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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
________________
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2003
OR
/X/ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file number: 0-25859
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1st STATE BANCORP, INC.
-----------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
VIRGINIA 56-2130744
- ------------------------------- -----------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
445 S. MAIN STREET, BURLINGTON, NORTH CAROLINA 27215
- ---------------------------------------------- --------------
(Address of Principal Executive Offices) (Zip Code)
(336) 227-8861
---------------------------------------------------
Registrant' s Telephone Number, Including Area Code
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. Yes X No
-- --
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of February 6, 2004, the issuer had 2,962,696 shares of common stock
issued and outstanding.
CONTENTS
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of December 31, 2003 (unaudited) and September 30, 2003...................2
Consolidated Statements of Income for the Three Months Ended December 31, 2003 and
2002 (unaudited).................................................................................3
Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Three
Months Ended December 31, 2003 and 2002 (unaudited)..............................................4
Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2003 and
2002 (unaudited).................................................................................5
Notes to Consolidated Financial Statements...............................................................7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................9
Item 3. Quantitative and Qualitative Disclosures About Market Risk..............................................17
Item 4. Controls and Procedures.................................................................................17
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.......................................................................................18
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities........................18
Item 3. Defaults Upon Senior Securities.........................................................................18
Item 4. Submission of Matters to a Vote of Security Holders.....................................................18
Item 5. Other Information.......................................................................................18
Item 6. Exhibits and Reports on Form 8-K........................................................................18
SIGNATURES........................................................................................................19
1
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2003 AND SEPTEMBER 30, 2003
(IN THOUSANDS, EXCEPT SHARE DATA)
AT AT
DECEMBER 31, SEPTEMBER 30,
2003 2003
------------ -------------
(Unaudited)
ASSETS
Cash and cash equivalents $ 9,750 9,359
Investment securities:
Held to maturity (fair value of $21,781 and $19,397
at December 31, 2003 and September 30, 2003, respectively) 21,832 19,462
Available for sale (cost of $87,897 and $92,971
at December 31, 2003 and September 30, 2003, respectively) 86,859 91,709
Loans held for sale, at lower of cost or fair value 1,171 645
Loans receivable (net of allowance for loan losses of $3,868
and $3,856 at December 31, 2003 and September 30, 2003,
respectively) 226,280 225,725
Real estate owned 273 95
Federal Home Loan Bank stock, at cost 1,900 1,675
Premises and equipment 8,366 8,413
Accrued interest receivable 2,052 1,967
Other assets 3,872 3,590
----------- ----------
Total assets $ 362,355 $ 362,640
=========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposit accounts 256,379 262,712
Advances from Federal Home Loan Bank 38,000 31,500
Advance payments by borrowers for property taxes and insurance 129 57
Dividend payable 297 297
Other liabilities 4,192 5,373
----------- ----------
Total liabilities 298,997 299,939
----------- ----------
Stockholders' Equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized;
none issued -- --
Common stock, $0.01 par value, 7,000,000 shares authorized;
2,966,284 and 2,971,977 shares issued and outstanding
at December 31, 2003 and September 30, 2003, respectively 33 33
Additional paid-in capital 35,839 35,778
Unallocated ESOP shares (2,997) (3,141)
Deferred compensation payable in treasury stock 5,466 5,466
Treasury stock (12,946) (12,785)
Retained income - substantially restricted 38,596 38,118
Accumulated other comprehensive income (loss) - net unrealized
loss on investment securities available for sale (633) (768)
----------- ---------
Total stockholders' equity 63,358 62,701
----------- ---------
Total liabilities and stockholders' equity $ 362,355 362,640
=========== =========
See accompanying notes to the consolidated financial statements.
2
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
For the Three Months Ended
December 31,
----------------------------
2003 2002
-------- --------
Interest income:
Interest and fees on loans $ 2,854 3,372
Interest and dividends on investments 1,184 1,152
Overnight deposits 9 43
--------- ---------
Total interest income 4,047 4,567
--------- ---------
Interest expense:
Deposit accounts 919 1,291
Borrowings 316 276
--------- ---------
Total interest expense 1,235 1,567
--------- ---------
Net interest income 2,812 3,000
Provision for loan losses 60 60
--------- ---------
Net interest income after provision for loan losses 2,752 2,940
--------- ---------
Other income:
Customer service fees 205 217
Commissions from sales of annuities and mutual funds 72 86
Mortgage banking income, net 98 401
Securities gains, net 97 --
Other 54 56
--------- ---------
Total other income 526 760
--------- ---------
Operating expenses:
Compensation and related benefits 1,332 1,344
Occupancy and equipment 342 351
Real estate operations, net (3) 6
Other expenses 432 445
--------- ---------
Total operating expenses 2,103 2,146
--------- ---------
Income before income taxes 1,175 1,554
Income taxes 417 571
--------- ---------
Net income $ 758 983
========= =========
Earnings per share:
Basic $ 0.27 $ 0.35
Diluted $ 0.26 $ 0.33
See accompanying notes to the consolidated financial statements.
3
1st STATE BANCORP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED)
(IN THOUSANDS)
Deferred
Additional Unearned compensation
Common paid-in ESOP payable in
stock capital shares treasury stock
--------- ----------- -------- --------------
Balance at September 30, 2002 $ 33 35,623 (3,739) 5,466
Comprehensive income:
Net income -- -- -- --
Other comprehensive loss-unrealized
loss on securities available-for-sale,
net of income taxes of $122 -- -- -- --
Total comprehensive income
Allocation of ESOP shares -- 39 151 --
Acquisition of treasury shares -- -- -- --
Cash dividends declared -- -- -- --
Cash dividend on unallocated ESOP shares -- -- -- --
--------- ------- ------ -------
Balance at December 31, 2002 $ 33 35,662 (3,588) 5,466
========= ======= ====== =======
Balance at September 30, 2003 $ 33 35,778 (3,141) 5,466
Comprehensive income:
Net income -- -- -- --
Other comprehensive income-unrealized
gain on securities available-for-sale,
net of income taxes of $88 -- -- -- --
Total comprehensive income
Allocation of ESOP shares -- 61 144 --
Acquisition of treasury shares -- -- -- --
Cash dividends declared -- -- -- --
Cash dividend on unallocated ESOP shares -- -- -- --
--------- ------- ------ -------
Balance at December 31, 2003 $ 33 35,839 (2,997) 5,466
========= ======= ====== =======
Accumulated
other Total
Treasury Retained comprehensive stockholders'
Stock income income (loss) equity
-------- -------- ------------- -------------
Balance at September 30, 2002 (11,899) 35,258 827 61,569
Comprehensive income:
Net income -- 983 -- 983
Other comprehensive loss-unrealized
loss on securities available-for-sale,
net of income taxes of $122 -- -- (191) (191)
-------
Total comprehensive income 792
Allocation of ESOP shares -- -- -- 190
Acquisition of treasury shares (224) -- -- (224)
Cash dividends declared -- (240) -- (240)
Cash dividend on unallocated ESOP shares -- 15 -- 15
-------- ------- ------ -------
Balance at December 31, 2002 (12,123) 36,016 636 62,102
======== ======= ====== =======
Balance at September 30, 2003 (12,785) 38,118 (768) 62,701
Comprehensive income:
Net income -- 758 -- 758
Other comprehensive income-unrealized
gain on securities available-for-sale,
net of income taxes of $88 -- -- 135 135
-------
Total comprehensive income 893
Allocation of ESOP shares -- -- -- 205
Acquisition of treasury shares (161) -- -- (161)
Cash dividends declared -- (297) -- (297)
Cash dividend on unallocated ESOP shares -- 17 -- 17
-------- ------- ------ -------
Balance at December 31, 2003 (12,946) 38,596 (633) 63,358
======== ======= ====== =======
See accompanying notes to the consolidated financial statements.
4
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
(UNAUDITED)
(IN THOUSANDS)
For the Three Months Ended
December 31,
----------------------------
2003 2002
-------- --------
Cash flows from operating activities:
Net income $ 758 983
Adjustment to reconcile net income to net cash used in
operating activities:
Provision for loan losses 60 60
Depreciation 227 178
Deferred tax expense 2 32
Amortization of premiums and discounts, net (2) (32)
Deferred compensation 60 60
Release of ESOP shares 205 190
Loan origination fees and unearned discounts
deferred, net of current amortization (16) (15)
Gain on sale of investment securities available for sale (97) --
Net (gain) loss on sale of loans 28 (10)
Proceeds from sales of loans held for sale 6,845 24,839
Originations of loans held for sale (7,399) (26,460)
Decrease (increase) in other assets (368) 335
Decrease (increase) in accrued interest receivable (85) 550
Decrease in other liabilities (1,241) (1,261)
---------- -------
Net cash used in operating activities (1,023) (551)
---------- -------
Cash flows from investing activities:
Proceeds from sale of FHLB stock 1,025 368
Purchase of FHLB stock (1,250) --
Purchases of investment securities available for sale (15,828) (32,233)
Purchases of investment securities held to maturity (2,373) --
Proceeds from maturities and issuer calls of investment securities
available for sale 17,019 34,250
Proceeds from sales of investment securities available for sale 3,979 --
Proceeds from maturities of investment securities
held to maturity 1 1
Net (increase) decrease in loans receivable (669) 87
Purchase of real estate owned (108) --
Purchases of premises and equipment (180) (670)
---------- -------
Net cash provided by investing activities 1,616 1,803
---------- -------
(Continued)
5
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002
(UNAUDITED)
(IN THOUSANDS)
For the Three Months Ended
December 31,
----------------------------
2003 2002
------ ------
Cash flows from financing activities:
Net decrease in deposits $ (6,333) (9,433)
Advances from the Federal Home Loan Bank 32,000 5,000
Repayments of advances from the Federal Home Loan Bank (25,500) --
Purchase of treasury stock (161) (224)
Dividends paid on common stock (280) (225)
Increase in advance payments by borrowers for
property taxes and insurance 72 76
------------- -------------
Net cash used in financing activities (202) (4,806)
------------- -------------
Net increase (decrease) in cash and cash equivalents 391 (3,554)
Cash and cash equivalents at beginning of period 9,359 18,865
------------- -------------
Cash and cash equivalents at end of period $ 9,750 $ 15,311
============= =============
Payments are shown below for the following:
Interest $ 1,591 $ 1,583
============= =============
Income taxes $ 269 $ 54
============= =============
Noncash activities:
Unrealized gains (losses) on investment securities
available for sale $ 223 $ (313)
============= =============
Cash dividends declared but not paid $ 280 $ 225
============= =============
Cash dividends on unallocated ESOP shares $ 17 $ 15
============= =============
Transfer from loans to real estate acquired in settlement of loans $ 70 $ --
============= =============
See accompanying notes to the consolidated financial statements.
6
1st STATE BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003 (UNAUDITED) AND SEPTEMBER 30, 2003
NOTE 1. NATURE OF BUSINESS
1st State Bancorp, Inc. (the "Company") was incorporated under the laws of
the Commonwealth of Virginia for the purpose of becoming the holding company for
1st State Bank (the "Bank") in connection with the Bank's conversion from a
North Carolina-chartered mutual savings bank to a North Carolina-chartered stock
savings bank (the "Converted Bank") pursuant to its Plan of Conversion (the
"Stock Conversion"). Upon completion of the Stock Conversion, the Converted Bank
converted from a North Carolina-chartered stock savings bank to a North Carolina
commercial bank (the "Bank Conversion"), retaining the name 1st State Bank (the
"Commercial Bank"), and the Commercial Bank succeeded to all of the assets and
liabilities of the Converted Bank. The Stock Conversion and the Bank Conversion
were consummated on April 23, 1999. The common stock of the Company began
trading on the Nasdaq National Market System under the symbol "FSBC" on April
26, 1999.
NOTE 2. BASIS OF PRESENTATION
The accompanying consolidated financial statements (which are unaudited,
except for the consolidated balance sheet at September 30, 2003, which is
derived from the September 30, 2003 audited consolidated financial statements)
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information and with the
rules and regulations of the Securities and Exchange Commission. Accordingly,
they do not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements. In the opinion of management, all adjustments (none of
which were other than normal recurring accruals) necessary for a fair
presentation of the financial position and results of operations for the periods
presented have been included.
The results of operations for the three month period ended December 31,
2003 are not necessarily indicative of the results of operations that may be
expected for the year ended September 30, 2004. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires management to make certain estimates.
These amounts may be revised in future periods because of changes in the facts
and circumstances underlying their estimation.
Certain amounts in the December 31, 2002 consolidated financial statements
(which are unaudited) have been reclassified to conform with the presentation
adopted in 2003. Such reclassifications did not change net income or
stockholders' equity as previously reported.
NOTE 3. EARNINGS PER SHARE
For purposes of computing basic and diluted earnings per share, weighted
average shares outstanding excludes unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's common stock has no net impact on
the Company's earnings per share computations. Diluted earnings per share
includes the potentially dilutive effects of the Company's benefit plans. There
were no anti-dilutive stock options for the three months ended December 31, 2003
and 2002. A reconciliation of the denominators of the basic and diluted earnings
per share computations is as follows:
2003 2002
---------- ---------
Average shares issued and outstanding 2,969,258 3,002,877
Less: Unallocated ESOP shares (156,807) (187,229)
--------- ---------
Average basic shares for earnings per share 2,812,451 2,815,648
Add: Potential common stock pursuant to stock
option plan (See Note 6) 149,240 126,396
--------- ---------
Average dilutive shares for earnings per share 2,961,691 2,942,044
========= =========
7
NOTE 4. EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP")
The Company sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate number of shares amounting to 253,050 or 8% of the stock issued in
the conversion was purchased for future allocation to employees. The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock purchased by the ESOP. During the three
months ended December 31, 2003 and 2002, 7,360 and 7,728 shares of stock were
committed to be released and approximately $205,000 and $190,000 of compensation
expense was recognized, respectively.
NOTE 5. DEFERRED COMPENSATION
Directors and certain executive officers participate in a deferred
compensation plan, which was approved by the Board of Directors on September 24,
1997. This plan generally provides for fixed payments beginning after the
participant retires. Each participant is fully vested in his account balance
under the plan. Directors may elect to defer their directors' fees and executive
officers may elect to defer 25% of their salary and 100% of bonus compensation.
Prior to the Stock Conversion, amounts deferred by each participant
accumulated interest at a rate equal to the highest rate of interest paid on the
Bank's one-year certificates of deposit. In connection with the Stock
Conversion, participants in the plan were given the opportunity to prospectively
elect to have their deferred compensation balance earn a rate of return equal to
the total return of the Company's stock. All participants elected this option
concurrent with the Stock Conversion, so the Company purchases its common stock
to fund this obligation. Refer to the Company's notes to consolidated financial
statements, incorporated by reference in the Company's 2003 Annual Report on
Form 10-K for a discussion of the Company's accounting policy with respect to
this deferred compensation plan and the related treasury stock purchased by the
Company to fund this obligation.
The expense related to this plan for each of the three months ended
December 31, 2003 and 2002 was $60,000. This expense is included in compensation
expense.
NOTE 6. STOCK OPTION AND INCENTIVE PLAN
On June 6, 2000, the Company's stockholders approved the 1st State Bancorp,
Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of this plan
is to advance the interests of the Company through providing select key
employees and directors of the Bank with the opportunity to acquire shares. By
encouraging such stock ownership, the Company seeks to attract, retain and
motivate the best available personnel for positions of substantial
responsibility and to provide incentives to the key employees and directors.
Under the Plan, the Company granted 316,312 options to purchase its $0.01 par
value common stock. The exercise price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant, and all options expire 10 years
from the date of the grant. As a result of the one-time cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71. No options were exercised or granted during the three months ended
December 31, 2003 and 2002. At December 31, 2003, 316,312 options are
outstanding, all of which are exercisable.
NOTE 7. MORTGAGE SERVICING RIGHTS
The rights to service mortgage loans for others are included in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized based on the allocated cost which is determined when the underlying
loans are sold. MSRs are amortized over a period which approximates the life of
the underlying loan as an adjustment of servicing income. Impairment reviews of
MSRs are performed on a quarterly basis. As of December 31, 2003 and September
30, 2003, MSRs totaled $531,000 and $547,000, respectively, and no valuation
allowance was required.
Amortization expense totaled $29,000 and $42,000 for the three months ended
December 31, 2003 and 2002, respectively.
8
NOTE 8. STANDBY LETTERS OF CREDIT
In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", which addressed the disclosure
to be made by a guarantor in its interim and annual financial statements about
its obligations under guarantees. FIN 45 requires the guarantor to recognize a
liability for the non-contingent component of the guarantee, such as the
obligation to stand ready to perform in the event that specified triggering
events or conditions occur. The initial measurement of this liability is the
fair value of the guarantee at inception. The recognition of the liability is
required even if it is not probable that payments will be required under the
guarantee or if the guarantee was issued with a premium payment or as part of a
transaction with multiple events. The initial recognition and measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified after December 31, 2002. The Company issues standby letters of credit
whereby the Company guarantees performance if a specified triggering event or
condition occurs (primarily nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically renewed depending on the terms of the guarantee. The
maximum potential amount of undiscounted future payments related to standby
letters of credit at December 31, 2003 is $1.6 million. At December 31, 2003 the
Company has recorded no liability for the current carrying amount of the
obligation to perform as a guarantor and no contingent liability is considered
necessary as such amounts are deemed immaterial. Substantially all standby
letters of credit are secured by real estate and/or guaranteed by third parties
in the event the Company had to advance funds to fulfill the guarantee.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
When used in this Form 10-Q, the words or phrases "will likely result,"
"are expected to," "will continue," "is anticipated," "estimate," "project" or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties including changes in
economic conditions in our market area, changes in policies by regulatory
agencies, fluctuations in interest rates, demand for loans in our market area,
and competition that could cause actual results to differ materially from
historical earnings and those presently anticipated or projected. We wish to
caution you not to place undue reliance on any such forward-looking statements,
which speak only as of the date made. We wish to advise you that the factors
listed above could affect our financial performance and could cause our actual
results for future periods to differ materially from any opinions or statements
expressed with respect to future periods in any current statements.
We do not undertake, and specifically disclaim any obligation, to publicly
release the result of any revisions which may be made to any forward-looking
statements to reflect events or circumstances after the date of such statements
or to reflect the occurrence of anticipated or unanticipated events.
GENERAL
1st State Bancorp, Inc. was formed in November 1998 and became the holding
company for 1st State Bank on April 23, 1999.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of interest paid on
deposits and borrowed funds. Net interest income also is affected by the
relative amounts of interest-earning assets and interest-bearing liabilities.
When interest-earning assets approximate or exceed interest-bearing liabilities,
any positive interest rate spread will generate net interest income. Our
profitability is also affected by the level of other income and operating
expenses. Other income consists of miscellaneous fees related to our loans and
deposits, mortgage banking income and commissions from sales of annuities and
mutual funds. Operating expenses consist of compensation and benefits, occupancy
related expenses, federal deposit insurance premiums, data processing,
advertising and other expenses.
9
Our operations are influenced significantly by local economic conditions
and by policies of financial institution regulatory authorities. Our cost of
funds is influenced by interest rates on competing investments and by rates
offered on similar investments by competing financial institutions in our market
area, as well as general market interest rates. These factors can cause
fluctuations in our net interest income and other income. Lending activities are
affected by the demand for financing of real estate and other types of loans,
which in turn is affected by the interest rates at which such financing may be
offered. In addition, local economic conditions can impact the credit risk of
our loan portfolio, in that local employers may be required to eliminate
employment positions of many of our borrowers, and small businesses and other
commercial borrowers may experience a downturn in their operating performance
and become unable to make timely payments on their loans. Management evaluates
these factors in estimating its allowance for loan losses, and changes in these
economic conditions could result in increases or decreases to the provision for
loan losses.
Our business emphasis has been to operate as a well capitalized, profitable
and independent community-oriented financial institution dedicated to providing
quality customer service. We are committed to meeting the financial needs of the
communities in which we operate. We believe that we can be more effective in
servicing our customers than many of our nonlocal competitors because of our
ability to quickly and effectively provide senior management responses to
customer needs and inquiries. Our ability to provide these services is enhanced
by the stability of our senior management team.
Over the years, we have sought to gradually increase the percentage of our
assets invested in commercial real estate loans, commercial loans and consumer
loans, which have shorter terms and adjust more frequently to changes in
interest rates than single-family residential mortgage loans. These loans
generally carry added risk when compared to a single family residential mortgage
loan, so we have concurrently increased our allowance for loan losses as we have
originated these loans.
Due to a general slowdown in the economy beginning in 2000, the Federal
Reserve acted to provide a stimulus through a series of interest rate reductions
that lowered the prime rate from 9.50% in January 2001 to 4.00% in June 2003.
These reductions in prime rate tended to negatively impact the Company's net
interest margin and net interest spread which resulted in lower net interest
income for the Company. The Company's asset growth has been slower as a result
of heavy refinancing as customers have taken advantage of these attractive
interest rates. The fee income associated with the heavy refinancing volume has
replaced some of the lost net interest income. Now that the refinancing activity
has slowed, the Company is looking to replace lost net interest income possibly
with leverage strategies. During periods of slow loan demand, the Company
purchases more investments, and the Company uses short-term borrowings as an
alternative to deposits for funding certain assets.
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are set forth in Note 1 of
the consolidated financial statements as of September 30, 2003 which was filed
on Form 10-K. Of these significant accounting policies, the Company considers
its policy regarding the allowance for loan losses to be its most critical
accounting policy, because it requires management's most subjective and complex
judgments. In addition, changes in economic conditions can have a significant
impact on the allowance for loan losses and therefore the provision for loan
losses and results of operations. The Company has developed appropriate policies
and procedures for assessing the adequacy of the allowance for loan losses,
recognizing that this process requires a number of assumptions and estimates
with respect to its loan portfolio. 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.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND SEPTEMBER 30, 2003
Total assets were relatively flat from September 30, 2003 to December 31,
2003. Assets decreased $345,000 to $362.4 million at December 31, 2003 from
$362.7 million at September 30, 2003. Increases in loans receivable, net and
loans held for sale were offset by decreases in investment securities. Deposits
decreased by $6.3 million or 2.4% from $262.7 million at September 30, 2003 to
$256.4 million at December 31,2003. This decrease resulted from the runoff of
$5.4 million of certificates of deposits held by municipalities which were
replaced with short-term borrowings from the Federal Home Loan Bank of Atlanta.
10
Investment securities available for sale decreased $4.2 million from $91.1
million at September 30, 2003 to $86.9 million at December 31, 2003. During the
quarter ended December 31, 2003, we purchased $15.8 million of securities and
received $21.0 million in proceeds from sales, maturities and issuer calls of
investment securities available for sale. Investment securities held to maturity
increased $2.4 million from $19.5 million at September 30, 2003 to $21.8 million
at December 31, 2003. During the quarter ended December 31, 2003, we purchased
$2.4 million of securities.
Loans held for sale increased to $1.2 million at December 31, 2003 from
$645,000 at September 30, 2003. Loans receivable, net increased from $225.7
million at September 30, 2003 to $226.3 million at December 31, 2003. The
increase in loans held for sale resulted from timing differences in the funding
of loan sales. During the quarter, mortgage originations were considerably
slower than in previous quarters as refinance activity slowed down in response
to higher mortgage interest rates. During the quarter ended December 31, 2003,
the Company saw growth in commercial loans and equity lines.
Stockholders' equity increased by $657,000 from $62.7 million at September
30, 2003 to $63.4 million at December 31, 2003 as a result of net income of
$758,000, release of ESOP shares of $205,000 and a decrease in unrealized loss
on available for sale securities of $135,000. These increases were partially
offset by cash dividends to stockholders declared of $280,000 and purchases of
treasury stock of $161,000.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND
2002
NET INCOME. We recorded net income of $758,000 for the quarter ended
December 31, 2003, as compared to $983,000 for the quarter ended December 31,
2002, representing a decrease of $225,000, or 22.9%. For the three months ended
December 31, 2003, basic and diluted earnings per share were $0.27 and $0.26,
respectively, compared to the basic and diluted earnings per share for the
quarter ended December 31, 2002 of $0.35 and $0.33, respectively. The decrease
in net income resulted primarily from decreased net interest income and
decreased other income that were offset partially by decreased operating
expenses and decreased income tax expense. The decrease in net interest income
resulted from lower net interest margins. The average prime interest rate for
the quarter ended December 31, 2003 was 4.00%, a decrease of 46 basis points
from 4.46% which was the average prime for the quarter ended December 31, 2002.
The repricing of loans and investments decreased the Company's average asset
yield by 86 basis points whereas the average cost of funds decreased only 61
basis points during the quarter ended December 31, 2003.
NET INTEREST INCOME. Net interest income, the difference between interest
earned on loans and investments and interest paid on interest-bearing
liabilities, decreased by $188,000 or 6.3% for the three months ended December
31, 2003, compared to the same quarter in the prior year. This decrease results
from a $520,000 decrease in interest income that was partially offset by the
$332,000 decrease in total interest expense. The average net interest rate
spread decreased 25 basis points from 3.23% for the three months ended December
31, 2002 to 2.98% for the quarter ended December 31, 2003.
INTEREST INCOME. The decrease in interest income for the three months ended
December 31, 2003 was the result of a decrease in yield on interest-earning
assets of 86 basis points from 5.63% for the three months ended December 31,
2002 to 4.77% for the three months ended December 31, 2003. This decrease was
partially offset by an increase of $14.9 million in average interest-earning
assets compared to the same quarter in the prior year . Average investment
securities increased $25.1 million, interest-bearing overnight funds decreased
$8.9 million and average loans receivable decreased $1.2 million. The increase
in average interest-earning assets increased interest income by approximately
$292,000 and the decrease in the average asset yield decreased interest income
by approximately $812,000.
INTEREST EXPENSE. Interest expense decreased in the three months ended
December 31, 2003 due to a decrease in the cost of interest-bearing liabilities
of 61 basis points from 2.40% for the three months ended December 31, 2002 to
1.79% for the three months ended December 31, 2003. This decrease was partially
offset by an increase in average interest-bearing liabilities of $15.3 million.
Average interest-bearing deposits increased by $2.1 million while average FHLB
advances increased $13.2 million for the three months ended December 31, 2003
compared to the same quarter in the prior year. The increase in average
interest-bearing liabilities increased interest expense by approximately
$191,000 and the decrease in the average cost of interest-bearing liabilities
decreased interest expense by approximately $523,000.
11
The following table presents average balances and average rates earned/paid
by the Company for the quarter ended December 31, 2003 compared to the quarter
ended December 31, 2002.
Three Months Ended Three Months Ended
December 31, 2003 December 31, 2002
------------------------------------ -----------------------------------
(Dollars in Thousands)
Average Average Average Average
Balance Interest Yield/Cost Balance Interest Yield/Cost
------- -------- ----------- ------- -------- ----------
Assets:
Loans receivable (1) $ 225,723 $ 2,854 5.06% $ 226,969 $3,372 5.94%
Investment securities (2) 109,942 1,184 4.31 84,869 1,152 5.43
Interest-bearing overnight deposits 4,013 9 0.91 12,928 43 1.33
---------- --------- ---- --------- ------ ----
Total interest-earning assets (4) 339,678 4,047 4.77 324,766 4,567 5.63
Non interest-earning assets 20,406 19,192
---------- ---------
Total assets $ 360,084 $ 343,958
========== =========
Liabilities and stockholders' equity
Interest bearing checking 36,102 19 0.21 33,712 39 0.46
Money market investment accounts 19,599 33 0.68 21,595 58 1.08
Passbook and statement savings 30,352 47 0.62 29,208 81 1.11
Certificates of deposit 157,108 820 2.09 156,527 1,113 2.84
FHLB advances 33,429 316 3.78 20,272 276 5.46
---------- --------- ---- --------- ------ ----
Total interest-bearing liabilities 276,590 1,235 1.79 261,314 1,567 2.40
Non interest-bearing liabilities 20,594 ---- 20,770 ----
---------- ---------
Total liabilities 297,184 282,084
Stockholders' equity 62,900 61,874
---------- ---------
Total liabilities and stockholders' equity $ 360,084 $ 343,958
========== =========
Net interest income $ 2,812 $3,000
========= ======
Interest rate spread 2.98% 3.23%
==== ====
Net interest margin (3) 3.31% 3.69%
==== ====
Ratio of average interest-earning assets to
average interest-bearing liabilities 122.81% 124.28%
====== ======
- ---------
(1) Includes nonaccrual loans and loans held for sale, net of discounts and
allowance for loan losses.
(2) Includes FHLB of Atlanta stock.
(3) Represents net interest income divided by the average balance of
interest-earning assets.
(4) Due to immateriality, the interest income and yields related to certain tax
exempt assets have not been adjusted to reflect a fully taxable equivalent
yield.
PROVISION FOR LOAN LOSSES. We charge provisions for loan losses to earnings
to maintain the total allowance for loan losses at a level we consider adequate
to provide for probable loan losses, based on existing loan levels and types of
loans outstanding, nonperforming loans, prior loss experience, general economic
conditions and other factors. We estimate the allowance using an allowance for
loan losses model which takes into considerations all of these factors. Our
policies require the review of assets on a regular basis, and we assign risk
grades to loans based on the relative risk of the credit, considering such
factors as repayment experience, value of collateral, guarantors, etc. Our
credit management systems have resulted in low loss experience; however, there
can be no assurances that such experience will continue. We believe we use the
best information available to make a determination with respect to the allowance
for loan losses, recognizing that future adjustments may be necessary depending
upon a change in economic conditions. The provision for loan losses was $60,000
and net charge-offs were $48,000 for the year quarter December 31, 2003 compared
with a provision of $60,000, and net charge-offs of $2,000 for the quarter ended
December 31, 2002. Nonperforming loans at December 31, 2003 and September 30,
2003 were $4.1 million and $4.2 million, respectively. The majority of the
non-performing loans resulted from three unrelated, distinct credits which are
not necessarily indicative of the credit quality of the entire portfolio. There
was no significant impact on the provision as these loans are well secured by
property and
12
equipment. The Company made no significant changes to the allowance for loan
losses methodology during the period which impacted the provision for loan
losses.
OTHER INCOME. Other income decreased $234,000, or 30.8%, from $760,000 for
the quarter ended December 31, 2002 to $526,000 for the quarter ended December
31, 2003. Mortgage banking, net decreased $326,000 from $401,000 for the quarter
ended December 31, 2002 to $98,000 for the quarter ended December 31, 2003. This
decrease results from a decrease in volume of mortgage loan originations and
sales. We sold loans totaling $6.8 million in the quarter ended December 31,
2003 compared with sales of $24.8 million in the previous year. The increase in
mortgage interest rates slowed the volume of mortgage originations and sales.
Given the current level of mortgage interest rates, the Company believes that
mortgage banking income will continue to decrease in future quarters due to
lower refinancing activity. The Company recorded gains on sales of investments
of $97,000 in the quarter ended December 31, 2003 which were not present in the
prior year.
OPERATING EXPENSES. Total operating expenses were $2.1 million for both the
quarters ended December 31, 2003 and 2002. Expenses incurred in operating real
estate owned were $6,000 for the three months ended December 31, 2002 compared
to income of $3,000 for the quarter ended December 31, 2003. The Company has
been able to control expenses during this period of slower asset growth.
INCOME TAX EXPENSE. Income tax expense decreased $154,000 from tax expense
of $571,000 for the quarter ended December 31, 2002 to $417,000 for the quarter
ended December 31, 2003. The effective tax rates were 35.5% and 36.7% for the
quarters ended December 31, 2003 and 2002, respectively. The decrease in the
effective rate was primarily due to an increase in the ratio of state
non-taxable income as a percentage of net income before taxes.
COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk
including commitments to extend credit under existing lines of credit and
commitments to sell loans. These instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheets.
Off-balance sheet financial instruments whose contract amounts represent
credit and interest rate risk are summarized as follows:
December 31, 2003 September 30, 2003
----------------- ------------------
(Dollars in thousands)
Commitments to originate new loans 4,927 1,552
Commitments to originate new loans held for sale 154 278
Unfunded commitments to extend credit under existing
equity line and commercial lines of credit 59,083 57,237
Commercial letters of credit 1,642 326
Commitments to sell loans held for sale 1,839 1,630
The Company does not have any special purpose entities or other similar
forms of off-balance sheet financing arrangements.
The increase in commitments at December 31, 2003 are the result of $4.6
million of commitments to originate commercial loans compared to $1.2 million at
September 30, 2003. These commitments are not indicative of any future upward
trend in volume.
Commitments to originate new loans or to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Loan commitments generally expire within 30 to 45 days. Most
equity line commitments are for a term of 15 years, and commercial lines of
credit are generally renewable on an annual basis. Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee. Since many of the commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements. The Company evaluates each customer's
13
creditworthiness on a case-by-case basis. The amounts of collateral obtained, if
deemed necessary by the Company upon extension of credit, is based on
management's credit evaluation of the borrower.
Commitments to sell loans held for sale are agreements to sell loans to a
third party at an agreed upon price. At December 31, 2003, the aggregate fair
value of these commitments exceeded the book value of the loans to be sold.
CONTRACTUAL OBLIGATIONS
As of December 31, 2003
PAYMENTS DUE BY PERIOD
----------------------
(DOLLARS IN THOUSANDS)
LESS THAN
1 YEAR 1-3 YEARS 4-5 YEARS OVER 5 YEARS TOTAL
--------- --------- --------- ------------ -----
Deposits $225,899 20,021 10,459 -- 256,379
Advances from FHLB 18,000 -- -- 20,000 38,000
Lease obligations 18 41 42 26 127
-------- ------ ------ ------ -------
Total contractual cash
obligations $243,917 20,062 10,501 20,026 294,506
======== ====== ====== ====== =======
ASSET QUALITY
At December 31, 2003, the Company had approximately $4.3 million in
nonperforming assets (nonaccrual loans and real estate owned) or 1.19% of total
assets. At September 30, 2003, nonperforming assets were $4.2 million or 1.17%
of total assets. At both December 31, 2003 and September 30, 2003, impaired
loans totaled $3.8 million, as defined by Statement of Financial Accounting
Standards No. 114, "Accounting by Creditors for Impairment of a Loan." The
impaired loans at December 31, 2003 and September 30, 2003 result from three
unrelated commercial loan customers, both of which have loans secured by
commercial real estate and business assets in Alamance County. At both December
31, 2003 and September 30, 2003, the entire $3.8 million of the impaired loans
are on non-accrual status, and their related reserve for loan losses totaled
$235,000. The average carrying value of impaired loans was $3.8 million during
the three months ended December 31, 2003. Interest income of $41,000 has been
recorded on impaired loans in the three months ended December 31, 2003. The
Bank's net chargeoffs for the three months ended December 31, 2003 were $48,000.
The Bank's allowance for loan losses was $3.9 million at both December 31, 2003
and September 30, 2003 and the ratio of the allowance for loan losses to total
loans, net of loans in process and deferred loan fees was 1.68% at both December
31, 2003 and September 30, 2003.
The following table presents an analysis of our nonperforming assets:
AT AT AT
DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
2003 2003 2002
------------ -------------- ------------
Nonperforming loans:
Nonaccrual loans $ 4,057 $ 4,153 $ 4,659
Loans 90 days past due and accruing -- -- --
Restructured loans -- -- --
------------- -------------- -----------
Total nonperforming loans 4,057 4,153 4,659
Other real estate 273 95 183
------------- -------------- -----------
Total nonperforming assets $ 4,330 $ 4,248 $ 4,842
============= ============== ===========
Nonperforming loans to loans receivable, net 1.79% 1.84% 2.12%
Nonperforming assets as a percentage
of loans and other real estate owned 1.91% 1.88% 2.20%
Nonperforming assets to total assets 1.19% 1.17% 1.40%
14
Regulations require that we classify our assets on a regular basis. There
are three classifications for problem assets: substandard, doubtful and loss. We
regularly review our assets to determine whether any assets require
classification or re-classification. At December 31, 2003, we had $4.9 million
in classified assets consisting of $4.6 million in substandard loans and
$273,000 in real estate owned. At September 30, 2003, we had $4.9 million in
substandard assets consisting of $4.8 million in loans and $95,000 in real
estate owned. At December 31, 2002, we had $5.4 million in substandard assets
consisting of $5.2 million in loans and $183,000 in real estate owned.
In addition to regulatory classifications, we also classify as "special
mention" and "watch" assets that are currently performing in accordance with
their contractual terms but may become classified or nonperforming assets in the
future. At December 31, 2003, we have identified approximately $935,000 in
assets classified as special mention and $34.7 million as watch. At December 31,
2002, we had identified approximately $1.2 million in assets classified as
special mention and $30.6 million as watch.
Included in the total of watch list assets are five loans with an aggregate
outstanding balance of $4.3 million at December 31, 2003 to a company affiliated
with one of our directors. In addition, the director has the ability to borrow
an additional $392,000 from us under a line of credit. At September 30, 2003,
the aggregate outstanding balance was $4.5 million with additional availability
of $172,000. All the loans are secured by a first lien on all assets, including
accounts receivable, inventory, equipment, furniture and real property occupied
by the borrower. In addition, the director and his spouse have personally
guaranteed repayment of the loans. At December 31, 2003, such loans were current
with respect to their payment terms and, except for the waiver of certain debt
covenants by the Bank, were performing in accordance with the related loan
agreements. Based on an analysis of the borrower's current financial statements
received in December 2003, management has concerns that the borrower may have
difficulty in complying with the present loan repayment terms on an ongoing
basis. Accordingly, this loan may become an impaired loan in future periods.
Management will continue to closely monitor the performance of these loans in
future periods.
LIQUIDITY AND CAPITAL RESOURCES
The Bank must meet certain liquidity requirements established by the State
of North Carolina Office of the Commissioner of Banks (the "Commissioner"). At
December 31, 2003, the Bank's liquidity ratio exceeded such requirements.
Liquidity generally refers to the Bank's ability to generate adequate amounts of
funds to meet its cash needs. Adequate liquidity guarantees that sufficient
funds are available to meet deposit withdrawals, fund loan commitments, maintain
adequate reserve requirements, pay operating expenses, provide funds for debt
service, pay dividends to stockholders and meet other general commitments.
Our primary sources of funds are deposits, principal and interest payments
on loans, proceeds from the sale of loans, and to a lesser extent, advances from
the FHLB of Atlanta. While maturities and scheduled amortization of loans are
predictable sources of funds, deposit flows and mortgage prepayments are greatly
influenced by general interest rates, economic conditions and local competition.
Our most liquid assets are cash and cash equivalents. The levels of these
assets are dependent on our operating, financing, lending and investing
activities during any given period. At December 31, 2003, cash and cash
equivalents totaled $9.8 million. We have other sources of liquidity should we
need additional funds. During the three months ended December 31, 2003, we sold
loans totaling $6.8 million. Additional sources of funds include FHLB of Atlanta
advances. Other sources of liquidity include loans and investment securities
designated as available for sale, which totaled $88.0 million at December 31,
2003.
We anticipate that we will have sufficient funds available to meet our
current commitments. At December 31, 2003, we had $5.1 million in commitments to
originate new loans, $59.1 million in unfunded commitments to extend credit
under existing equity lines and commercial lines of credit and $1.6 million in
standby letters of credit. At December 31, 2003, certificates of deposit, which
are scheduled to mature within one year, totaled $125.0 million. We believe that
a significant portion of such deposits will remain with us.
The Federal Deposit Insurance Corporation ("FDIC") requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%. The FDIC also requires the Bank to meet a ratio of total capital to
risk-weighted assets of 8%, of which 4% must be in the form of Tier I capital.
The Commissioner requires the Bank at
15
all times to maintain certain minimum capital levels. The Bank was in compliance
with all capital requirements of the FDIC and the Commissioner at December 31,
2003 and is deemed to be "well capitalized."
The Federal Reserve also mandates capital requirements on all bank holding
companies, including 1st State Bancorp, Inc. These capital requirements are
similar to those imposed by the FDIC on the Bank. At December 31, 2003, the
Company was in compliance with the capital requirements of the Federal Reserve.
On October 2, 2000, the Company paid a one-time special cash distribution
of $5.17 per share to its stockholders. The distribution was made to manage the
Company's capital and enhance shareholder value. Returning capital to the
stockholders reduced the Company's equity to asset ratio from 21.2% to 17.2%.
The Company's equity to asset ratio at December 31, 2003 was 17.5%. The
Company's capital level is sufficient to support future growth.
The Company has declared cash dividends per common share of $0.10, $0.10
and $0.08 for each of the three months ended December 31, 2003, September 30,
2003 and December 31, 2002, respectively. The Company's ability to pay dividends
is dependent upon earnings. The Company's dividend payout ratio for the three
months ended December 31, 2003, September 30, 2003 and December 31, 2003 was
38.5%, 31.2% and 24.2%, respectively.
ACCOUNTING MATTERS
In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", which addresses the disclosure
to be made by a guarantor in its interim and annual financial statements about
its obligations under guarantees. FIN 45 requires the guarantor to recognize a
liability for the non-contingent component of the guarantee, such as the
obligation to stand ready to perform in the event that specified triggering
events or conditions occur. The initial measurement of this liability is the
fair value of the guarantee at inception. The recognition of the liability is
required even if it is not probable that payments will be required under the
guarantee or if the guarantee was issued with a premium payment or as part of a
transaction with multiple events. The disclosure requirements are effective for
interim and annual financial statements ending after December 15, 2002. The
initial recognition and measurement provisions are effective for all guarantees
within the scope of FIN 45 issued or modified after December 31, 2002. The
Company issues standby letters of credit whereby the Company guarantees
performance if a specified triggering event or condition occurs (primarily
nonperformance under construction contracts entered into by construction
customers.) The guarantees generally expire within one year and may be
automatically renewed depending on the terms of the guarantee. The maximum
potential amount of undiscounted future payments related to standby letters of
credit at December 31, 2003 is $1.6 million. At September 30, 2003, the Company
has recorded no liability for the current carrying amount of the obligation to
perform as a guarantor and no contingent liability is considered necessary, as
such amounts are deemed immaterial. Substantially all standby letters of credit
are secured by real estate and/or guaranteed by third parties in the event the
Company had to advance funds to fulfill the guarantee.
In a recent speech regarding loan commitments related to the origination of
mortgage loans that will be held for sale, the SEC staff has indicated that the
practice of recognizing assets, and no liabilities, should be discontinued. In
view of the ongoing discussions and the nature of this particular issue, the SEC
staff would not object if registrants discontinue this practice beginning with
commitments entered into in the first reporting period beginning after March 31,
2004. Any previously recognized loan commitments should be taken care of in the
normal course of closing loans in the mortgage pipeline. The Company is
evaluating the impact of this accounting change on the consolidated financial
statements.
In January 2003, FASB Interpretation No. 46, "Consolidation of Variable
Interest Entities, an interpretation of ARB No. 51", (Interpretation 46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the Interpretation. Interpretation 46
applies immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable interests in variable interest entities
obtained after January 31, 2003.
In December 2003, the FASB issued FASB Interpretation No. 46 (revised
December 2003), "Consolidation of Variable Interest Entities", which addresses
how a business enterprise should evaluate whether it has a controlling financial
interest in an entity through means other than voting rights and accordingly
should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities", which was issued in January 2003.
The Company will be required to apply FIN 46R to variable interests in VIEs
16
created after December 31, 2003. The application of this revised interpretation
is not expected to have a material effect on the consolidated financial
statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the possible chance of loss from unfavorable changes in
market prices and rates. These changes may result in a reduction of current and
future period net interest income, which is the favorable spread earned from the
excess of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.
The Company considers interest rate risk to be its most significant market
risk, which could potentially have the greatest impact on operating earnings.
The structure of the Company's loan and deposit portfolios is such that a
significant decline in interest rates may adversely impact net market values and
net interest income.
The Company monitors whether material changes in market risk have occurred
since September 30, 2003. The Company does not believe that any material adverse
changes in market risk exposures occurred since September 30, 2003.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management of the
Company carried out an evaluation, under the supervision and with the
participation of the Company's principal executive officer and principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by the Company in reports that it files or submits under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported, within the time periods specified in the Securities and Exchange
Commission's rules and forms. It should be noted that the design of the
Company's disclosure controls and procedures is based in part upon certain
reasonable assumptions about the likelihood of future events, and there can be
no reasonable assurance that any design of disclosure controls and procedures
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote, but the Company's principal executive and
financial officers have concluded that the Company's disclosure controls and
procedures are, in fact, effective at a reasonable assurance level.
In addition, there have been no changes in the Company's internal control
over financial reporting identified in connection with the evaluation described
in the above paragraph that occurred during the Company's last fiscal quarter,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
17
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time, we are a party to various legal proceedings incident to
our business. There currently are no legal proceedings to which we are a party,
or to which any of our property was subject, except as described in the
following paragraph, and none which are expected to result in a material loss.
There are no pending regulatory proceedings to which we are a party or to which
any of our properties is subject which are expected to result in a material
loss.
A civil action was filed against 1st State Bank and Brokers, Incorporated
by Michael Locklar in Davidson County Superior Court, in the State of North
Carolina on May 16, 2003. Mr. Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County, North Carolina, which 1st State Bank wrongfully sold to Brokers,
Incorporated for $150,000 in breach of the option granted to Mr. Locklar. Mr.
Locklar is seeking to set aside the conveyance of property to Brokers,
Incorporated and to purchase the property from 1st State Bank for the option
price. Brokers, Incorporated has filed a cross-claim against 1st State Bank
seeking indemnification in the form of return of the purchase price they paid
for the property, damages and attorneys fees should Locklar be successful in
setting aside the real estate conveyance. 1st State Bank intends to vigorously
contest Mr. Locklar's allegations.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
EQUITY SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS.
---------
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Certification Pursuant to 18 U.S.C. Section 1350 as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) REPORTS ON FORM 8-K.
--------------------
The Registrant filed the following Current Reports on Form 8-K during
the quarter ended December 31, 2003:
Date of Report Item(s) Reported Financial Statements Filed
-------------- ---------------- --------------------------
October 27, 2003 7, 12 N/A
18
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
1st STATE BANCORP, INC.
/s/ James C. McGill
Date: February 13, 2004 ----------------------------------------
James C. McGill
President and Chief Executive Officer
(Principal Executive Officer)
/s/ A. Christine Baker
Date: February 13, 2004 ----------------------------------------
A. Christine Baker
Executive Vice President
Treasurer and Secretary
(Principal Financial and Accounting
Officer)
19