UWHARRIE CAPITAL CORP - Quarter Report: 2008 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2008

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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

Indicate the number of shares outstanding of each of the classes of common stock issuer’s as of the latest practicable date: 7,407,851 shares of common stock outstanding as of November 1, 2008.

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Uwharrie Capital Corp and Subsidiaries

Consolidated Balance Sheets

Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

See accompanying notes

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Uwharrie Capital Corp and Subsidiaries

Consolidated Statements of Operations (Unaudited)

See accompanying notes

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Uwharrie Capital Corp and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity (Unaudited)

See accompanying notes

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Uwharrie Capital Corp and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

See accompanying notes

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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”) and 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 an entire year. 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.

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 2007 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.

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Note 3 – Per Share Data

On November 3, 2008, the Company’s Board of Directors declared a 3% stock dividend payable on December 4, 2008 to shareholders of record on November 17, 2008. 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.

Basic and diluted net income per common share is computed based on the weighted average number of shares outstanding during each period after retroactively adjusting for stock dividends. Diluted net income per common share 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 net income of the Company. On September 30, 2008 the Company had 89,798 shares that were anti-dilutive and were excluded from the diluted net income per common share computation.

Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding. The computation of basic and dilutive earnings per share is summarized below:

Note 4 – Investment Securities

Securities available for sale are summarized below:

Management has evaluated these securities to determine whether they should be considered other-than-temporarily impaired at September 30, 2008. This evaluation considered, among other things, the extent and duration of the impairment, current and expected future yields, the

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Company’s ability to continue to hold these securities in its portfolio and the issuers’ credit ratings. The majority of the gross unrealized losses are related mortgage-backed securities portfolio. Further evaluations were made on these investments including analyzing prepayment rates, general market data, delinquency rates on the underlying mortgage loans and current and anticipated losses in foreclosure.

Based on these evaluations, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2008. Management expects to collect all contractual interest and principal payments and that recovery of these temporarily impaired securities will occur within a reasonable time frame. Management will continue to evaluate these securities on an ongoing basis, and if it is subsequently determined that an other than temporary impairment has occurred, the Company will record any such impairment as a charge to earnings.

Note 5 – Loans

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, 2008, outstanding financial instruments whose contract amounts represent credit risk were approximately:

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Note 7 – Fair Value Disclosures

The Company adopted the provisions of Statement of Financial Accounting Statements (SFAS) No. 157 Fair Value Measurements (SFAS 157) and SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities (SFAS 159) on January 1, 2008.

SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but clarifies and standardizes some divergent practices that have emerged since prior guidance was issued. SFAS 157 creates a three-level hierarchy under which individual fair value estimates are to be ranked based on the relative reliability of the inputs used in the valuation.

SFAS 157 defines fair value as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, the Company considers the principal or most advantageous market in which those assets or liabilities are sold and considers assumptions that market participants would use when pricing those assets or liabilities. Fair values determined using Level 1 inputs rely on active and observable markets to price identical assets or liabilities. In situations where identical assets and liabilities are not traded in active markets, fair values may be determined based on Level 2 inputs, which exist when observable data exists for similar assets and liabilities. Fair values for assets and liabilities for which identical or similar assets and liabilities are not actively traded in observable markets are based on Level 3 inputs, which are considered to be unobservable.

Among the Company’s assets and liabilities, investment securities available for sale are reported at their fair values on a recurring basis. Certain other assets are adjusted to their fair value on a nonrecurring basis, including loans held for sale, which are carried at the lower of cost or market, loan servicing rights, where fair value is determined using similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions, foreclosed real estate, which is carried at lower of cost or fair market value and goodwill, which is periodically tested for impairment. Deposits, short-term borrowings and long-term obligations are not reported at fair value.

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, Accounting by Creditors for Impairment of a Loan, (SFAS 114). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2008, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair

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value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

For assets and liabilities carried at fair value, the following table provides fair value information as of September 30, 2008:

Prices for US Treasury and government agency securities are readily available in the active markets in which those securities are traded, and the resulting fair values are shown in the ‘Level 1 input’ column. Prices for mortgage-backed securities and for state, county and municipal securities are obtained for similar securities, and the resulting fair values are shown in the ‘Level 2 input’ column. Prices for all other non-marketable investments are determined based on various assumptions that are not observable. The fair values for these investment securities are shown in the ‘Level 3 input’ column. Non-marketable investment securities, which are carried at their purchase price, include those that may only be redeemed by the issuer.

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis are included in the table below as of September 30, 2008:

SFAS 159 allows an entity to elect to measure certain financial assets and liabilities at fair value with changes in fair value recognized in the income statement each period. The statement also requires additional disclosures to identify the effects of an entity’s fair value election on its earnings. Upon the adoption of SFAS 159, the Company did not elect to report any assets and liabilities at fair value.

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Note 8 – Recent Accounting Pronouncements

SAB 109

Staff Accounting Bulletin No. 109 (“SAB 109”), Written Loan Commitments Recorded at Fair Value Through Earnings supersedes Staff Accounting Bulletin No. 105 by requiring the expected net future cash flows related to servicing a loan to be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The adoption of SAB 109 on January 1, 2008, did not have a significant impact on the Company’s consolidated financial statements.

SFAS 157

Statement of Financial Accounting Standards No. 157 (“SFAS 157”), Fair Value Measurements, defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The Company adopted the provisions of SFAS 157 on January 1, 2008 as discussed in Note 7 above.

SFAS 159

Statement of Financial Accounting Standards No. 159 (“SFAS 159”), The Fair Value Option for Financial Assets and Financial Liabilities, permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this standard is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is effective for fiscal years beginning after November 15, 2007, with early adoption permitted under certain circumstances. The adoption of SFAS 159 did not have any impact on the Company’s consolidated financial statements. See Note 7 above.

SFAS 161

In March of 2008, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“SFAS 161”). SFAS 161 amends and expands the disclosure requirement of Statement No. 133 for derivative instruments and hedging activities to provide users of financial statements with an enhanced understanding of the derivative instrument’s purpose, how it is accounted for, and its impact on the financial statements. This statement is effective for fiscal years beginning after November 15, 2008, with early adoption encouraged. The Company has chosen not to early adopt the provisions of SFAS 161. The Company has evaluated this statement and does not believe it will have a material effect on the Company’s consolidated financial statements.

EITF 06-4

The Emerging Issues Task Force (EITF) reached a consensus at its September 2006 meeting regarding EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. The scope of EITF 06-4 is limited to the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods. Therefore, this EITF would not apply to a split-dollar life insurance arrangement that provides a specified benefit to an employee that is limited to the employee’s active service period with an employer. This EITF 06-4 is effective for fiscal years beginning after December 15, 2007, with earlier application permitted. The Company adopted EITF 06-4 on January 1, 2008 and it had the effect of reducing beginning consolidated undivided profits by approximately $273,000.

From time to time, the FASB issues exposure drafts of proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting

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standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.

Reclassification

Certain amounts in the 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation. The reclassifications had no effect on net income or shareholders’ equity as previously reported.

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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, 2008 and December 31, 2007.

During the nine months ended September 30, 2008, the Company’s total assets increased $13.4 million, from $411.9 million to $425.3 million. During the nine months, loans held for investment increased $19.8 million or 6.2%, from $322.0 million at December 31, 2007 to $341.8 million at September 30, 2008. This increase, however, was offset by a decline in investment securities of $8.0 million and a decrease in loans held for sale of $1.8 million during the period.

Cash and cash equivalents decreased $71 thousand during the nine months ended September 30, 2008. Cash and due from banks declined $447 thousand, while interest-earning deposits with banks increased $376 thousand.

Investment securities decreased $8.0 million or 15.7% for the nine months. Market values have declined $2.3 million due to the recent downturn in the investment markets. Management believes this decline in investment market values is only temporary and does not expect to incur a loss at this time. The Company had $4.7 million in securities that matured during the period and $3.9 million in new securities purchased. The Company did have an $8 thousand investment in 400 shares of FNMA stock that were written off at the end of the period. The remainder of the decrease resulted primarily from normal mortgage backed securities pay down activity during the period.

As previously stated, loans held for investment increased $19.8 million to $341.8 million during the period ended September 30, 2008. The Company has experienced positive growth trends in all areas of its loan portfolio. The commercial and residential construction areas of the loan portfolio lead the way with growth of 22.7% and 11.7%, respectively. Loans held for sale decreased 63.2% or $1.8 million during the period. The allowance for loan losses was $4.1 million at September 30, 2008 which represents 1.21% of the loan portfolio.

Other changes in our consolidated assets related to premises and equipment, interest receivable, Federal Home Loan Bank stock, bank owned life insurance, other real estate owned and other assets. The Company has been renovating an office building to gain some much needed office space. These renovations were the leading factor in the increase of $1.5 million in fixed assets. Interest receivable declined $14 thousand, bank owned life insurance increased $141 thousand and other real estate owned increased $589 thousand. Other assets increased $1.9 million, resulting primarily from increases in the income tax benefit of $309 thousand and deferred income taxes of $877 thousand. Federal Home Loan Bank stock decreased $45 thousand. Federal Home Loan Bank stock ownership is a requirement for member banks that utilize Federal Home Loan Bank for borrowing funds. The amount of stock owned by each member bank is based primarily on the amount of borrowings outstanding.

Customer deposits, our primary funding source, experienced a $19.9 million increase during the nine months ended September 30, 2008, increasing from $324.7 million to $344.6 million.

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Interest checking and money market accounts increased $12.8 million, while demand noninterest-bearing grew $1.8 million. Time deposits over $100,000 and other deposits experienced positive growth of $2.7 million and $3.0 million, respectively. These increases were offset by a decline in savings deposits of $314 thousand.

Total borrowings decreased $7.4 million for the period. Borrowings consist of both short-term and long-term borrowed funds. The Company utilizes both short-term and long-term advances from the Federal Home Loan Bank. At September 30, 2008, $28.0 million of the total borrowings of $46.2 million were comprised of Federal Home Loan Bank advances. The Company has also been conducting a private placement of junior subordinated debt during the period ending September 30, 2008. At the end of the period, the Company had placed $7.1 million.

Other liabilities increased from $1.5 million at December 31, 2007 to $2.2 million at September 30, 2008, an increase of $724 thousand. The Company has a supplemental retirement plan in place for four executive officers. The Company has purchased life insurance policies in order to provide future funding of benefit payments. As discussed in Note 8, with the adoption of EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements, the Company recorded a $273 thousand liability. This adjustment coupled with an increase in the reserve for income taxes were the primary factors associated with the increase in other liabilities.

At September 30, 2008, total shareholders’ equity was $31.8 million, an increase of $205 thousand from December 31, 2007. Net income for the period was $1.9 million and the Company received $300 thousand from the exercise of stock options. These increases were offset by the repurchase of 76,598 shares of the Company’s common stock at a cost of $412 thousand and unrealized losses on investment securities, net of tax, of $1.4 million. The Company also recorded a $273 thousand one-time cumulative adjustment to undivided profits for the adoption of EITF 06-4. At September 30, 2008, the Company and its subsidiary banks exceeded all applicable regulatory capital requirements.

Comparison of Results of Operations For the Three Months Ended September 30, 2008 and 2007.

Net Income

Uwharrie Capital Corp reported net income of $343 thousand, or $0.05 per basic share, for the three months ended September 30, 2008, as compared to $774 thousand, or $0.10 per basic share, for the three months ended September 30, 2007, a decrease of $431 thousand, or $0.05 per share.

Net Interest Income

The Company’s primary source of income, net interest income, increased $38 thousand or 1.0% for the three months ended September 30, 2008, as compared to the same period for 2007. Refer to the nine month discussion on page 18 for further information.

Provision and Allowance for Loan Losses

The provision for loan losses was $529 thousand for the three months ending September 30, 2008 compared to $18 thousand for the same period in 2007. There were net loan charge-offs of $43 thousand for the three months ended September 30, 2008 as compared with net loan recoveries of $39 thousand during the same period of 2007. Refer to the Asset Quality discussion on page 19 for further information.

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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 decreased $10 thousand for the three month period ending September 30, 2008 as compared to the same period in 2007. Service charges on deposit accounts produced earnings of $599 thousand for the three months ended September 30, 2008. Other service fees and commissions experienced a 1.7% decrease for the comparable three month period. Growth in ATM fees of $24 thousand was offset by a decrease in investment fees of $28 thousand. Income from mortgage loan sales decreased $29 thousand from $235 thousand for the quarter ended September 30, 2007 to $206 thousand for the same period in 2008. The slow down in the economy and the current problems in the mortgage industry attributed to the decrease in mortgage loan sales.

Noninterest Expense

Noninterest expense for the quarter ended September 30, 2008 was $4.5 million compared to $4.4 million for the same period of 2007, an increase of $128 thousand. Salaries and employee benefits, the largest component of noninterest expense, increased $127 thousand, from $2.5 million for the quarter ending September 30, 2007 to $2.6 million for the same period in 2008. The Company has a non-qualifying deferred compensation plan for certain executive officers. The costs associated with this plan increased $106 thousand for the comparable periods. This increase coupled with normal salary increases contributed to the overall increase in noninterest expense. Net occupancy expense and equipment expense had a combined increase of $59 thousand related to the aforementioned renovations to a new office building. Other noninterest expense decreased $64 thousand for the comparable three month periods. The table below reflects the composition of other noninterest expense.

Other noninterest expense

Income Tax Expense

The Company had income tax expense of $156 thousand for the three months ended September 30, 2008 resulting in an effective tax rate of 31.3% compared to income tax expense of $336 thousand and an effective rate of 30.3% in the 2007 period. Income taxes computed at the statutory rate are reduced primarily by the eligible amount of interest earned on state and municipal securities, tax free municipal loans and income earned on bank owned

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life insurance. The increase in the effective tax rate resulted primarily from the decrease in the level of such tax free income as a percentage of income before income taxes in the current year quarter compared to the 2007 quarter.

Comparison of Results of Operations For the Nine Months Ended September 30, 2008 and 2007.

Net Income

Uwharrie Capital Corp reported net income of $1.9 million or $0.25 per basic share, for the nine months ended September 30, 2008, as compared to $2.1 million, or $0.29 per basic share, for the nine months ended September 30, 2007, a decrease of $259 thousand, or $0.04 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.

Net interest income for the nine months ended September 30, 2008 was $11.8 million as compared with $11.0 million during the nine months ended September 30, 2007, resulting in an increase of $722 thousand, or 6.5%. During the nine months ended September 30, 2008 our growth in the volume of interest-earning assets outpaced the growth in interest-bearing liabilities by $897 thousand. The average yield on our interest–earning assets decreased 72 basis points to 6.77%, while the average rate we paid for our interest-bearing liabilities decreased 85 basis points. The Company’s assets that are interest rate sensitive adjust at the time the Federal Reserve Open Market Committee adjusts interest rates, while, interest-bearing time deposits adjust at the time of maturity. The fore mentioned decreases resulted in an increase of 13 basis points in our interest rate spread, from 3.64% in 2007 to 3.77% in 2008. Our net interest margin was 4.17% and 4.19% for the comparable periods in 2008 and 2007.

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The following table presents average balance sheets and a net interest income analysis for the nine months ended September 30, 2008 and 2007:

Average Balance Sheet and Net Interest Income Analysis

For the Nine Months Ended September 30,