SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10 - Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003
Commission File Number: 0-13086
FNB FINANCIAL SERVICES CORPORATION
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(Exact name of registrant as specified in its charter)
North Carolina 56 - 1382275
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
202 South Main Street, Reidsville, North Carolina 27320
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(Address of principal executive offices) (Zip Code)
(336) 342-3346
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(Registrant's telephone number, including area code)
Not Applicable
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(Former name, former address, and former fiscal years, 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 [X] No [ ]
4,391,281 common shares were outstanding as of October 31, 2003, with a par
value per share of $1.00.
FNB FINANCIAL SERVICES CORPORATION
FORM 10-Q
INDEX
Page
PART I FINANCIAL INFORMATION
Item 1 Financial Statements
Consolidated Balance Sheets
September 30, 2003 and December 31, 2002 3
Consolidated Statements of Income and Comprehensive Income Three and
Nine Months Ended September 30, 2003 and 2002 4
Consolidated Statements of Cash Flows
Nine months ended September 30, 2003 and 2002 5
Notes to Consolidated Financial Statements 7
Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations 13
Item 3 Quantitative and Qualitative Disclosures About Market Risk 18
Item 4 Controls and Procedures 20
PART II OTHER INFORMATION
Item 1 Legal Proceedings 20
Item 2 Changes in Securities and Use of Proceeds 20
Item 3 Defaults Upon Senior Securities 20
Item 4 Submission of Matters to a Vote of Security Holders 20
Item 5 Other Information 20
Item 6 Exhibits and Reports on Form 8 - K 20
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
FNB FINANCIAL SERVICES CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands except per share data)
September 30, December 31,
2003 2002
(Unaudited) (Audited)
------------- -------------
ASSETS
Cash and due from banks $ 22,277 $ 24,524
Investment securities:
Securities available for sale 147,208 125,084
Federal Home Loan Bank and Federal Reserve Bank Stock 3,232 3,732
Loans, net of allowance for credit losses of $7,071 at
September 30, 2003 and $7,059 at December 31, 2002 555,671 556,541
Premises and equipment, net 12,843 10,916
Accrued income and other assets 20,696 13,235
------------- -------------
Total assets $ 761,927 $ 734,032
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest bearing $ 66,958 $ 61,651
Interest bearing 566,594 543,354
------------- -------------
Total deposits 633,552 605,005
Federal funds purchased and retail repurchase agreements 12,840 8,258
Other borrowings 47,500 52,500
Accrued expenses and other liabilities 3,635 3,936
------------- -------------
Total liabilities 697,527 669,699
------------- -------------
Shareholders' Equity:
Preferred stock no par value; authorized 10,000,000 shares;
none issued -- --
Common stock, $1.00 par value; authorized 40,000,000 shares;
outstanding 4,394,231 at September 30, 2003 and
4,467,239 at December 31, 2002 4,394 4,467
Paid-in capital 22,411 23,833
Retained earnings 38,156 34,549
Accumulated other comprehensive income (loss) (561) 1,484
------------- -------------
Total shareholders' equity 64,400 64,333
------------- -------------
Total liabilities and shareholders' equity $ 761,927 $ 734,032
============= =============
See notes to unaudited consolidated financial statements.
3
FNB FINANCIAL SERVICES CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(Unaudited; dollars in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Interest income
Loans $ 9,054 $ 9,416 $ 27,153 $ 27,658
Federal funds sold and overnight deposits 27 107 68 150
Investment securities
Taxable 879 1,235 3,148 3,987
Tax exempt 329 50 759 243
Other 34 58 129 177
----------- ---------- ---------- ----------
Total interest income 10,323 10,866 31,257 32,215
----------- ---------- ---------- ----------
Interest expense
Deposits 3,770 4,437 11,866 13,578
Federal funds purchased and other borrowings 348 431 1,166 1,103
----------- ---------- ---------- ----------
Total interest expense 4,118 4,868 13,032 14,681
----------- ---------- ---------- ----------
Net interest income 6,205 5,998 18,225 17,534
Provision for credit losses 303 250 1,080 1,215
----------- ---------- ---------- ----------
Net interest income after provision for credit losses 5,902 5,748 17,145 16,319
Noninterest income
Service charges on deposit accounts 959 783 2,590 2,028
Net gain on sales of securities 0 -- 562 318
Net gain on disposition of asset 0 -- 0 104
Investment services fees 179 51 422 197
Mortgage banking fees 719 318 1,664 760
Other income 154 100 334 323
----------- ---------- ---------- ----------
Total noninterest income 2,011 1,252 5,572 3,730
Noninterest expense
Salaries and employee benefits 2,625 2,437 7,751 7,373
Occupancy expense 298 291 856 820
Furniture and equipment expense 638 458 1,746 1,437
Insurance expense, including FDIC assessment 38 55 134 152
Marketing expense 194 80 376 199
Printing and supply expense 118 100 328 329
Other expenses 1,101 616 3,191 2,635
----------- ---------- ---------- ----------
Total noninterest expense 5,012 4,037 14,382 12,945
Income before income taxes 2,901 2,963 8,335 7,104
Income tax expense 965 1,032 2,875 2,386
----------- ---------- ---------- ----------
Net income 1,936 1,931 5,460 4,718
Other comprehensive income (loss) (2,187) 83 (2,045) (4
----------- ---------- ---------- ----------
Comprehensive income (loss) $ (249) $ 2,014 $ 3,415 $ 4,714
=========== ========== ========== ==========
Per share data
Net income, basic $ 0.44 $ 0.43 $ 1.23 $ 1.03
Net income, diluted $ 0.42 $ 0.42 $ 1.19 $ 1.01
Cash dividends $ 0.14 $ 0.13 $ 0.42 $ 0.39
Weighted average shares outstanding, basic 4,399,919 4,549,869 4,436,949 4,587,011
Weighted average shares outstanding, diluted 4,570,652 4,658,277 4,577,517 4,682,293
See notes to unaudited consolidated financial statements.
4
FNB FINANCIAL SERVICES CORPORATION AND SUBSIDIARy
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; dollars in thousands)
Nine Months Ended
September 30,
---------------------------
2003 2002
----------- ------------
Cash flows from operating activities:
Interest received $ 28,893 $ 32,645
Fees and commissions received 7,556 3,658
Interest paid (13,378) (14,914)
Noninterest expense paid (14,069) (12,369)
Income taxes paid (2,769) (2,752)
Funding of loans held for sale (93,800) (18,824)
Proceeds from sales of loans held for sale 93,243 18,964
----------- ------------
Net cash provided by operating activities 5,676 6,408
----------- ------------
Cash flows from investing activities:
Proceeds from sales or calls of securities available for sale 94,373 55,318
Proceeds from maturities of securities available for sale 3,300 --
Purchases of securities (120,618) (49,587)
Capital expenditures (3,022) (369)
Increase in other real estate owned (2,498) (1,319)
(Increase) decrease in gross loans 1,886 (18,831)
----------- ------------
Net cash used in investing activities (26,579) (14,788)
----------- ------------
Cash flows from financing activities:
Increase (decrease) in demand, savings and interest
checking accounts 12,192 (1,749)
Increase in time deposits 16,354 6,521
Decrease in federal funds purchased and
retail repurchase agreements (1,542) (11,751)
Increase (decrease) in other borrowings (5,000) 22,500
Proceeds from issuance of common stock 415 1,200
Repurchase of common stock (1,910) (3,450)
Dividends paid (1,853) (1,783)
----------- ------------
Net cash provided by financing activities 18,656 11,488
----------- ------------
Net increase (decrease) in cash and cash equivalents (2,247) 3,108
Cash and cash equivalents, January 1 24,524 23,673
----------- ------------
Cash and cash equivalents, September 30 $ 22,277 $ 26,781
=========== ============
Supplemental disclosure of non-cash transactions:
Non-cash transfers from loans to other real estate $ 1,585 $ 1,526
=========== ============
See notes to unaudited consolidated financial statements.
5
FNB FINANCIAL SERVICES CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; dollars in thousands)
Reconciliation of net income to net cash provided by operating activities:
Nine Months Ended
September 30,
---------------------
2003 2002
---------- --------
Net income $ 5,460 $ 4,718
Adjustments to reconcile net income to net cash provided by operating
activities:
Provision for credit losses 1,080 1,215
Depreciation 1,135 961
Accretion and amortization 610 131
Gain on sales of securities available for sale (562) (318)
Funding of loans held for sale (93,800) (18,824)
Proceeds from sales of loans held for sale 93,243 18,964
Gain on other assets (4) (104)
(Increase) decrease in accrued income and other assets (1,185) 252
Decrease in accrued expenses and other liabilities (301) (587)
---------- ---------
Net cash provided by operating activities $ 5,676 $ 6,408
========== =========
See notes to unaudited consolidated financial statements.
6
FNB FINANCIAL SERVICES CORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles and with
the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
these statements do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation have been included.
Operating results for the nine-month period ended September 30, 2003 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003.
2. Significant Activities
FNB Financial Services Corporation (the "Company") is a North Carolina
financial holding company. The Company's wholly owned subsidiary, FNB Southeast
(the "Bank"), is a North Carolina chartered commercial bank. As of September 30,
2003, the Bank operated thirteen banking offices in North Carolina and five
banking offices in Virginia. The Bank has two wholly owned subsidiaries; FNB
Southeast Investment Services, Inc., which operated three offices, and FNB
Southeast Mortgage Corporation, which operated seven offices. The Company and
the Bank are headquartered in Reidsville, North Carolina.
3. New Accounting Pronouncements
During 2003, the Securities and Exchange Commission has promulgated rules
to implement several provisions of the Sarbanes-Oxley Act of 2002. These rules
included conditions for using financial measures that excluded information that
would be required under generally accepted accounting principles, ("non-GAAP
financial measures"). Additionally, new rules expand the number of events that
require current reporting on Form 8-K. Furthermore; new rules have been issued
pertaining to an audit committee and its need for a financial expert and code of
ethics requirements for senior management. Also, new rules were issued defining
audit committee responsibility for external auditor retention and determination
of external auditor independence. Additional rules have been promulgated to
implement provisions requiring management to certify its responsibilities for
establishing, maintaining and monitoring internal reporting and disclosure
controls. Management anticipates additional costs to implement the various
provisions of this law; however, it is difficult to determine the full impact of
implementation until such time as all rules have been promulgated.
In December 2002, the FASB issued FASB Statement No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure" (SFAS 148), which amends
FASB Statement No. 123, "Accounting for Stock Based Compensation" (SFAS 123), to
provide alternative methods of transition for an entity that voluntarily changes
to the fair value based method of accounting for stock-based employee
compensation. The provisions of the statement were effective December 31, 2002.
Management currently intends to continue to account for stock-based compensation
under the intrinsic value method set forth in Accounting Principles Board
("APB") Opinion 25 and related interpretations. For this reason, the transition
guidance of SFAS 148 does not have an impact on the Company's consolidated
balance sheet or consolidated statements of income and comprehensive income. The
Statement does amend existing guidance with respect to required disclosures,
regardless of the method of accounting used. The revised disclosure requirements
are presented herein.
The proforma impact on net income and net income per share as if the fair
value of stock-based compensation plans had been recorded as a component of
compensation expense in the consolidated financial statements as of the date of
grant of awards related to such plans, pursuant to the provisions of SFAS 123
and SFAS 148, is disclosed as follows.
7
(Dollars in thousands, except per share data) Nine Months Ended
September 30,
-------------------------
2003 2002
--------- -----------
Net income, as reported $ 5,460 $ 4,718
Less: Stock-based compensation as calculated
per fair value method, net of tax effect (173) (349)
--------- -----------
Proforma net income $ 5,287 $ 4,369
Earnings per share:
Basic - as reported $ 1.23 $ 1.03
Basic - proforma $ 1.19 $ 0.95
Diluted - as reported $ 1.19 $ 1.01
Diluted - proforma $ 1.15 $ 0.93
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted average
assumptions used in 2003 and 2002: dividend yield of 3.26% and 3.30%; expected
volatility of 4.58% and 16.0%; risk free interest rates of 3.50% and 3.47%, and
expected lives of seven years for both periods.
These plans provide that shares granted come from the Company's authorized
but unissued or reacquired common stock. The price of the options granted
pursuant to these plans will not be less than 100 percent of the fair market
value of the shares on the date of grant. The options granted in 1989, 1992, and
1995 vest ratably over a five-year period, and the options granted in 1996 and
thereafter vest ratably over a four-year period. No option will be exercisable
after ten years from the date granted.
On November 25, 2002, the FASB issued FASB Interpretation No. 45 ("FIN
45"),"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others (an interpretation of
FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No.
34)." FIN 45 clarifies the requirements of FASB Statement No. 5 (SFAS
5),"Accounting for Contingencies," relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. For guarantees that
fall within the scope of FIN 45, the Interpretation requires that guarantors
recognize a liability equal to the fair value of the guarantee upon its
issuance. The Corporation's primary guarantees included within the scope of FIN
45 relates to financial standby letters of credit issued to commercial
customers. FIN 45 requires the liability recognized in standalone arm's-length
transactions to be the premium received or receivable by the guarantor.
Management does not anticipate the implementation of this interpretation to have
a material impact on the Company's financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN
46"),"Consolidation of Variable Interest Entities (an interpretation of ARB
No.51)." FIN 46 addresses the consolidation by business enterprises of certain
variable interest entities. Management does not anticipate the implementation of
this interpretation to have a material impact on the Company's financial
statements.
In April 2003, the FASB issued Statement of Financial Accounting Standards
No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities." FSAB Statements No. 133 "Accounting for Derivative Instruments and
Hedging Activities" and No. 138 "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," establish accounting and reporting standards
for derivative instruments including derivatives embedded in other contracts
(collectively referred to as derivatives) and for hedging activities. This
Statement 149 amends Statement 133 for certain decisions made by the Board as
part of the Derivatives Implementation Group (DIG) process. This Statement
contains amendments relating to FASB Concepts Statement No. 7, "Using Cash Flow
Information and Present Value in Accounting Measurements," and FASB Statements
No. 65, "Accounting for Certain Mortgage Banking Activities," No. 91 "Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases," No. 95, "Statement of Cash Flows," and No.
126, "Exemption from Certain Required Disclosures about Financial Instruments
for Certain Nonpublic Entities." The Company is presently evaluating the effect
of this pronouncement.
8
In May 2003, FASB issued Statement of Financial Accounting Standards No.
150 "Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity". This Statement establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances). Many of those instruments were previously classified as equity.
Some of the provisions of this Statement are consistent with the current
definition of liabilities in FASB Concepts Statement No. 6, Elements of
Financial Statements. The remaining provisions of this Statement are consistent
with the Board's proposal to revise that definition to encompass certain
obligations that a reporting entity can or must settle by issuing its own equity
shares, depending on the nature of the relationship established between the
holder and the issuer. While the Board still plans to revise that definition
through an amendment to Concepts Statement 6, the Board decided to defer issuing
that amendment until it has concluded its deliberations on the next phase of
this project. That next phase will deal with certain compound financial
instruments including puttable shares, convertible bonds, and dual-indexed
financial instruments. This Statement is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003, except for
mandatorily redeemable financial instruments of nonpublic entities. It is to be
implemented by reporting the cumulative effect of a change in an accounting
principle for financial instruments created before the issuance date of the
Statement and still existing at the beginning of the interim period of adoption.
Restatement is not permitted. Management does not anticipate the implementation
of this statement to have a material impact on the Corporation's consolidated
financial position or consolidated results of operations.
Based on the Company's operations as of September 30, 2003, none of these
standards are expected to have a material effect on the Company's financial
statements.
4. Comprehensive Income
The Company's other comprehensive income for the three and nine month
periods ended September 30, 2003 and 2002 consists of unrealized gains and
losses on available for sale securities, net of related income taxes, as
follows:
(Dollars in thousands) Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- --------------------
2003 2002 2003 2002
---------- -------- -------- ---------
Unrealized gains (losses) on
available for sale securities $ (3,585) $ 135 $ (3,914) $ 311
Reclassification of realized gains -- -- (562) (318)
---------- -------- -------- ---------
Other comprehensive income (loss)
before tax (3,585) 135 (3,352) (7)
Income tax effect 1,398 (52) 1,307 3
---------- -------- -------- ---------
$ (2,187) $ 83 $ (2,045) $ (4)
Other comprehensive income (loss) ========== ======== ======== =========
9
5. Segment Information
The Company follows the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 131, "Disclosure about Segments of an Enterprise and
Related Information." SFAS 131 establishes standards for determining an entity's
operating segments and the type and level of financial information to be
disclosed in both annual and interim financial statements. It also establishes
standards for related disclosures about products and services, geographic areas,
and major customers.
Operating segments are components of an enterprise with separate financial
information available for use by the chief operating decision maker to allocate
resources and to assess performance. The Company has determined that it has one
significant operating segment: the providing of general financial services to
the customers of its wholly owned subsidiary, FNB Southeast. The various
products offered by FNB Southeast are those generally offered by community
banks, and the allocation of resources is based on the overall performance of
the Company, rather than the individual performance of banking offices or
products.
6. Calculation of Earnings Per Common Share
Basic and diluted earnings per share amounts have been computed based upon
net income as presented in the accompanying income statements divided by the
weighted average number of common shares outstanding or assumed to be
outstanding as summarized.
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- -------------------------
2003 2002 2003 2002
------------ ----------- ---------- -----------
Weighted average number of shares
used in basic EPS 4,399,919 4,549,869 4,436,949 4,587,011
Effect of dilutive stock options 170,733 108,408 140,568 95,282
------------ ----------- ---------- -----------
Weighted average number of common
shares and dilutive potential common
shares used in dilutive EPS 4,570,652 4,658,277 4,577,517 4,682,293
============ =========== ========== ===========
As of September 30, 2003, there were 114,833 potentially dilutive share
options not included in the weighted average calculation since the option
exercise prices are greater than the fair market value of the common shares.
7. Investment Securities
September 30, 2003 December 31, 2002
--------------------------- -----------------------
(Dollars in thousands) Amortized Fair Amortized Fair
Cost Value Cost Value
------------ ----------- ---------- ---------
Available for sale:
U.S. Agency securities $ 93,169 $ 92,651 $ 97,364 $ 99,024
Mortgage backed securities 21,883 21,865 17,945 18,388
State and municipal obligations 32,720 32,322 7,036 7,351
Other 357 370 306 321
------------ ----------- ---------- ---------
Total available for sale 148,129 147,208 122,651 125,084
Federal Reserve Bank and
Federal Home Loan Bank stock 3,232 3,232 3,732 3,732
------------ ----------- ---------- ---------
Total investment securities $ 151,361 $ 150,440 $ 126,383 $ 128,816
============ =========== ========== =========
10
8. Loans (net of unearned income)
(Dollars in thousands) September 30, December 31,
2003 2002
------------- ------------
Loan Category:
Real estate - commercial $ 154,311 $ 170,657
Real estate - residential 94,866 119,316
Real estate - construction 111,479 87,696
Commercial, financial and agricultural 88,434 87,458
Consumer 113,652 98,473
------------- ------------
Gross loans $ 562,742 $ 563,600
============= ============
9. Allowance for Credit Losses
September 30, 2003 December 31, 2002
--------------------------- ----------------------------
(Dollars in thousands) % of Loans in % of Loans in
Each Category Each Category
Allowance to Total Loans Allowance to Total Loans
--------- -------------- --------- ----------------
Balance at end of period
applicable to:
Real estate - construction $ 5 20 $ 7 16
Real estate - mortgage 58 44 180
51
Commercial 5,182 16 5,201 16
Consumer 1,829 20 1,671 17
--------- -------------- --------- ----------------
Total $ 7,071 100% $ 7,059 100%
========= ============== ========= ================
11
10. Analysis of Allowance for Credit Losses
Nine Months Ended
September 30,
-------------------------
(Dollars in thousands) 2003 2002
-------------------------
Balance, beginning of period $ 7,059 $ 6,731
Charge-offs 1,237 1,080
Recoveries (169) (272)
----------- ----------
Net charge-offs 1,068 808
----------- ----------
Provision charged to operations 1,080 1,215
----------- ----------
Balance, end of period $ 7,071 $ 7,138
=========== ==========
Ratio of annualized net charge-offs during the period to
average loans outstanding during the period 0.25% 0.20%
=========== ==========
Ratio of allowance for credit losses to month-end loans 1.26% 1.29%
=========== ==========
11. Nonperforming Assets
September 30, December 31,
(Dollars in thousands) 2003 2002
------------- -------------
Nonaccrual (1) $ 7,443 $ 3,614
Past due 90 days or more and still accruing interest 56 65
Other real estate 2,574 1,662
Renegotiated troubled debt -- --
(1) Other than amounts listed above, there are no other loans which: (a)
represent or result from trends or uncertainties which management
reasonably expects will materially affect future operating results,
liquidity, or capital resources, or (b) represent material credits about
which management is aware of any information which causes management to
have serious doubts as to the ability of such borrowers to comply with the
loan repayment terms.
12
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Information set forth below may contain various forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934, which statements represent the Company's
judgment concerning the future and are subject to risks and uncertainties that
could cause the Company's actual operating results to differ materially. Such
forward-looking statements can be identified by the use of forward-looking
terminology, such as "may", "will", "expect", "anticipate", "estimate",
"believe", or "continue", or the negative thereof or other variations thereof or
comparable terminology. The Company cautions that such forward-looking
statements are further qualified by important factors that could cause the
Company's actual operating results to differ materially from those in the
forward-looking statements.
Critical Accounting Policies
The Company's accounting policies are fundamental to understanding
management's discussion and analysis of results of operations and financial
condition. The Company's significant accounting policies are discussed in detail
in Note 1 of the consolidated financial statements included in the Company's
2002 Annual Report. The following is a summary of the allowance for credit
losses, one of the most complex and judgmental accounting policies of the
Company.
The allowance for credit losses, which is utilized to absorb actual losses
in the loan portfolio, is maintained at a level consistent with management's
best estimate of probable credit losses incurred as of the balance sheet date.
The Company's allowance for credit losses is also analyzed quarterly by
management. This analysis includes a methodology that separates the total loan
portfolio into homogeneous loan classifications for purposes of evaluating risk.
The required allowance is calculated by applying a risk adjusted reserve
requirement to the dollar volume of loans within a homogenous group. Major loan
portfolio subgroups include: risk graded commercial loans, mortgage loans, home
equity loans, retail loans and retail credit lines. Management also analyzes the
loan portfolio on an ongoing basis to evaluate current risk levels, and risk
grades are adjusted accordingly. While management uses the best information to
make evaluations, future adjustments may be necessary, if economic or other
conditions differ substantially from the assumptions used.
Summary
On January 27, 2003 the Company completed the acquisition of the
Harrisonburg, Virginia branch of another financial institution. The Company
acquired approximately $5.4 million in loans and $11.0 million in deposits.
Assets at September 30, 2003 were $761.9 million, an increase of $27.9
million since December 31, 2002. An increase in investment securities available
for sale of $21.6 million was the principal factor contributing to this increase
in assets during the first nine months of 2003. Over the past nine months,
noninterest-bearing deposits increased $5.3 million, while interest-bearing
deposits rose $23.2 million.
Net income for the quarter ended September 30, 2003, of $1.9 million was
$5,000, or .3%, higher than the amount earned in the third quarter last year.
Diluted earnings per share for the third quarters of 2003 and 2002 were $0.42
per share. For the nine months to date of 2003, earnings of $5.5 million were
$742,000, or 15.7%, higher than the same period a year ago. Diluted earnings per
share for the nine months ended September 30, 2003 and 2002 were $1.19 and
$1.01, respectively.
Interest Income and Interest Expense
Total interest income was $10.3 million for the third quarter of 2003,
compared to $10.9 million during the same period in 2002. Average earning assets
for the current quarter were $724.2 million, an increase of 6.8% over the third
quarter average of $677.8 million a year ago. Interest income from loans was
$9.1 million, down 3.8% from $9.4 million in the third quarter of 2002. The
decrease in interest income was driven primarily by a continuing decline in the
prime lending rate. Average loans of $571.8 million were 3.2% higher than the
13
$553.9 million last year. For the nine months ended on September 30, 2003, total
interest income was $31.3 million, compared to $32.2 million during the same
period in 2002. Earning assets averaged $716.8 million during the first nine
months of 2003, an 8.7% increase over the 2002 average of $659.7 million.
Interest income on investments totaled $1.3 million for the three months
ended September 30, 2003, compared to $1.5 million for the same period in 2002.
The $45.2 million, or 45.5%, increase in the average balance of the investment
portfolio was offset by a decline in the yield from 5.21% in 2002 to 3.84% in
2003. Investment income for the nine-month period totaled $4.1 million in 2003
and $4.6 million in 2002. Market pressure continues on yields as interest rates
are at 45 year lows.
Third quarter total interest expense was $4.1 million, compared to $4.9
million from the third quarter of last year, a 15.4% decrease. Average interest
bearing liabilities for the third quarter 2003 increased 8.4%, to $628.5 million
from $579.6 million for the third quarter of 2002. Total interest expense for
the first nine months of 2003 was $13.0 million, an 11.2% decrease from the
$14.7 million expense for the first nine months of 2002. Overall cost of funds
for the nine months ended September 30, 2003 and 2002 was 2.55% and 3.16%,
respectively.
Interest expense on deposits for the third quarter decreased 15.0%, to $3.8
million for 2003 from $4.4 million in 2002. Average interest bearing deposits
increased 12.0%, to $578.2 million, from $516.2 for the third quarter of 2002. A
campaign directed at increasing certificates of deposit accounted for a
significant amount of this growth. Deposit interest expense for the nine months
ended September 30, 2003, decreased from $13.6 million in 2002 to $11.9 million
in 2003. The average rate for the nine months on interest bearing deposits
decreased to 2.84% in 2003; from 3.62% one year earlier while the average
balance of interest bearing deposits increased 11.4%, from $502.1 million in
2002 to $559.1 million in 2003.
Interest expense on federal funds purchased and other borrowings was
$348,000 for the quarter ended September 30, 2003, down 19.2%, from $430,000 in
the third quarter of 2002. For the nine months ended September 30, interest
expense for this category increased from $1.1 million in 2002 to $1.2 million in
2003.
Comparable net interest margins are as follows:
Liability
Time Period Asset Yield Rate Interest Rate Spread
----------- -------- ---------------------
Third Quarter, 2003 5.75% - 2.60% = 3.15%
Third Quarter, 2002 6.38% - 3.33% = 3.05%
Year-To-Date, 2003 5.90% - 2.82% = 3.08%
Year-To-Date, 2002 6.56% - 3.49% = 3.07%
Provision for Credit Losses
A provision for credit losses is charged against earnings in order to
maintain the allowance for credit losses at a level that reflects management's
evaluation of the incurred losses inherent in the portfolio. The amount of the
provision is based on continuing assessments of nonperforming and "watch list"
loans, analytical reviews of loan loss experience in relation to outstanding
loans, loan charge-offs, nonperforming asset trends and management's judgment
with respect to current and expected economic conditions and their impact on the
existing credit portfolio.
The provision for credit losses in the third quarter of 2003 was $303,000
compared to $250,000 in 2002. The allowance for credit losses as a percentage of
gross loans outstanding was 1.26% at September 30, 2003, 1.25% at December 31,
2002, and 1.29% at September 30, 2002. Annualized net credit losses, as a
percent of average loans, was 0.23% and 0.01% for the quarters ended September
30, 2003 and 2002, respectively. Year to date annualized net credit loss was
0.25% of average loans in 2003, compared to 0.20% for the same period in 2002.
For the first nine months of 2003, the provision was $1.1 million, compared to
$1.2 million for the same period a year ago.
14
Noninterest Income and Noninterest Expense
Noninterest income in the third quarter of this year increased 60.6% to
$2.0 million from $1.3 million in the same period last year. Deposit service
charges of $959,000 for the third quarter of 2003 increased 22.5% from the
$783,000 in the third quarter of 2002. Enhancements to deposit service charges
contributed to this increase. Noninterest income in the third quarter of 2003
included $718,000 in mortgage banking fees and $179,000 in investment service
fees compared to revenues of $318,000 and $51,000, respectively, for the
previous year. Total noninterest income for the first nine months of 2003
totaled $5.6 million; a 49.4% increase over the $3.7 million earned in the first
nine months of 2002. Mortgage banking fees totaled $1.7 million for the first
nine months of 2003, compared to $760,000 for the same period in 2002, an
increase of 119.0%. The $904,000 increase in mortgage banking fees for the first
nine months of 2003 was attributable to the continuing growth of the
mortgage-banking subsidiary, combined with the refinancing activity associated
with the declining interest rate environment. Deposit service charges of $2.6
million for the nine months were 27.7% higher than the $2.0 million recorded in
the same period last year. Net gains on securities available for sale totaled
$562,000 for the first nine months of 2003, a 76.5% increase over the gains
recorded for the same period a year ago.
Noninterest expense for the third quarter of 2003 was $5.0 million, a 24.0%
increase over the $4.0 million expense in the third quarter of 2002. Salaries
and employee benefits increased $187,000 because of higher insurance and
retirement costs and furniture and equipment expense increased $187,000,
compared to third quarter 2002. Other expense for the third quarters of 2003 and
2002 totaled $1.1 million and $617,000, respectively. Other expense in the first
nine months of 2003 totaled $3.2 million, an increase of $556,000 from the first
nine months of 2002. This year's nine-month noninterest expense of $14.4 million
was 11.1% higher than the $12.9 million in the same period last year.
Income Taxes
The effective income tax rate of 34.5% for the first nine months of 2003
was higher than the 33.6% rate for the same period of 2002. The lower effective
tax rate for 2002 was primarily due to the reduced amount of current expense
required to provide adequate income tax provision during the first nine months
of 2002. The Company anticipates the effective tax rate for the 2003 full year
will be similar to the results of the first nine months of 2003.
ANALYSIS OF FINANCIAL CONDITION
The Company's total assets at September 30, 2003 and 2002 were $761.9
million and $720.4 million, respectively. The $41.5 million growth represents a
5.8% increase over one year earlier. Since December 31, 2002, assets have
increased $27.9 million An increase in investment securities available for sale
of $21.6 million was the principal factor contributing to this increase in
assets during the first nine months of 2003. Average earning assets for the
third quarter of 2003 were $724.2 million, or 6.8%, higher than the $677.8
million average for the same quarter last year.
Loans at September 30, 2003 totaled $562.7 million, compared to $554.2
million one year earlier, an increase of 1.5%. Loans were $563.6 million at
December 31, 2002. Average loans for the third quarter of 2003 were $571.8
million, a 3.2% increase over the $553.9 million average in this same period
last year.
Investment securities of $150.4 million at September 30, 2003 were 23.0%
higher than the $122.4 million balance a year ago. Average investment securities
were $144.6 million and $99.3 million for the third quarters of 2003 and 2002,
respectively. The Company elected to use the proceeds from successful campaigns
directed at increasing core deposits to fund the growth in the investment
portfolio.
15
Deposits totaled $633.6 million at September 30, 2003, a 7.1% increase
versus $591.5 million one year ago, and a 4.7% increase from the $605.0 million
recorded at December 31, 2002. At the end of the third quarter 2003,
noninterest-bearing deposits were $67.0 million, or 10.6% of total deposits. The
increase in deposits was the result of campaigns designed to attract demand
deposits and certificates of deposit with a nine-month maturity. As mentioned in
the preceding paragraph, the growth in core deposits funded the rise in the
investment portfolio, as well as contributing to the decrease in other
borrowings.
At September 30, 2003, borrowings at the Federal Home Loan Bank of Atlanta
(FHLB) totaled $47.5 million, a decrease of 9.5% compared to $52.5 million at
December 31, 2002. Federal funds purchased and retail repurchase agreements
totaled $3.5 million at September 30, 2003, a decrease of $4.7 million from
December 31, 2002.
Shareholders' equity increased to $64.4 million at the end of the third
quarter 2003, compared to $64.3 million at December 31, 2002. The Company paid
dividends of $0.14 per share during the quarter ended September 30, 2003, a 7.7%
increase over the $0.13 per share dividend rate for the third quarter of 2002.
Year to date dividends per share for 2003 were $0.42, compared to $0.39 in 2002.
A second stock repurchase program of the outstanding common stock, initiated
during the fourth quarter of 2002, continued in 2003. This program is intended
to help the Company achieve its goal of building shareholder value while
maintaining appropriate capital levels. A total of 223,851 shares are eligible
to be repurchased, and through September 30, 2003, a total of 121,553 shares
have been purchased at an average price of $17.980. In accordance with state
law, repurchased shares are cancelled and are no longer considered issued.
Asset Quality
The credit loss allowance ratio was 1.26% at September 30, 2003, 1.25% at
December 31, 2002, and 1.29% at September 30, 2002. For the third quarter of
2003, provision charges against earnings totaled $303,000, compared to $250,000
in the third quarter of 2002. Net charge-offs for the third quarter of 2003
totaled $324,000, or a 0.23% annualized loss ratio based on average loans
outstanding, compared to net charge-offs for the third quarter of 2002 of
$20,000, or 0.01% annualized loss ratio. Annualized net charge-offs for the
first nine months of 2003 and 2002 were 0.25% and 0.20%, respectively, based on
average loans outstanding.
Other real estate owned at September 30, 2003 was $2.6 million, compared to
$1.7 million at December 31, 2002. Approximately $1.6 million has been
transferred from loans into other real estate and approximately $689,000 of such
assets were disposed of during the first nine months of 2003. A net loss of
$38,000 has been recorded on disposition of other real estate in the current
year.
Management places great emphasis on maintaining the Company's asset
quality. The allowance for credit losses, which is utilized to absorb actual
losses in the loan portfolio, is maintained at a level consistent with
management's best estimate of probable credit losses incurred as of the balance
sheet date. Management believes the allowance for credit losses is sufficient to
absorb known risk in the portfolio.
The loan portfolio is analyzed on an ongoing basis to evaluate current risk
levels, and risk grades are adjusted accordingly. The Company's allowance for
credit losses is also analyzed quarterly by management. This analysis includes a
methodology that separates the total loan portfolio into homogeneous loan
classifications for purposes of evaluating risk and considers the current status
of the portfolio, historical charge-off experience, current levels of
delinquent, impaired and non-performing loans, as well as economic and other
risk factors. It is also subject to regulatory examinations and determinations
as to adequacy, which may take into account such factors as the methodology
employed and other analytical measures in comparison to a group of peer banks. .
The required allowance is calculated by applying a risk adjusted reserve
requirement to the dollar volume of loans within a homogenous group. Major loan
portfolio subgroups include: risk graded commercial loans, mortgage loans, home
equity loans, retail loans and retail credit lines. The provisions of Statement
of Financial Accounting Standard No. 114 ("SFAS No. 114"), Accounting by
Creditors for Impairment of a Loan, and related pronouncements are applied to
individually significant loans. Finally, individual reserves may be recorded
based on a review of loans on the "watch list." At September 30, 2003, the
recorded investment in loans considered impaired was approximately $12,920,672.
Impaired loans at September 30, 2003 consisted of $1,168,442 of retail loans
past due 90 days or more, and $11,752,230 of risk grade 7 and risk grade 8
commercial loans. Calculated reserves for impaired loans at September 30, 2003
totaled $2,261,532.
16
Capital Resources
Banks and financial holding companies, as regulated institutions, must meet
required levels of capital. The Office of the Commissioner of Banks in North
Carolina and the Board of Governors of the Federal Reserve, which are the
primary regulatory agencies for FNB Southeast and the Company, respectively,
have adopted minimum capital regulations or guidelines that categorize
components and the level of risk associated with various types of assets.
Financial institutions are required to maintain a level of capital commensurate
with the risk profile assigned to their assets in accordance with the
guidelines.
As shown in the following table, the Company and its wholly owned banking
subsidiary have capital levels exceeding the minimum levels for "well
capitalized" banks and financial holding companies as of September 30, 2003.
Regulatory Guidelines
-----------------------------------
Well Adequately FNB
Ratio Capitalized Capitalized Company Southeast
----------- ----------- ------------ ---------
Total Capital 10.0% 8.0% 12.1% 11.8%
Tier 1 Capital 6.0 4.0 10.9 10.6
Leverage Capital 5.0 4.0 8.3 8.2
Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and
became some of the most sweeping federal legislation addressing accounting,
corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act
is wide-ranging as it applies to all public companies and imposes significant
new requirements for public company governance and disclosure requirements. Some
of the provisions of the Sarbanes-Oxley Act became effective immediately while
others will be implemented over the coming months.
In general, the Sarbanes-Oxley Act mandates important new corporate
governance and financial reporting requirements intended to enhance the accuracy
and transparency of public companies' reported financial results. It establishes
new responsibilities for corporate chief executive officers, chief financial
officers and audit committees in the financial reporting process and creates a
new regulatory body to oversee auditors of public companies. It backs these
requirements with new SEC enforcement tools, increases criminal penalties for
federal mail, wire and securities fraud, and creates new criminal penalties for
document and record destruction in connection with federal investigations. It
also increases the opportunity for more private litigation by lengthening the
statute of limitations for securities fraud claims and providing new federal
corporate whistleblower protection.
The full impact of the Sarbanes-Oxley Act cannot be fully measured until
the SEC acts to implement the numerous provisions for which Congress has
delegated implementation authority. The economic and operational effects of this
new legislation on public companies, including the Bank, will be significant in
terms of the time, resources and costs associated with complying with the new
law. Because the Sarbanes-Oxley Act, for the most part, applies equally to
larger and smaller public companies, the Bank will be presented with additional
challenges as a smaller, community-oriented financial institution seeking to
compete with larger financial institutions in its market.
17
Liquidity Management
Liquidity management refers to the ability to meet day-to-day cash flow
requirements based primarily on activity in loan and deposit accounts of the
Company's customers. Deposit withdrawals, loan funding and general corporate
activity create a need for liquidity for the Company. Liquidity is derived from
sources such as deposit growth; maturity, calls, or sales of investment
securities; principal and interest payments on loans; access to borrowed funds
or lines of credit; and profits.
During the first nine months of 2003 the Company had net cash provided by
operating activities of $5.7 million. This was a decrease from $6.4 million of
net cash provided by operating activities in the first nine months of 2002. The
decrease is primarily attributable to the decline of $3.8 million in interest
received and a $1.7 million increase noninterest expense paid, offset by an
increase in fees and commissions received.
Net cash used in investing activities in the first nine months of 2003
totaled $26.4 million. Purchases of investment securities in the current year
totaled $120.4 million and proceeds from sales, calls, or maturity of securities
were $97.6 million. This compares to the first nine months of 2002 when proceeds
from sales and/or calls of securities totaled $55.3 million and purchases of
securities totaled $49.6 million, resulting in net cash provided by investment
activities of $14.8 million. A decrease in loans outstanding provided $1.9
million in cash during 2003, compared to an increase in outstanding loans in
2002 that used $18.8 million of cash during the same period in 2002. Capital
expenditures used $3.0 million in 2003, compared to $369,000 in 2002.
Financing activities in the 2003 first nine months provided $18.5 million,
based primarily on $28.5 million rise in deposits. These cash inflows were
partially offset by a repayment of other borrowings of $6.5 million during the
first nine months. During the 2002 first nine months, financing activities
provided $11.5 million.
Overall cash and cash equivalents totaled $22.3 million at September 30,
2003 compared to $24.5 million at December 31, 2002 and $26.8 million at
September 30, 2002.
Liquidity is further enhanced by an approximately $115 million line of
credit with the FHLB collateralized by FHLB stock, investment securities and
qualifying 1-4 family residential mortgage loans, and qualifying commercial real
estate loans. The Company provides various reports to the FHLB on a regular
basis throughout the year to maintain the availability of the credit line. Each
borrowing request to the FHLB is initiated through an advance application that
is subject to approval by the FHLB before funds are advanced under the credit
agreement.
The Company also has unsecured overnight borrowing lines totaling $19
million available through four financial institutions. These lines are used to
manage the day-to-day, short-term liquidity needs of the Company. Each Federal
funds line has a requirement to repay the line in full on a frequent basis,
typically within five to ten business days.
Effects of Inflation
Inflation affects financial institutions in ways that are different from
most commercial and industrial companies, which have significant investments in
fixed assets and inventories. The effect of inflation on interest rates can
materially impact bank operations, which rely on net interest margins as a major
source of earnings. Non-interest expenses, such as salaries and wages, occupancy
and equipment cost are also negatively impacted by inflation.
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.
18
The Company considers interest rate risk to be its most significant market
risk, which could potentially have the greatest impact on operating earnings.
The Company is asset sensitive, which means that falling interest rates could
result in a reduced amount of net interest income. The monitoring of interest
rate risk is part of the Company's overall asset/liability management process.
The primary oversight of asset/liability management rests with the Company's
Asset and Liability Committee. The Committee meets on a regular basis to review
asset/liability activities and to monitor compliance with established policies.
The Company has not experienced any substantive changes in portfolio risk
during the nine months ended September 30, 2003.
19
Item 4. Controls and Procedures
Evaluation of disclosure controls and procedures
Within 90 days prior to the date of this report, the Company's Chief
Executive Officer and the Chief Financial Officer evaluated the effectiveness of
the Company's disclosure controls and procedures in accordance with Rule 13a-14
under the Exchange Act. Based on their evaluation, the Chief Executive Officer
and the Chief Financial Officer concluded that the Company's disclosure controls
and procedures enable the Company to record, process, summarize and report in a
timely manner the information that the Company is required to disclose in its
Exchange Act reports.
Changes in internal controls
There were no significant changes in the Company's internal controls or in
other factors that could significantly affect these controls subsequent to the
date of the evaluation referred to above.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
Not Applicable.
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
Exhibit No. Description
---------- -----------
3.01 Amended and Restated Articles of Incorporation.
3.02 By laws of Company, as amended.
4.01 Specimen Common Stock Certificate.
10.01 Stock Compensation Plan of the Registrant approved
April 11, 1989, by the shareholders of the
Registrant, with forms of stock option and stock
bonus agreements attached.
10.02 Omnibus Equity Compensation Plan of the Registrant.
10.03 Severance Policy for Senior Officers of the
Registrant (employed for five years or more).
10.04 Revised Severance Plan for Senior Officers of the
Registrant (employed for five years or more).
20
10.05 Severance Policy for Senior Officers of the
Registrant (employed for less than five years).
10.07 Benefit Equivalency Plan of the Registrant effective
January 1, 1994.
10.08 Annual Management Incentive Plan of the Registrant.
10.09 Long Term Incentive Plan of the Registrant.
10.10 Long Term Incentive Plan of the Registrant for certain
Senior Management employees.
10.11 Employment Agreement dated May 18, 1995, between the
Registrant, as employer, and Ernest J. Sewell, President
and Chief Executive Officer of the Registrant.
10.12 Amendment to Employment Agreement between the Registrant,
as employer, and Ernest J. Sewell, President and Chief
Executive Officer of the Registrant dated May 16, 2002.
10.13 Split-Dollar Agreement dated January 27, 1995, between
the Registrant and Ernest J. Sewell.
10.14 Lease, dated January 31, 1997, between the Registrant
and Landmark Commercial, Inc., relating to the Wilmington
branch office.
10.15 Amendment to Benefit Equivalency Plan of the Registrant
effective January 1, 1998.
10.15 Amendment to Benefit Equivalency Plan of the Registrant
effective January 1, 1998.
10.15 Amendment to Benefit Equivalency Plan of the Registrant
effective January 1, 1998.
10.15 Amendment to Benefit Equivalency Plan of the Registrant
effective January 1, 1998.
(b) Reports on Form 8-K
None.
21
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.
FNB FINANCIAL SERVICES CORPORATION
(Registrant)
November 10, 2003 /s/ Michael W. Shelton
------------------------------------
Michael W. Shelton
(Vice President, Secretary and
Treasurer)
22