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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
(Mark One)
x
Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended March 31, 2005

o
Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from ___________ to _____________

Commission File Number: 000-19235
 
 
 

SUMMIT FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)


SOUTH CAROLINA
(State or other jurisdiction
of incorporation or organization)
57-0892056
(I.R.S. Employer
Identification No.)

Post Office Box 1087
937 North Pleasantburg Drive
Greenville, South Carolina 29602
(Address, including zip code, of principal executive offices)

(Registrant’s telephone number, including area code) (864) 242-2265


Not applicable
(Former name or former address, 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. YES x NO o

 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of May 11, 2005, 4,527,406 shares of $1.00 par value common stock were outstanding.



SUMMIT FINANCIAL CORPORATION
FORM 10-Q FOR QUARTER ENDED MARCH 31, 2005
TABLE OF CONTENTS OF INFORMATION REQUIRED IN REPORT


PART I. FINANCIAL INFORMATION
  
Item 1.
  
3
4
5
6
7
   
Item 2.
  
11
   
Item 3.
  
24
   
Item 4.
  
25
   
26
   
27
   
EXHIBITS:
 
 
 
 
 
 
 



 
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
(Unaudited)
           
           
 
    
March 31, 
 
 
December 31,
 
 
 
 
2005
 
 
2004
  
ASSETS
          
 
Cash and due from banks
  
$
9,112
  
$
6,548
  
Interest-bearing bank balances
    
2,538
   
147
 
Federal funds sold
    
4,792
   
218
 
Investments available for sale
   
55,706
   
59,838
 
Investment in Federal Home Loan Bank and other stock
    
3,078
   
3,326
 
Loans, net of unearned income and net of
             
allowance for loan losses of $3,711 and $3,649
    
244,059
   
238,811
 
Premises and equipment, net
   
5,209
   
4,805
 
Accrued interest receivable
    
1,509
   
1,430
 
Other assets
    
6,357
   
5,815
 
   
$
332,360
  
$
320,938
  
LIABILITIES AND SHAREHOLDERS' EQUITY
              
Deposits:
              
Noninterest-bearing demand
  
$
28,787
  
$
36,897
  
Interest-bearing demand
    
41,585
   
32,478
 
Savings and money market
    
73,543
   
81,896
 
Time deposits, $100,000 and over
    
55,886
   
38,925
 
Other time deposits
    
47,015
   
41,522
 
     
246,816
   
231,718
 
Federal Home Loan Bank advances
    
45,401
   
50,134
 
Accrued interest payable
    
758
   
581
 
Other liabilities
    
1,511
   
1,240
 
     
294,486
   
283,673
 
Shareholders' equity:
              
Common stock, $1.00 par value; 20,000,000
             
shares authorized; issued and
             
outstanding 4,525,855 and 4,515,553 shares
    
4,526
   
4,516
 
Additional paid-in capital
    
27,023
   
26,993
 
Retained earnings
    
7,027
   
5,868
 
Accumulated other comprehensive income, net of tax
    
(507
)
  
98
 
Nonvested resticted stock
    
(195
)
  
(210
)
Total shareholders' equity
    
37,874
   
37,265
 
   
$
332,360
  
$
320,938
  
               
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
              

3


CONSOLIDATED STATEMENTS OF INCOME
(Dollars, except per share data, in Thousands)
(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended March 31,
 
 
 
 
2005
 
 
2004
 
Interest Income:
              
Loans
  
$
4,142
  
$
3,538
  
Taxable investment securities
    
408
   
622
 
Nontaxable investment securities
    
213
   
250
 
Federal funds sold
    
12
   
2
 
Other
    
42
   
31
 
     
4,817
   
4,443
 
Interest Expense:
              
Deposits
    
922
   
763
 
Federal Home Loan Bank advances
    
379
   
410
 
Other borrowings
    
7
   
6
 
     
1,308
   
1,179
 
Net interest income
    
3,509
   
3,264
 
Provision for loan losses
    
102
   
210
 
 
              
Net interest income after provision for loan losses
    
3,407
   
3,054
 
               
Noninterest Income:
              
Service charges and fees on deposit accounts
    
96
   
133
 
Insurance commission fee income
    
145
   
139
 
Gain on sale of investment securities
    
-
    
22
 
Other income
    
210
   
326
 
     
451
   
620
 
Noninterest Expense:
              
Salaries, wages and benefits
    
1,400
   
1,361
 
Occupancy
    
187
   
174
 
Furniture, fixtures and equipment
    
152
   
158
 
Other operating expenses
    
429
   
549
 
     
2,168
   
2,242
 
Income before income taxes
    
1,690
   
1,432
 
Income taxes
   
531
   
445
 
Net income
  
$
1,159
  
$
987
  
               
Net income per share:
              
Basic
  
$
.26
  
$
.23
  
Diluted
  
$
.23
  
$
.20
  
Average shares outstanding:
              
Basic
    
4,513,851
   
4,319,720
 
Diluted
    
5,000,213
   
4,857,367
 
               
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
              

4

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004
(Dollars in Thousands)
(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Accumulated
 
 
 
 
 
 
 
 
 
Additional
 
 
 
other
 
Nonvested
 
Total
 
 
 
Common
 
paid-in
 
Retained
 
comprehensive
 
restricted
 
shareholders'
 
 
 
stock
 
capital
 
earnings
 
income (loss), net
 
stock
 
equity
  
Balance at December 31, 2003
  
$
4,313
  
$
25,791
  
$
2,102
  
$
28
    
($29
)
$
32,205
  
Net income for the three months ended March 31, 2004
    
-
    
-
    
987
   
-
    
-
    
987
 
Other comprehensive income:
                                      
Unrealized holding gains arising during the period, net of tax of ($415)
    
-
    
-
    
-
    
677
   
-
    
-
  
Less: reclassification adjustment for gains included in net income, net of tax of ($8)
    
-
    
-
    
-
    
(14
)
  
-
    
-
  
Other comprehensive income
    
-
    
-
    
-
    
663
   
-
    
663
 
Comprehensive income
    
-
    
-
    
-
    
-
    
-
    
1,650
 
Stock options exercised
    
87
   
327
   
-
    
-
    
-
    
414
 
Stock issued purshant to restricted stock plan
    
14
   
238
   
-
    
-
    
(252
)
  
-
  
Amortization of deferred compensation on restricted stock
    
-
    
-
    
-
    
-
    
14
   
14
 
Balance at March 31, 2003
  
$
4,414
  
$
26,356
  
$
3,089
  
$
691
    
($267
)
$
34,283
  
                                       
Balance at December 31, 2004
  
$
4,516
  
$
26,993
  
$
5,868
  
$
98
    
($210
)
$
37,265
  
Net income for the three months ended March 31, 2005
    
-
    
-
    
1,159
   
-
    
-
    
1,159
 
Other comprehensive loss:
                                      
Unrealized holding losses arising during the period, net of tax of $370
    
-
    
-
    
-
    
(605
)
  
-
    
-
  
Less: reclassification adjustment for gains included in net income, net of tax
   
-
    
-
    
-
    
-
    
-
    
-
  
Other comprehensive loss
    
-
    
-
    
-
    
(605
)
  
-
    
(605
)
Comprehensive income
    
-
    
-
    
-
    
-
    
-
    
554
 
Stock options exercised
    
10
   
30
   
-
    
-
    
-
    
40
 
Amortization of deferred compensation on restricted stock
    
-
    
-
    
-
    
-
    
15
   
15
 
Balance at March 31, 2005
  
$
4,526
  
$
27,023
  
$
7,027
    
($507
)
  
($195
)
$
37,874
  
                                       
                                       
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                      
 
 
5
 
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
(Unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For the Three Months Ended March 31,
 
 
 
 
2005
 
 
2004
  
Cash flows from operating activities:
             
Net income
 
$
1,159
  
$
987
  
Adjustments to reconcile net income to net cash provided by operating activities:
              
Provision for loan losses
    
102
   
210
 
Depreciation and amortization
    
105
   
106
 
Net gain on sale of and disposal of equipment and vehicles
    
-
    
(22
)
Net gain on sale of investments available for sale
    
-
    
(22
)
Net amortization of net premium on investments
    
21
   
30
 
Amortization of deferred compensation on restricted stock
   
15
   
14
 
Increase in other assets
    
(260
)
  
(162
)
Increase in other liabilities
    
448
   
152
 
Deferred income taxes
    
9
   
(36
)
Net cash provided by operating activities
    
1,599
   
1,257
 
               
Cash flows from investing activities:
              
Purchases of securities available for sale
    
(2,913
)
  
(2,268
)
Proceeds from maturities of securitiesavailable for sale
    
1,300
   
5,025
 
Proceeds from sales of securities available for sale
    
4,749
   
18,715
 
Purchases of investments in FHLB and other stock
    
-
    
(66
)
Redeemption of FHLB stock
    
248
   
-
  
Net increase in loans
    
(5,350
)
  
(8,339
)
Purchases of premises and equipment
    
(509
)
  
(67
)
Proceeds from sale of equipment and vehicles
    
-
    
22
 
Net cash (used) provided by investing activities
    
(2,475
)
  
13,022
 
               
Cash flows from financing activities:
              
Net increase (decrease) in deposit accounts
    
15,098
   
(8,500
)
Proceeds from Federal Home Loan Bank advances
    
-
    
4,000
 
Repayments of Federal Home Loan Bank advances
    
(4,733
)
  
(2,683
)
Proceeds from employee stock options exercised
    
40
   
414
 
Net cash provided (used) by financing activities
    
10,405
   
(6,769
)
Net increase in cash and cash equivalents
    
9,529
   
7,510
 
Cash and cash equivalents, beginning of period
   
6,913
   
10,396
 
Cash and cash equivalents, end of period
  
$
16,442
  
$
17,906
  
               
SUPPLEMENTAL INFORMATION:
              
Cash paid during the period for interest
  
$
1,131
  
$
1,358
  
Cash paid during the period for income taxes
  
$
605
  
$
455
  
Change in market value of investment securities available for sale, net of income taxes
  
$
(605
)
$
663
  
               
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
              
 
 
6

SUMMIT FINANCIAL CORPORATION
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005

NOTE 1 - BASIS OF PRESENTATION:
The unaudited consolidated financial statements include the accounts of Summit Financial Corporation (the “Company”), a South Carolina corporation, and its wholly-owned subsidiaries, Summit National Bank (the “Bank”), a nationally chartered bank, and Freedom Finance, Inc. (the “Finance Company”), a consumer finance company. Also included are the accounts of Summit Investment Services, Inc. (the “Investment Company”) which is a wholly-owned subsidiary of the Bank. All significant intercompany items related to the consolidated subsidiaries have been eliminated.

Through its bank subsidiary, which commenced operations in July 1990, the Company provides a full range of banking services, including the taking of demand and time deposits and the making of commercial and consumer loans. The Bank currently has four full service branch locations in Greenville and Spartanburg, South Carolina. In 1997, the Bank incorporated the Investment Company as a wholly-owned subsidiary to offer nondeposit products and financial management services. The Finance Company commenced operations in November 1994 and makes and services small installment loans to individuals from its eleven offices throughout South Carolina.

The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) which requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. In addition, the estimates affect the reported income and expense during the reporting period. Actual results could differ from these estimates and assumptions.

The significant accounting policies followed by the Company for interim reporting are consistent with the accounting policies followed for annual financial reporting. The unaudited consolidated financial statements of the Company at March 31, 2005 and for the three month periods ended March 31, 2005 and 2004 were prepared in accordance with the instructions for Form 10-Q. In the opinion of management, all adjustments (consisting only of items of a normal recurring nature) necessary for a fair presentation of the financial position at March 31, 2005, and the results of operations and cash flows for the periods ended March 31, 2005 and 2004 have been included. The information contained in the footnotes included in the Company’s latest annual report on Form 10-K for the year ended December 31, 2004 should be referred to in connection with the reading of these unaudited interim consolidated financial statements. Certain interim 2004 amounts have been reclassified to conform with the statement presentations for the interim 2005. The results for the three month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE 2 - MERGER AGREEMENT:
On March 7, 2005, the Company entered into a definitive agreement to merge with First Citizens Bank and Trust Company, Inc., a South Carolina state bank (“First Citizens”), under which the Company and the Bank will be merged with and into First Citizens, with First Citizens continuing after the merger as the surviving corporation.

Under the terms of the agreement, each shareholder of the Company will receive $22.00 per share in cash upon consummation of the proposed merger. In addition, in exchange for signing an option release, holders of the Company’s stock options will receive for each share that may be acquired pursuant to their options, a cash payment equal to the difference between $22.00 per share and the exercise price per share of the Company’s stock covered by the option. The transaction has been unanimously approved by the board of directors of each company and is subject to the approval of the shareholders of Summit, receipt of required regulatory approvals, and other customary closing conditions.

7
 
NOTE 3 - SUBSEQUENT EVENTS:
On May 5, 2005, the Company entered into a letter of intent (the “Letter”) to sell substantially all the assets of the Finance Company. The Letter specifies the assets to be sold, the purchase price, non-competition provisions for the Company, and other customary closing conditions. The sale of the Finance Company’s assets is expected to close prior to the consummation of the Company’s merger with First Citizens.

NOTE 4 - CASH FLOW INFORMATION:
For the purposes of reporting cash flows, cash includes currency and coin, cash items in process of collection and due from banks. Included in cash and cash equivalents are federal funds sold and overnight investments. The Company considers the amounts included in the balance sheet line items, “Cash and due from banks”, “Interest-bearing bank balances” and “Federal funds sold” to be cash and cash equivalents. These accounts totaled $16,442,000 and $17,906,000 at March 31, 2005 and 2004, respectively.

NOTE 5 - NONPERFORMING ASSETS:
Loans past due in excess of 90 days at March 31, 2005 were $103,000, compared to $156,000 at December 31, 2004, and $144,000 at March 31, 2004. Total nonperforming assets, including loans past due in excess of 90 days, nonaccrual loans and other real estate owned (“OREO”), at March 31, 2005 were $709,000, compared to $904,000 at December 31, 2004, and $795,000 at March 31, 2004. There were no impaired loans at March 31, 2005, December 31, 2004 or March 31, 2004.

NOTE 6 - INTANGIBLE ASSETS:
As of January 1, 2002, the Company adopted SFAS 142, “Goodwill and Other Intangible Assets”. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. The Company’s intangible assets consist of goodwill resulting from the Finance Company’s branch acquisitions and are included in “Other assets” on the accompanying consolidated balance sheets. The balance of goodwill at March 31, 2005 and December 31, 2004 was $187,000. There was no impairment expense charged in any period presented.

NOTE 7 - PER SHARE INFORMATION:
The following is a reconciliation of the denominators of the basic and diluted per share computations for net income for the three months ended March 31, 2005 and 2004. There is no required reconciliation of the numerator from the net income reported on the accompanying statements of income.

   
Three Months Ended March 31,
  
     
2005
 
 
2005
 
 
2004
 
 
2004
 
 
 
 
BASIC 
 
 
DILUTED
 
 
BASIC
 
 
DILUTED
  
                           
Net Income
  
$
1,159,000
  
$
1,159,000
  
$
987,000
  
$
987,000
  
                           
Average shares outstanding
    
4,513,851
   
4,513,851
   
4,319,720
   
4,319,720
 
Effect of Dilutive Securities:
                          
Stock options
    
-
    
475,162
   
-
    
520,730
 
Unvested restricted stock
    
-
    
11,200
   
-
    
16,917
 
     
4,513,851
   
5,000,213
   
4,319,720
   
4,857,367
 
                           
Per-share amount
  
$
0.26
  
$
0.23
  
$
0.23
  
$
0.20
  
 
 
8

NOTE 8 - STOCK COMPENSATION PLANS:
At March 31, 2005, the Company had three stock-based employee and director option plans, which are described more fully in Note 13 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for December 31, 2004. The Company reports stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion 25, “Accounting for Stock Issued to Employees”, which measures compensation expense as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. SFAS 123, “Accounting for Stock-Based Compensation”, encourages but does not require companies to record compensation cost for stock-based compensation plans at fair value. Accordingly, no compensation cost has been recognized for the stock-based option plans as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee and non-employee compensation.
 

             
 
    
For the Quarter Ended March 31, 
  
(dollars, except per share, in thousands)
    
2005
 
 
2004
  
               
Net income, as reported
  
$
1,159
  
$
987
  
Less - total stock-based employee compensation expense determined under fair value based method, net of taxes
    
27
    
31
  
Proforma net income
 
$
1,132
  
$
956
  
Earnings per share:
              
Basic - as reported
  
$
0.26
  
$
0.23
  
Basic – proforma
  
$
0.25
  
$
0.22
  
Diluted - as reported
  
$
0.23
  
$
0.20
  
Diluted – proforma
  
$
0.23
  
$
0.19
  

 
9


NOTE 9 - SEGMENT INFORMATION:
The Company reports information about its operating segments in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”. Summit Financial Corporation is the parent holding company for Summit National Bank (“Bank”), a nationally chartered bank, and Freedom Finance, Inc. (“Finance”), a consumer finance company. The Company considers the Bank and the Finance Company separate business segments.

Financial performance for each segment is detailed in the following tables. Included in the “Corporate” column are amounts for general corporate activities and eliminations of intersegment transactions.


At and for the three months ended March 31, 2005
          
 
    
Bank 
    
Finance
 
 
Corporate
 
 
Total
  
Interest income
  
$
4,371
  
$
446
  
$
0
  
$
4,817
  
Interest expense
    
1,308
   
36
   
(36
)
  
1,308
 
Net interest income
    
3,063
   
410
   
36
   
3,509
 
Provision for loan losses
    
65
   
37
   
0
   
102
 
Other income
    
358
   
108
   
(15
)
  
451
 
Other expenses
    
1,780
   
345
   
43
   
2,168
 
Income before taxes
    
1,576
   
136
   
(22
)
  
1,690
 
Income taxes
    
488
   
51
   
(8
)
  
531
 
Net income
  
$
1,088
  
$
85
    
($14
)
$
1,159
  
Net loans
  
$
241,545
  
$
2,514
  
$
0
  
$
244,059
  
Total assets
  
$
329,408
  
$
2,999
    
($47
)
$
332,360
  
                           
                           
At and for the three months ended March 31, 2004
            
   
Bank 
    
Finance
 
 
Corporate
 
 
Total
  
Interest income
  
$
3,991
  
$
455
    
($3
)
$
4,443
  
Interest expense
    
1,178
   
32
   
(31
)
  
1,179
 
Net interest income
    
2,813
   
423
   
28
   
3,264
 
Provision for loan losses
    
145
   
65
   
0
   
210
 
Other income
    
537
   
98
   
(15
)
  
620
 
Other expenses
    
1,896
   
339
   
7
   
2,242
 
Income before taxes
    
1,309
   
117
   
6
   
1,432
 
Income taxes
    
401
   
42
   
2
   
445
 
Net income
  
$
908
  
$
75
  
$
4
  
$
987
  
Net loans
  
$
233,914
  
$
2,617
    
($37
)
$
236,494
  
Total assets
  
$
335,941
  
$
3,078
    
($51
)
$
338,968
  


10


SUMMIT FINANCIAL CORPORATION

PART I. FINANCIAL INFORMATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following information presents management’s discussion and analysis of the financial condition and results of operations of Summit Financial Corporation (“the Company” or “Summit Financial”), a financial holding company, and its wholly-owned subsidiaries, Summit National Bank (“the Bank” or “Summit”) and Freedom Finance, Inc. (“the Finance Company” or “Freedom”). The Bank, which is the principal subsidiary, owns all the outstanding shares of Summit Investment Services, Inc. Throughout this discussion and analysis, the term “the Company” refers to Summit Financial Corporation and its subsidiaries.

This discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Annual Report of Summit Financial Corporation (the “Company”) on Form 10-K for the year ended December 31, 2004. Certain reclassifications have been made to prior years’ financial data to conform to current financial statement. Results of operations for the three month period ended March 31, 2005 are not necessarily indicative of results to be attained for any other period.

FORWARD-LOOKING STATEMENTS AND NON-GAAP FINANCIAL INFORMATION
Certain statements contained herein are “forward-looking statements” identified as such for purposes of the safe harbor provided in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but are not limited to, statements as to industry trends, future results of operations or financial position, borrowing capacity and future liquidity, future investment results, future credit exposure, future loan losses and plans and objectives for future operations, and other statements that do not relate strictly to historical facts. These statements are not historical facts, but instead are based on current expectations, estimates and projections about the Company, are subject to numerous assumptions, risks and uncertainties, and represent only management’s belief regarding future events, many of which, by their nature, are inherently uncertain and outside the Company’s control. Any forward-looking statements made speak only as of the date on which such statements are made. The Company disclaims any obligation to update any forward-looking statements. Forward-looking statements are not guarantees of future performance and it is possible that actual results and financial position may differ, possibly materially, from the anticipated results and financial condition indicated in or implied by these forward-looking statements.

Factors that could cause actual results to differ from those indicated by any forward-looking statements include, but are not limited to, the following:

·  
Inflation, interest rates, market and monetary fluctuations;
·  
Geopolitical developments and any future acts or threats of war or terrorism;
·  
The effects of, and changes in trade, monetary and fiscal policies and laws, including interest policies of the Federal Reserve;
·  
A decline in general economic conditions and the strength of the local economies in which the Company operates;
·  
The financial condition of the Company’s borrowers and potential deterioration of credit quality;
·  
Competitive pressures on loan and deposit pricing and demand;
·  
Changes in technology and their impact on the marketing of products and services;
·  
The timely development and effective marketing of competitive new products and services;
·  
The impact of changes in financial service laws and regulations, including laws concerning taxes, banking, securities and insurance;
·  
Changes in accounting principles, policies, and guidelines;
·  
The Company’s success at managing the risks involved in the foregoing as well as other risks and uncertainties detailed from time to time in press releases and other public filings.

11
 
    This report contains certain financial information determined by methods other than in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s management uses these non-GAAP measures to analyze the Company’s performance. In particular, net interest income and net interest margin ratios are presented on a fully tax-equivalent basis. Management believes that the presentation of net interest margin on a fully tax-equivalent basis aids in the comparability of net interest margin arising from both taxable and tax-exempt sources. These disclosures should not be viewed as a substitute for GAAP measures, and furthermore, the Company’s non-GAAP measures may not necessarily be comparable to non-GAAP performance measures of other companies.

COMPANY BUSINESS
The Company is headquartered in Greenville, South Carolina. Through its primary subsidiary, the Bank, the Company offers a full range of financial products and services, including business and consumer loans, commercial and residential mortgage lending and brokerage, asset-based financing, corporate and consumer deposit services, and investment management services. The Bank currently has four full service offices in Greenville and Spartanburg, South Carolina. Freedom is a consumer finance company headquartered in Greenville, South Carolina. The Finance Company primarily makes and services installment loans to individuals with loan principal amounts generally not exceeding $2,000 and with maturities ranging from three to 18 months. Freedom operates 11 branches throughout South Carolina.

CRITICAL ACCOUNTING POLICIES
The preparation of consolidated financial statements requires management to make estimates and assumptions in the application of certain of its accounting policies about the effect of matters that are inherently uncertain. These estimates and assumptions affect the reported amounts of certain assets, liabilities, revenues and expenses. Different amounts could be reported under different conditions, or if different assumptions were used in the application of these accounting policies. The Company’s accounting policies are discussed in Note 1 under Notes to Consolidated Financial Statements included in the Company’s Form 10-K for December 31, 2004. Of these significant accounting policies, the Company has determined that accounting for the allowance for loan losses and income taxes are deemed critical because of the valuation techniques used, and the sensitivity of these financial statement amounts to the methods, assumptions and estimates underlying these balances. Accounting for these critical areas requires the most subjective and complex judgments that could be subject to revision as new information becomes available.

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. This estimate is based on the current economy’s impact on the timing and expected amounts of future cash flows on problem or impaired loans, as well as historical loss experience associated with homogenous pools of loans. The Company’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.

The income tax calculations reflect the current period income tax expense for all periods shown, as well as future tax liabilities associated with differences in the timing of expenses and income recognition for book and tax accounting purposes. The income tax returns, usually filed three months after year-end, are subject to review and possible revision by the tax authorities up until the statute of limitations has expired. These statutes usually expire three years after the time the respective tax returns have been filed.

BALANCE SHEET ACTIVITY
Total assets increased $11.4 million or 4% from December 31, 2004 to March 31, 2005 to total $332.4 million. Total deposits increased $15.1 million or 7% from December 31, 2004, primarily in the certificates of deposit categories related to deposit campaigns during the first quarter of 2005. During the first quarter of 2005, there was a shift in deposits between noninterest-bearing demand and interest-bearing demand related to a change in South Carolina law related to attorney trust accounts. As a result, trust accounts with balance of approximately $8 million which previously had been in noninterest-bearing type accounts, were required to be transferred to interest-bearing accounts.

The increase in deposits funded loan growth of $5.3 million, or 2%, and maturities of FHLB advances totaling $4.7 million. Deposit growth also contributed to the increase in liquidity. Loans totaled $247.8 million as of the end of the first quarter of 2005, while advances from the FHLB were $45.4 million at March 31, 2005. Liquidity was further enhanced by the reduction in investment securities of $4.1 million to total $55.7 million at March 31, 2005 as management positioned the balance sheet for rising interest rates. Total equity increased $609,000 related to the retention of earnings, which was offset by the increase in unrealized loss on investment securities related to changes in market values due to treasury yield curve movement during the quarter.

12
 
ALLOWANCE FOR LOAN LOSSES AND NON-PERFORMING ASSETS
The allowance for loan losses is established through charges in the form of a provision for loan losses based on management’s periodic evaluation of the loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. The amount of the allowance reflects management’s opinion of an adequate level to absorb probable losses inherent in the loan portfolio at March 31, 2005. In assessing the adequacy of the allowance and the amount charged to the provision, management relies predominately on its ongoing review of the loan portfolio, which is undertaken both to ascertain whether there are losses which must be charged-off, and to assess the risk characteristics of the portfolio in the aggregate as well as the credit risk associated with particular loans. The Company’s methodology for evaluating the adequacy of the allowance for loan losses incorporates management’s current judgments about the credit quality of the loan portfolio through a disciplined and consistently applied process. The methodology includes segmentation of the loan portfolio into reasonable components based on loan purpose for calculation of the most accurate reserve. Appropriate reserve estimates are determined for each segment based on a review of individual loans, application of historical loss factors for each segment, and adjustment factors applied as considered necessary. The adjustment factors are applied consistently and are quantified for consideration of national and local economic conditions; exposure to concentrations that may exist in the portfolio; impact of off-balance sheet risk; alterations of lending policies and procedures; the total amount of and changes in trends of past due loans, nonperforming loans, problem loans and charge-offs; the total amount of and changes in trends of the Bank’s internally graded “watch list” loans which include classified loans; variations in the nature, maturity, composition, and growth of the loan portfolio; changes in trends of collateral value; entry into new markets; and other factors which may impact the current credit quality of the loan portfolio.

Management maintains an allowance for loan losses which it believes adequate to cover probable losses in the loan portfolio. It must be emphasized, however, that the determination of the allowance for loan losses using the Company’s procedures and methods rests upon various judgments and assumptions about future economic conditions, events, and other factors affecting loans which are believed to be reasonable, but which may or may not prove valid. While it is the Company’s policy to provide for the loan losses in the current period in which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, industry trends, and conditions affecting individual borrowers, management’s judgment of the allowance is necessarily approximate and imprecise. No assurance can be given that the Company will not in any particular period sustain loan losses which would be sizable in relationship to the amount reserved or that subsequent evaluation of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. The allowance for loan losses is also subject to review by various regulatory agencies through their periodic examinations of the Company’s subsidiaries. Such examination could result in required changes to the allowance for loan losses. No adjustment in the allowance or significant adjustments to the Bank’s internal classified loans were made as a result of the Bank’s most recent examination performed by the Office of the Comptroller of the Currency.

13
 
    The following table sets forth certain information with respect to changes in the Company’s allowance for loan losses for each period presented.
 

(dollars in thousands) 
  
At and For the Three Months Ended
 
At and For the Year Ended 
 
At and For the Three Months Ended
 
 
 
 
March 31, 2005 
    
December 31, 2004
    
March 31, 2004 
  
Balance at beginning of period
  
$
3,649
  
$
3,437
  
$
3,437
  
Charge-offs:
                    
Commercial and industrial
    
6
    
37
    
-
  
Commercial real estate
    
15
    
95
    
-
  
Installment and consumer
    
93
    
444
    
127
  
     
114
    
576
    
127
  
Recoveries:
                    
Commercial and industrial
    
14
    
89
    
29
  
Commercial real estate
    
23
    
130
    
115
  
Installment and consumer
    
37
    
133
    
35
  
     
74
    
352
    
179
  
Net charge-offs (recoveries)
   
40
    
224
    
-52
  
Provision charged to expense
    
102
    
436
    
210
  
Balance at end of period
  
$
3,711
  
$
3,649
  
$
3,699
  
Net charge-offs (recoveries) to average loans
                    
     
0.07
%
  
0.10
%
  
-0.09
%
Allowance to loans, period end
    
1.50
%
  
1.51
%
  
1.54
%


The allowance for loan losses totaled $3.7 million, or 1.50% of total loans, at March 31, 2005. This is compared to a $3.6 million allowance, or 1.51% of total loans, at December 31, 2004, and a $3.7 million, or 1.54% of total loans, at March 31, 2004. Changes in the allowance for loan losses as a percent of loans between periods is reflective of the factors discussed previously as well as under the “Provision for Loan Losses” section below, primarily related to the trends in the level classified and watch list loans, changes in economic factors, and the overall quality of the loan portfolio.

The Company’s nonperforming assets consist of loans on nonaccrual basis, loans which are contractually past due 90 days or more on which interest is still being accrued, troubled debt restructurings, and other real estate owned (“OREO”). Generally, loans of the Bank are placed on nonaccrual status at the earlier of when they are 90 days past due or when the collection of the loan becomes doubtful. Loans of the Finance Company are not classified as nonaccrual, but are charged-off when such become 150 days contractually past due or earlier if the loan is deemed uncollectible. There were no loans considered to be impaired under Statement of Financial Accounting Standards (“SFAS”) 114, “Accounting by Creditors for Impairment of a Loan” for any period presented.

14

The following table summarizes the nonperforming assets for each period presented.
 
(dollars in thousands)
    
March 31, 2005
 
 
December 31, 2004
 
 
March 31, 2004
  
Loans past due 90 days or more, still accruing
  
$
103
  
$
156
  
$
144
  
Nonaccrual loans
    
259
    
531
    
268
  
Troubled debt restructurings
   
-
    
-
    
-
  
Other real estate owned
    
347
    
217
    
383
  
Total nonperforming assets
  
$
709
  
$
904
  
$
795
  
Nonperforming assets to total loans and OREO
    
0.29
%
  
0.37
%
  
0.33
%

Management maintains a list of potential problem loans which includes nonaccrual loans, loans past due in excess of 90 days which are still accruing interest, and other loans which are credit graded (either graded internally, by independent review or regulatory examinations) as “OAEM”, "substandard”, “doubtful”, or “loss”. A loan is added to the list when management becomes aware of information about possible credit problems of borrowers that causes doubts as to the ability of such borrowers to comply with the current loan repayment terms. The total amount of classified loans (i.e., defined as loans with a credit grade of “substandard”, “doubtful”, or “loss”) at March 31, 2005, based upon management’s internal designations, was $8.8 million or 3.6% of the loan portfolio, compared to $4.1 million or 1.7% of the loan portfolio at December 31, 2004, and $8.9 million or 3.8% of the loan portfolio at March 31, 2004. The amount of potential problem loans at March 31, 2005 does not represent management’s estimate of potential losses since the majority of such loans are considered adequately secured by real estate or other collateral. The increase in classified loans since year end is related primarily to two commercial relationships which are being closely monitored by management and which are currently anticipated to be collected in total. Management believes that the allowance for loan losses as of March 31, 2005 is adequate to absorb any losses related to the nonperforming loans and potential problem loans as of that date. Management continues to monitor closely the levels of nonperforming and potential problem loans, and will address the weaknesses in these credits to enhance the amount of ultimate collection or recovery on these assets. Should increases in the overall level of nonperforming and potential problem loans accelerate from the current trend, management will adjust the methodology for determining the allowance for loan losses and will increase the provision for loan losses accordingly. This would likely decrease net income.


EARNINGS REVIEW FOR THE THREE MONTHS ENDED MARCH 31, 2005 AND 2004

GENERAL
The Company reported consolidated net income for the three months ended March 31, 2005 of $1,159,000, compared to net income of $987,000 for the three months ended March 31, 2004, or an improvement of approximately $172,000 or 17%. The primary contributor to increased earnings for the first quarter of 2005 was the 8% growth in net interest income resulting from the 50 basis point increase in net interest margin related to the higher interest rate environment. Also adding to the higher net income was the lower provision for loan losses of 51% resulting from the improvement in the overall quality of the loan portfolio and lower net originations in the first quarter of 2005 compared to 2004. Reductions in overhead expenses, primarily in merchant discount fees and consultant fees, were more than offset by lower other income related to reduced gain on sale of investment securities, and lower service charges and merchant discount income for the quarter ended March 31, 2005 as compared to the prior year.

NET INTEREST INCOME
Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company’s earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During the three months ended March 31, 2005, the Company recorded net interest income of $3.5 million, an 8% increase from the net interest income of $3.3 million for the three months ended March 31, 2004. The increase in this amount is directly related to the 50 basis point increase in the net interest margin for the Company. Also contributing to the higher net interest income is fluctuations in the volume of average earning assets, which declined only 4%, while interest-bearing liabilities decreased nearly 7% and offset the increase in cost of funds.


15

For the three months ended March 31, 2005 and 2004, the Company’s net interest margin was 4.76% and 4.26%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The increase in net interest margin is related primarily to the 74 basis point increase in the average yield on assets, offset somewhat by the 35 basis point increase in the average cost of funds. Rates on both assets and liabilities increased in 2005 due to the rising interest rate environment as the Federal Reserve began increasing short-term rates in mid-2004. During the period between the first quarter of 2004 and 2005, the average prime rate increased 143 basis points resulting in an average prime rate of 5.43% for the first quarter of 2005 compared to 4.00% for the first quarter of the prior year.

INTEREST INCOME
For the three months ended March 31, 2005, the Company’s earning assets averaged $308.3 million and had an average yield of 6.48%. This compares to average earning assets of $320.0 million for the first three months of 2004, yielding approximately 5.74%. Thus, the 4% decrease in volume of average earning assets slightly offset the 74 basis point increase in average yield, accounting for the $374,000 (8%) increase in interest income between the first quarters of 2004 and 2005.

Gross loans comprised approximately 79% of the Company’s average earning assets for the first three months of 2005 and compared to 74% for the first quarter of 2004. The majority of the Company’s loans are tied to the prime rate (over 75% of the Bank’s loan portfolio is at floating rates at March 31, 2005), which averaged 5.43% and 4.00% for the three months ended March 31, 2005 and 2004, respectively. During the first three months of 2005, loans averaged $244.8 million, yielding an average of 6.86%, compared to $235.9 million, yielding an average of 6.03% for the first three months of 2004. The 83 basis point increase in the average yield on loans is directly related to the higher general interest rate environment and prime lending rate increases starting in the latter half of 2004. The higher level of average loans (which increased 4%), combined with the higher average yields, resulted in the increase in interest income on loans of $604,000 or 17%.

Investment securities averaged $57.2 million and yielded 5.10% (tax equivalent basis) during the first three months of 2005, compared to average securities of $79.2 million yielding 5.05% (tax equivalent basis) for the three months ended March 31, 2004. The increase in the average yield of the investment portfolio is related to the general increases in market interest rates, the portfolio mix, and the timing of security sales, calls and maturities which were reinvested at higher current market rate instruments. During 2004, the Company implemented a strategic decision to realign the balance sheet in anticipation of rising rates, resulting in a reduction in securities which had increased during 2003 from the investment of excess liquidity in higher yielding, cash flowing securities and returning the level of investment securities back to more historical levels of investments as a percent of total assets. This strategy resulted in the $22.0 million decline in average investment securities between the two quarterly periods. The 28% decrease in average securities, offset slightly by the increase in yield, resulted in the decrease of interest income on securities of $251,000 or 29%.

INTEREST EXPENSE
The Company’s interest expense for the three months ended March 31, 2005 was $1.3 million. The increase in interest expense of $129,000, or 11%, from the comparable three months in 2004 of $1.2 million was related to the 35 basis point increase in the average rate on liabilities, offset somewhat by the 7% decrease in the level of average interest-bearing liabilities. Interest-bearing liabilities averaged $250.3 million for the first three months of 2005 with an average rate of 2.12%. This is compared to average interest-bearing liabilities of $268.3 million with an average rate of 1.77% for the three months ended March 31, 2004. The increase in average rate on liabilities is directly related to the rising market interest rates and the maturities of fixed rate deposits and borrowings which were renewed at higher current market rates.

16
 
PROVISION FOR LOAN LOSSES
The provision for loan losses was $102,000 for the first quarter of 2005, compared to $210,000 for the comparable period of 2004. As discussed further under the “Allowance for Loan Losses” section above, in addition to the level of net originations, other factors influencing the amount charged to the provision each period include (1) trends in and the total amount of past due, nonperforming, and classified loans; (2) trends in and the total amount of net chargeoffs, (3) concentrations of credit risk in the loan portfolio, and (4) local and national economic conditions and anticipated trends. Thus, the $108,000 or 51% decrease in the provision for loan losses is primarily related to the lower level of net originations of $5.4 million for the first quarter of 2005 as compared to $8.3 million for the first quarter of 2004. In addition, the overall improvement in the quality of the loan portfolio contributed to the lower provision for the first quarter of 2005. Loans past due in excess of 90 days at March 31, 2005 decreased to $103,000 or 0.04% of gross loans from $156,000 at December 31, 2004. Total nonperforming assets at March 31, 2005 declined to $709,000 or 0.29% of gross loans plus OREO, compared to $904,000 or 0.37% at December 31, 2004. Total classified loans where down somewhat from March 31, 2004 and loans graded OAEM decreased significantly from $8.5 million at March 31, 2004 to $924,000 at March 31, 2005. Estimates charged to the provision for loan losses are based on management’s judgment as to the amount required to cover probable losses in the loan portfolio and are adjusted as necessary based on a calculated model quantifying the estimated required balance in the allowance.

NONINTEREST INCOME AND EXPENSES
Noninterest income, which is primarily related to service charges on customers’ deposit accounts; credit card merchant discount fees; commissions on nondeposit investment product sales and insurance product sales; mortgage origination fees; and gains on sales of investment securities, was $451,000 for the three months ended March 31, 2005 compared to $620,000 for the first three months of 2004, or a decrease of 27%. The decrease is related to (1) lower service charge income of $37,000 due to changes in transaction accounts and a reduction in NSF fee income related to numerous accounts with recurring overdrafts being closed during the year; (2) lower gain on sale of available for sale investment securities, which decreased $22,000; (3) $22,000 lower gains on sale of vehicles compared to the first quarter of 2004; and (4) the decline of $80,000 in merchant discount and transaction fees related to the Company’s sale of the merchant portfolio in mid-2004 and thereafter, receiving a residual net revenue amount.

For both the three months ended March 31, 2005 and 2004, noninterest expense was $2.2 million. The decrease of $74,000 or 3% is primarily related to lower merchant expenses and consultant expenses. The most significant item included in noninterest expense is salaries, wages and benefits, which totaled $1.4 million for both the three months ended March 31, 2005 and 2004. The increase of $39,000 or 3% is primarily a result of normal annual raises. Occupancy expenses increased a total of $13,000 or 7% between the first three months of 2004 and 2005 related primarily to the completion of and move into a new branch location in February 2005.

Included in the line item “other operating expenses”, which decreased $120,000 or 22% from the comparable period of 2004, are charges for OCC assessments; property and bond insurance; ATM switch fees; professional services; education and seminars; advertising and public relations; and other branch and customer related expenses. The decrease is primarily related to (1) a decline in merchant processing transaction expense of $86,000 due to the Company’s selling the merchant portfolio in mid-2004 and thereafter, receiving a residual net revenue amount; (2) $30,000 reduction in consultant fees related to fewer contracted services and projects in 2005; and (3) lower advertising and public relations expense of $13,000 related to fewer promotional campaigns as compared to the prior year.

INCOME TAXES
For the three months ended March 31, 2005, the Company reported $531,000 in income tax expense, or an effective tax rate of 31.4%. This is compared to income tax expense of $445,000 for the same period of the prior year, or an effective tax rate of 31.1%. The slight increase in effective tax rate is primarily related to the level of tax-free municipal securities in each period.

17
 
CAPITAL MANAGEMENT
The Company’s capital serves to support asset growth and provides protection against loss to depositors and creditors. The Company strives to maintain an optimal level of capital, commensurate with its risk profile, on which an attractive return to shareholders will be realized over both the short and long-term, while serving depositors’, creditors’ and regulatory needs. Total shareholders’ equity amounted to $37.9 million, or 11.4% of total assets, at March 31, 2005. This is compared to $37.3 million, or 11.6% of total assets, at December 31, 2004. The $609,000 increase in total shareholders’ equity resulted from retention of earnings, offset by the $605,000 increase in unrealized loss on investment securities available for sale during the year. The Company’s unrealized loss on securities, net of tax, which is included in accumulated other comprehensive income, was ($507,000) as of March 31, 2005 as compared to an unrealized gain of $98,000 as of December 31, 2004. Book value per share at March 31, 2005 and December 31, 2004 was $8.37 and $8.25, respectively.

The Company and its bank subsidiary are subject to certain regulatory restrictions on the amount of dividends they are permitted to pay. The Company paid semi-annual cash dividends totaling $0.15 per share during 2004. The Company presently intends to pay a semi-annual cash dividend on the common stock; however, future dividends will depend upon the Company’s earnings, financial condition, capital position, and such other factors as the Board may deem relevant. Further, the ability of the Company to pay cash dividends is dependent upon its receiving cash in the form of dividends from the Bank. The dividends that may be paid by the Bank to the Company are subject to legal limitations and regulatory capital requirements. The approval of the Comptroller of the Currency is required if the total of all dividends declared by a national bank in any calendar year exceeds that bank’s net profits (as defined by the Comptroller) for that year combined with its retained net profits (as defined by the Comptroller) for the two preceding calendar years. It is currently the Bank’s intention to pay all dividends only from the net income of the current year.

To date, the capital needs of the Company have been met through the retention of earnings, from the proceeds of its initial offering of common stock, and from the proceeds of stock issued pursuant to the Company’s stock option plans. The Company believes that the rate of asset growth will not negatively impact the capital base. The Company has no commitments or immediate plans for any significant capital expenditures outside of the normal course of business. The Company’s management does not know of any trends, events or uncertainties that may result in the Company’s capital resources materially increasing or decreasing.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. The purpose of these regulations is to quantitatively measure capital against risk-weighted assets, including certain off-balance sheet items. These regulations define the elements of total capital and establish minimum ratios for capital adequacy purposes. To be categorized as “well capitalized”, as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), Summit Financial and its banking subsidiary must maintain a risk-based Total Capital ratio of at least 10%, a risk-based Tier 1 Capital ratio of at least 6%, and a Tier 1 Leverage ratio of at least 5%, and not be subject to a written agreement, order, or capital directive with any of its regulators. At March 31, 2005, the Company and the Bank exceeded all regulatory required minimum capital ratios, and satisfied the requirements of the well capitalized category established by FDICIA. There are no current conditions or events that management believes would change the Company’s or the Bank’s category. The following table summarizes capital ratios for the Company and the Bank at March 31, 2005 and December 31, 2004.

18


RISK-BASED CAPITAL CALCULATION

               
 
  
   
ACTUAL
  
FOR CAPITAL ADEQUACY PURPOSES
  
TO BE CATEGORIZED
"WELL-CAPITALIZED"
  
   
AMOUNT 
    
RATIO
 
 
AMOUNT
 
 
RATIO
 
 
AMOUNT
 
 
RATIO
  
                                       
As of March 31, 2005
                                      
THE COMPANY
                                      
Total capital to risk-weighted assets
  
$
41,827
    
15.22
%
$
21,981
    
8.00
%
  
N.A.
        
Tier 1 capital to risk-weighted assets
  
$
38,389
    
13.97
%
$
10,991
    
4.00
%
  
N.A.
        
Tier 1 capital to average assets
  
$
38,389
    
11.78
%
$
13,031
    
4.00
%
  
N.A.
        
                                       
THE BANK
                                      
Total capital to risk-weighted assets
  
$
35,452
    
13.03
%
$
21,759
    
8.00
%
$
27,199
    
10.00
%
Tier 1 capital to risk-weighted assets
  
$
32,051
    
11.78
%
$
10,880
    
4.00
%
$
16,319
    
6.00
%
Tier 1 capital to average assets
  
$
32,051
    
9.93
%
$
12,910
    
4.00
%
$
16,137
    
5.00
%
                                       
As of December 31, 2004
                                      
THE COMPANY
                                      
Total capital to risk-weighted assets
  
$
40,511
    
15.27
%
$
21,228
    
8.00
%
  
N.A.
        
Tier 1 capital to risk-weighted assets
  
$
37,190
    
14.02
%
$
10,614
    
4.00
%
  
N.A.
        
Tier 1 capital to average assets
  
$
37,190
    
11.39
%
$
13,061
    
4.00
%
  
N.A.
        
                                       
THE BANK
                                      
Total capital to risk-weighted assets
  
$
34,246
    
13.05
%
$
20,994
    
8.00
%
$
26,242
    
10.00
%
Tier 1 capital to risk-weighted assets
  
$
30,963
    
11.80
%
$
10,497
    
4.00
%
$
15,745
    
6.00
%
Tier 1 capital to average assets
  
$
30,963
    
9.57
%
$
12,939
    
4.00
%
$
16,174
    
5.00
%

LIQUIDITY
Liquidity risk is defined as the risk of loss arising from the Company’s inability to meet known near-term and projected long-term funding commitments and cash flow requirements. The objective of liquidity risk management is to ensure the ability of the Company to meet its financial obligations. These obligations are the payment of deposits on demand or at their contractual maturity; the repayment of borrowings as they mature; the payment of lease obligations as they become due; the ability to fund new and existing loan and other commitments; the payment of operating expenses; and the ability to take advantage of new business opportunities. Liquidity is measured and monitored frequently at both the parent company and the Bank levels, allowing management to better understand and react to balance sheet trends. A comprehensive liquidity analysis provides a summary of anticipated changes in loans, core deposits, and wholesale funds. Management also maintains a detailed liquidity contingency plan designed to respond to an overall decline in the condition of the banking industry or a problem specific to the Company.
 
Liquidity is achieved by the maintenance of assets which can easily be converted to cash; a strong base of core customer deposits; maturing short-term assets; the ability to sell marketable securities; and access to borrowed funds and capital markets. Historically, deposits have been the primary source of funds for lending and investing activities. The amortization and scheduled payment of loans and mortgage-backed securities and maturities of investment securities provide a stable source of funds, while deposit fluctuations and loan prepayments are significantly influenced by the interest rate environment and other market conditions and competitive factors. Management meets frequently and makes changes relative to the mix, maturity and pricing of assets and liabilities in order to minimize the impact on earnings from such external conditions. Deposits are attractive sources of liquidity because of their stability and generally lower cost than other funding.
 

19


In addition to deposits and normal cash flows, FHLB advances and short-term borrowings (including purchasing federal funds from other financial institutions or lines of credit through the Federal Reserve Bank) provide liquidity sources based on specific needs or if management determines that these are the best sources of funds to meet current requirements. At March 31, 2005, based on its approved line of credit equal to 25% of total assets and limited to eligible collateral available, the Bank had additional available credit of approximately $4.8 million from the FHLB. Further, the Bank had short-term lines of credit to purchase unsecured federal funds from unrelated correspondent banks with available balances of $23.1 million at March 31, 2005. The Bank considers advances from the FHLB to be a reliable and readily available source of funds for both liquidity purposes and asset-liability management and interest rate risk management strategies.

Liquid assets, consisting primarily of cash and due from banks, interest-bearing deposits at banks, federal funds sold, and unpledged investment securities available for sale, accounted for 9% and 17%, respectively, of average assets for each of the three month period ended March 31, 2005 and 2004. The decline in average liquid assets between the two periods is directly related to the increase in public fund certificate of deposit accounts requiring pledges in the first quarter of 2005. Investment securities are an important tool to the Company’s liquidity management. Securities classified as available for sale may be sold in response to changes in interest rates, liquidity needs, and/or significant prepayment risk. In management’s opinion, the Company maintains adequate levels of liquidity by retaining sufficient liquid assets and assets which can be easily converted into cash and by maintaining access to various sources of funds.

As of March 31, 2005, there was no substantial change from the future contractual obligations as of December 31, 2004 as presented in the Company’s 2004 Annual Report on Form 10-K. The foregoing disclosures related to the liquidity of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2004 included in the Company’s 2004 Annual Report on Form 10-K.

Summit Financial, the parent holding company, has limited liquidity needs required to pay operating expenses and to provide funding to its consumer finance subsidiary, Freedom Finance. Summit Financial has approximately $5.4 million in available liquidity remaining from its initial public offering and the retention of earnings. A total of $2.0 million of this liquidity was advanced to the Finance Company in the form of an intercompany loan to fund its operations as of March 31, 2005. This amount could be replaced by a loan from an unrelated source to create additional liquidity for Summit Financial. Other sources of liquidity for Summit Financial include borrowing funds from unrelated correspondent banks, borrowing from individuals, and payments for management fees and debt service which are made by the Company’s subsidiary on a monthly basis.

Liquidity needs of Freedom Finance, primarily for the funding of loan originations, paying operating expenses, and servicing debt, have been met to date through the initial capital investment of $500,000 made by Summit Financial, retention of earnings, borrowings from unrelated private investors, and line of credit facilities provided by Summit Financial and Summit National Bank. The Company’s management believes its liquidity sources are adequate to meet its operating needs.

 
20

OFF-BALANCE SHEET ARRANGEMENTS
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the liquidity, credit enhancement, and financing needs of its customers. These financial instruments include legally binding commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the amount of credit risk should the instruments be fully drawn upon and the customer defaults.

To control the credit risk associated with entering into commitments and issuing letters of credit, the Company uses the same credit quality, collateral policies, and monitoring controls in making commitments and letters of credit as it does with its lending activities. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation.

Legally binding commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit obligate the Company to meet certain financial obligations of its customers, if, under the contractual terms of the agreement, the customers are unable to do so. The financial standby letters of credit issued by the Company are irrevocable. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. As such, there are no “stand-ready obligations” in any of the letters of credit issued by the Company and the contingent obligations are accounted for in accordance with SFAS 5, “Accounting for Contingencies”. At March 31, 2005 and 2004, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor, as such amounts are not considered material.

At March 31, the Company’s total contractual amounts of commitments and letters of credit are as follows:


(dollars in thousands)
    
2005
 
 
2004
  
Legally binding commitments to extend credit:
              
Commercial and industrial
  
$
16,415
  
$
15,446
  
Residential real estate, including prime equity lines
    
19,873
    
18,916
  
Construction and development
    
28,618
    
11,624
  
Consumer and overdraft protection
    
1,803
    
2,242
  
     
66,709
    
48,228
  
Standby letters of credit
    
3,637
    
2,763
  
Total commitments
  
$
70,346
  
$
50,991
  
 
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EFFECT OF INFLATION AND CHANGING PRICES
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America which require the measurement of financial position and results of operations in terms of historical dollars, without consideration of changes in the relative purchasing power over time due to inflation. Unlike most industries, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect in the financial institution’s performance than does the effect of inflation.

The yield on a majority of the Company’s earning assets adjusts simultaneously with changes in the short-term rates established by the Federal Reserve Board of Governors, specifically the discount rate, changes in which leads to a change in the prime lending rate. Given the Company’s asset-sensitive balance sheet position, assets reprice faster than liabilities, which generally results in decreases in net interest income during periods of declining interest rates. This may cause a decrease in the net interest margin until the fixed rate deposits mature and are repriced at lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. The opposite effect (that is, an increase in net interest income) is generally realized in a rising rate environment. The degree of interest rate sensitivity of the Company’s assets and liabilities and the differences in timing of repricing assets and liabilities provides an indication of the extent to which the Company’s net interest income may be affected by interest rate movements.

MARKET RISK AND ASSET-LIABILITY MANAGEMENT
The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and has invested in resources to assist in the management of market risk. The Company’s net interest income is affected by changes in market interest rates, and by the level and composition of earning assets and interest-bearing liabilities. The Company’s objectives in its asset-liability management are to utilize its capital effectively, to provide adequate liquidity and enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its capital, liquidity, and interest rate risk.

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in its lending, investment, deposit, and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Other types of market risks, such as foreign currency exchange rate risk, and equity and commodity price risk, do not arise in the normal course of the Company’s business.

Interest rate risk is the exposure to changes in market interest rates. The major source of the Company’s interest rate risk is the difference in the maturity and repricing characteristics between core banking assets and liabilities — loans and deposits. This difference, or mismatch, poses a risk to net interest income. The Company attempts to control the mix and maturities of assets and liabilities to maintain a reasonable balance between exposure to interest rate fluctuations and earnings and to achieve consistent growth in net interest income, while maintaining adequate liquidity and capital. A sudden and substantial increase or decrease in interest rates may adversely impact the Company’s earnings to the extent that the interest rates on earning assets and interest-bearing liabilities do not change at the same speed, to the same extent, or on the same basis.


22

The Company monitors the interest rate sensitivity of its balance sheet position and controls this risk by identifying and quantifying exposures in its near-term sensitivity through the use of simulation and valuation models, as well as its long-term gap position, reflecting the known or assumed maturity, repricing, and other cash flow characteristics of assets and liabilities. The Company’s simulation analysis involves dynamically modeling interest income and expense from current assets and liabilities over a specified time period under various interest rate scenarios and balance sheet structures, primarily to measure the sensitivity of net interest income over relatively short (e.g., less than 2-year) time horizons. As the future path of interest rates cannot be known in advance, management uses simulation analysis to project earnings under various interest rate scenarios including reasonable or “most likely”, as well as deliberately extreme and perhaps unlikely, scenarios. Key assumptions in these simulation analyses relate to the behavior of interest rates and spreads, changes in the mix and volume of assets and liabilities, repricing and/or runoff of deposits, and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets, the majority of which are based on external indices and change in concert with market interest rates. According to the model, the Company is presently positioned so that net interest income will increase in the short-term if interest rates rise and will decrease in the short-term if interest rates decline.

A traditional gap analysis is also prepared based on the maturity and repricing characteristics of earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on net interest income. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income, and is thus not, in management’s opinion, a true indicator of the Company’s interest rate sensitivity position.

The Company’s balance sheet structure is primarily short-term in nature with a substantial portion of assets and liabilities maturing within one year. The Company’s gap analysis indicates an asset-sensitive position over the entire lives of the assets and liabilities. For a 12 month period, the gap analysis indicates a positive position as of March 31, 2005 of $18.0 million. When the “effective change ratio” (the historical relative movement of each asset’s and liability’s rates in relation to a 100 basis point change in the prime rate) is applied to the interest gap position, the Company actually has a somewhat higher asset sensitive position over a 12 month period and the entire repricing lives of the assets and liabilities. This is primarily due to the fact that in excess of 75% of the loan portfolio moves immediately on a one-to-one ratio with a change in the prime lending rate, while the deposit rates do not increase or decrease as much or as quickly relative to a prime rate movement. The Company’s asset sensitive position means that assets reprice faster than the liabilities, which causes a decrease in the short-term in the net interest income and net interest margin in periods of declining rates until the fixed rate deposits mature and are repriced at then lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. Given the Company’s current balance sheet structure, the opposite effect (that is, an increase in net interest income and net interest margin) is realized in the short-term in a rising rate environment.


23

The Company monitors and considers methods of managing the rate sensitivity and repricing characteristics of the balance sheet components in order to minimize the impact of sudden and sustained changes in interest rates. Accordingly, the Company also performs a valuation analysis involving projecting future cash flows from current assets and liabilities to determine the Economic Value of Equity (“EVE”) which is the estimated net present value of those discounted cash flows. EVE represents the market value of equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for certain off-balance sheet items, over a range of assumed changes in market interest rates. The sensitivity of EVE to changes in the level of interest rates is a measure of the sensitivity of long-term earnings to changes in interest rates, and is used primarily to measure the exposure of earnings and equity to changes in interest rates over a relatively long (e.g., greater than 2 years) time horizon.

The Company’s market risk exposure is measured using interest rate sensitivity analysis by computing estimated changes in EVE in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 - 300 basis points increase or decrease in the market interest rates. The Company’s Board of Directors has adopted an interest rate risk policy which establishes maximum allowable decreases in EVE in the event of a sudden and sustained increase or decrease in market interest rates.

At December 31, 2004, the Company’s estimated changes in EVE were within the limits established by the Board. As of March 31, 2005, there was no substantial change from the interest rate sensitivity analysis or the market value of portfolio equity for various changes in interest rates calculated as of December 31, 2004. The foregoing disclosures related to the market risk of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2004 included in the Company’s 2004 Annual Report on Form 10-K.

ACCOUNTING, REPORTING AND REGULATORY MATTERS
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R (“SFAS 123R”), “Share-Based Payment” as a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” and superseding APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS 123, however non-employee directors are scoped into SFAS 123R. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. SFAS 123R allows the use of valuation models other than the Black-Scholes model prescribed in SFAS 123, specifically the Binomial Lattice method. Therefore, the proforma costs of stock option expense estimated in Note 5 to the foregoing Condensed Notes to Consolidated Financial Statements using the Black-Scholes method may not be representative of the costs recognized by the Company upon adoption of SFAS 123R. The Company is still in the process of analyzing the cost of stock options under SFAS 123R. On April 14, 2005, the Securities and Exchange Commission delayed the effective date for SFAS 123R, which allows companies to implement the statement at the beginning of their first fiscal year beginning after June 15, 2005, which would be January 1, 2006 for the Company.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See “Market Risk and Asset-Liability Management” in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.

24

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

 
The Company’s principal executive officer and principal financial officer have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, (“the Exchange Act”) as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are designed and effective to provide reasonable assurance that information required to be disclosed by the Company in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and to provide reasonable assurance that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes in Internal Controls

 
There was no significant change in the Company’s “internal control over financial reporting” (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.


25

SUMMIT FINANCIAL CORPORATION

PART II. OTHER INFORMATION


Item 1.
Legal Proceedings.
 
The Corporation and its subsidiaries from time to time may be involved as plaintiff or defendant in various legal actions incident to its business. There are no material actions currently pending.
   
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
None.
   
Item 3.
Defaults Upon Senior Securities.
 
None.
   
Item 4.
Submission of Matters to a Vote of Security Holders.
 
No matters were submitted to the shareholders for a vote at any time during the first quarter of 2005.
   
Item 5.
Other Information.
 
None.
   
Item 6.
Exhibits.
   
2.1 -
Agreement and Plan of Reorganization and Merger dated as of March 7, 2005 by and among Summit Financial Corporation, Summit National Bank, and First Citizens Bank and Trust Company, Inc., and joined in by First Citizens Bancorporation, Inc.
10.1 -
Employment Agreement of James B. Schwiers dated March 7, 2005
31.1 -
Rule 13a - 14(a) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.
31.2 -
Rule 13a - 14(a) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.
32.1 -
Section 1350 Certificate of Chief Executive Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002.
32.2 -
Section 1350 Certificate of Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002.


26


SUMMIT FINANCIAL CORPORATION

SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SUMMIT FINANCIAL CORPORATION


Date: May 11, 2005
 
J. Randolph Potter, President and Chief Executive Officer


Date: May 11, 2005
 
Blaise B. Bettendorf, Senior Vice President and Chief Financial Officer

 
 
 
27