4%, during the first nine months of 2006. FHLB stock ownership is a requirement for member banks that utilize FHLB for borrowing funds. The amount of stock owned by each member bank is based on the amount of borrowings outstanding.

Customer deposits, our primary funding source, experienced a $30.6 million, or 11.2%, increase, increasing from $274.0 million at December 31, 2005 to $304.6 million at September 30, 2006. The most significant factor contributing to the increase was the growth of $26.8 million in time deposits. Customers that have kept their deposit funds in a liquid position while interest rates have been down are now beginning to invest in longer term time deposits. This fact coupled with the Company beginning an aggressive marketing campaign while offering attractive interest rates, are the primary reasons for the growth. Noninterest bearing demand accounts, interest checking and money market accounts also experienced a positive growth trend for the period. This increase was offset by a decline in savings deposits.

The Company utilizes both short-term and long-term borrowings as funding sources. During the period, total borrowings outstanding increased $1.5 million. At September 30, 2006, $28.4 million of the total borrowings of $48.5 million were comprised of FHLB advances.

At September 30, 2006, total shareholders’ equity was $29.1 million, an increase of $1.6 million from December 31, 2005. Net income for the period was $1.5 million and the Company received $204 thousand from the exercise of stock options. These increases were offset by a decrease in unrealized gains on our investment securities, net of tax of $61 thousand and by the Company’s repurchase of 23,864 shares of common stock at a cost of $145 thousand.

At September 30, 2006, the Company and its subsidiary banks exceeded all applicable regulatory capital requirements.

Comparison of Results of Operations For the Three Months Ended September 30, 2006 and 2005.

Net Income

Uwharrie Capital Corp reported net income of $653 thousand, or $.09 per basic share, for the three months ended September 30, 2006, as compared to $350 thousand, or $.05, for the three months ended September 30, 2005, an increase of $303 thousand or $.04 per share.

Net Interest Income

The Company’s primary source of income, net interest income, increased $296 thousand or 9.4% for the period ending September 30, 2006, as compared to the same period for 2005. Increased levels of interest earning assets, coupled with interest rate increases by the Federal Reserve Bank during the past year are the contributing factors for this increase. Refer to the nine month discussion on page 16 for further information.

Provision and Allowance for Loan Losses

The Company’s allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. The allowance is increased by provisions charged to operations and by recoveries of amounts previously charged off, and reduced by loans charged off. Management evaluates the adequacy of the allowance at least quarterly. In evaluating the adequacy of the allowance, management considers the growth, composition and industry

-13-

Table of Contents

diversification of the portfolio, historical loan loss experience, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors. The Company’s credit administration function, through a review process, validates the accuracy of the initial risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, the credit administration department has the responsibility to change the borrower’s risk grade accordingly. For loans determined to be impaired, the allowance is based either on discounted cash flows using the loan’s initial effective interest rate or on the fair value of the collateral for certain collateral dependent loans. This evaluation is inherently subjective, as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans, which may be susceptible to significant change. In addition, regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require additions for estimated losses based upon judgments different from those of management.

Management uses the risk-grading program to facilitate the evaluation of probable inherent loan losses and the adequacy of the allowance for loan losses. In this program, risk grades are initially assigned by loan officers and reviewed and monitored by credit administration. The Company strives to maintain its loan portfolio in accordance with conservative loan underwriting policies that result in loans specifically tailored to the needs of its market area. Every effort is made to identify and minimize the credit risks associated with such lending strategies. The Company has no foreign loans and does not engage in significant lease financing or highly leveraged transactions. The Company follows a loan review program designed to evaluate the credit risk in the loan portfolio. This process includes the maintenance of an internally classified watch list that helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. In establishing the appropriate classification for specific assets, management considers, among other factors, the estimated value of the underlying collateral, the borrower’s ability to repay, the borrower’s payment history and the current delinquent status. As a result of this process, certain loans are categorized as substandard, doubtful or loss and reserves are allocated based on management’s judgment and historical experience.

The allowance for loan losses represents management’s estimate of an amount adequate to provide for known and inherent losses in the loan portfolio in the normal course of business. While management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while management believes it has established the allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Company’s portfolio, will not require an adjustment to the allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed herein. Any material increase in the allowance for loan losses may adversely affect the Company’s financial condition and results of operations.

The provision for loan losses was $54 thousand and $210 thousand for the quarters ended September 30, 2006 and 2005 respectively. During 2005 reserves were increased on certain impaired loans that have since been charged off in 2006 resulting in the decrease in the provision for loan loss. For the quarter ended September 30, 2006 net loan charge offs were $1.5 million compared to $888 thousand for the same period in 2005.

-14-

Table of Contents

Our allowance for loan losses decreased to $3.2 million at September 30, 2006 a decrease of $1.3 million from December 2005. The allowance expressed as a percentage of total loans decreased from 1.62% at December 31, 2005 to 1.09% at September 30, 2006. This 53 basis point decline in the allowance was a direct reflection of the aforementioned chargeoffs of $1.6 million. The Company had three major loan chargeoffs in the third quarter of 2006 representing approximately $1.4 million of the total $1.6 million charged off during the nine month period. These impaired loans that were charged off had significant specific loss reserves assigned to them at December 31, 2005. During the nine month period, total non-performing loans declined $368 thousand and loans 90 days past due and still accruing interest decreased $126 thousand. Restructured loans, excluding those included in nonperforming loans, amounted to $2.2 million at September 30, 2006, a decrease of $1.1 million since December 31, 2005. The ratio of non-performing loans to total loans decreased from .68% at December 31, 2005 to .51% at September 30, 2006. The nine month period did see an increase in net loan charge-offs of $426 thousand compared to the same nine month period in 2005. After a detailed analytical review of the loan portfolio management believes the current level of allowance for loan losses to be adequate at this time. The following table sets forth information with respect to nonperforming assets for the dates indicated.

Noninterest Income

The Company generates most of its revenue from net interest income; however, like all financial institutions, diversification of our earnings base is of major importance in our long term success. Total noninterest income increased $316 thousand, from $1.1 million for the quarter ended September 30, 2005 to $1.4 million for the same period in 2006. Service charges on deposit accounts produced earnings of $508 thousand for the three months ended September 30, 2006, an increase of $37 thousand, or 7.9%. During the third quarter of 2005, the Company implemented a new non-sufficient funds program. This program along with the growth in deposit accounts generated an increase of $36 thousand in fee income. Other service fees and commissions experienced a 30.7% increase for the comparable three month periods. Growth in electronic banking fees of $24 thousand and investment related fees of $93 thousand enhanced this increase. Also contributing to the growth in noninterest income was an increase of $134 thousand in mortgage loan sales.

Noninterest Expense

Noninterest expense for the quarter ended September 30, 2006 was $3.9 million compared to $3.6 million for the same period of 2005, an increase of $316 thousand. Salaries and employee

- 15 -

Table of Contents

benefits, the largest component of noninterest expense, increased $237 thousand, from $2.0 million for the quarter ending September 30, 2005 to $2.2 million for the same period in 2006. Additions at the executive and bank support staff levels during the past year coupled with normal salary increases attributed to this increase. Data processing costs increased $62 thousand for the three month period resulting from growth in our transaction accounts. Other noninterest expense was $1.0 million for each of the comparable three month periods. The table below reflects the composition of other noninterest expense.

Income Tax Expense

Income taxes computed at the statutory rate are reduced primarily by the eligible amount of interest earned on state and municipal securities and tax advantaged loans. Income tax expense calculated for the quarter ended September 30, 2006 totaled $282 thousand compared to $132 thousand in the quarter ended September 30, 2005. The effective tax rate increased from 27.4% for the period ended September 30, 2005 to 30.1% for the three months ended September 30, 2006 due primarily to the decrease in the level of nontaxable income compared to total taxable income in the 2006 period versus the 2005 period.

Comparison of Results of Operations For the Nine Months Ended September 30, 2006 and 2005.

Net Income

Uwharrie Capital Corp reported net income of $1.5 million, or $.21 per basic share, for the nine months ended September 30, 2006, as compared to $1.0 million, or $.14, for the nine months ended September 30, 2005, an increase of $471 thousand, or $.07 per share.

Net Interest Income

As with most financial institutions, the primary component of earnings for our banks, is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities and capital.

-16-

Table of Contents

Net interest income for the nine months ended September 30, 2006 was $10.2 million as compared with $9.3 million during the nine months ended September 30, 2005, resulting in an increase of $869 thousand, or 9.3%. This increase resulted from the increased volume of interest-earning assets coupled with a 95 basis point increase in the overall yield on interest-earning assets. The yield on interest earning assets for the current nine months was 7.19%. The cost of interest-bearing liabilities increased 120 basis points to 3.58%. The net interest spread decreased 25 basis points to 3.61%. A large majority of our loan portfolio is comprised of adjustable rate loans. These loans reprice each time the Federal Reserve adjusts interest rates, however, deposits are repriced at maturity. The net interest margin for the first nine months of 2006 was 4.15%, as compared to 4.22% for the same period in 2005.

The following table presents average balance sheets and a net interest income analysis for the nine months ended September 30, 2006 and 2005.

Average Balance Sheet and Net Interest Income Analysis

For the Nine Months Ended September 30,