Back to GetFilings.com
================================================================================
SECURITIES AND EXCHANGE COMMISSION
UNITED STATES
Washington, D.C. 20549
FORM 10-K
----------
Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended:
December 31, 2004
Commission File Number: 000-13086
FNB FINANCIAL SERVICES CORPORATION
(Exact name of Registrant as specified in its Charter)
North Carolina 56-1382275
(State of Incorporation) (I.R.S. Employer Identification No.)
1501 Highwoods Blvd., Suite 400
Greensboro, North Carolina 27410
(Address of principal executive offices) (Zip Code)
(336) 369-0900
(Registrant's telephone number, including area code)
----------
Securities Registered Pursuant to Section 12(g) of the Securities Exchange Act
of 1934:
Name of each exchange
Title of each class on which registered
------------------- ---------------------
Common Stock, $1.00 par value Nasdaq Stock Market
Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K contained herein, and none will be contained, to the best of
Registrant's knowledge, in definitive proxy or information statements
incorporated by references in Part III of this Form 10-K or any amendment to
this Form 10-K.|X|
Check 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 Act). YES |X| NO |_|
The aggregate market value of the Registrant's Common Stock held by
non-affiliates of the Registrant, based on the average bid and asked price of
the Common Stock on the last business day of the Registrant's most recently
completed second fiscal quarter, was approximately $92.7 million. As of March
14, 2005 (the most recent practicable date), the Registrant had outstanding
5,578,895 shares of Common Stock.
Portions of the Proxy Statement of the Registrant for the Annual Meeting of
Shareholders to be held on May 19, 2005, are incorporated by reference in Part
III of this report.
The Exhibit Index begins on page 77.
================================================================================
FNB Financial Services Corporation
Form 10-K
Table of Contents
Index Page
- ----- ----
PART I
Item 1. Business .............................................................. 4
Item 2. Properties ............................................................ 17
Item 3. Legal Proceedings ..................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders ................... 17
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities .......................... 18
Item 6. Selected Financial Data ............................................... 19
Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations ................... 21
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ............ 41
Item 8. Financial Statements and Supplementary Data ........................... 45
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure ............................. 72
Item 9A. Controls and Procedures ............................................... 72
Item 9B. Other Information ..................................................... 72
PART III
Item 10. Directors and Executive Officers of the Registrant .................... 73
Item 11. Executive Compensation ................................................ 73
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters ........................................ 73
Item 13. Certain Relationships and Related Transactions ........................ 73
Item 14. Principal Accountant Fees and Services ................................ 74
PART IV
Item 15. Exhibits and Financial Statement Schedules ............................ 74
Signatures ............................................................ 76
Statement Regarding Forward-Looking Statements
This Annual Report on Form 10-K contains and incorporates by reference
statements relating to future results of FNB Financial Services Corporation (the
"Company" ) that are considered "forward-looking" within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21B of the Securities
Exchange Act of 1934, as amended (the "Exchange Act" ). The forward-looking
statements are principally, but not exclusively, contained in Item 1: "Business"
and Item 7: "Management's Discussion and Analysis of Financial Condition and
Results of Operations." These statements relate to, among other things,
expectations concerning loan demand, growth and performance, simulated changes
in interest rates and the adequacy of our allowance for loan losses. These
statements involve known and unknown risks, uncertainties and other factors that
may cause our actual results, performance or achievements to be materially
different from any future results, performance or achievements expressed or
implied by the forward-looking statements. Actual results may differ materially
from those expressed or implied as a result of certain risks and uncertainties,
including, but not limited to, changes in political and economic conditions,
interest rate fluctuations, competitive product and pricing pressures within our
markets, equity and fixed income market fluctuations, personal and corporate
customers' bankruptcies, inflation, acquisitions and integrations of acquired
businesses, technological changes, changes in law and regulations, changes in
fiscal, monetary, regulatory and tax policies, monetary fluctuations, success in
gaining regulatory approvals when required, as well as, other risks and
uncertainties reported from time to time in our filings with the Securities and
Exchange Commission (the "SEC" ). Forward-looking statements and factors that
may cause actual results to differ materially are also discussed at the
beginning of Item 7: "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Broadly speaking, forward-looking
statements include:
o projections of the Company's revenues, income, earnings per share,
capital expenditures, dividends, capital structure or other
financial items;
o descriptions of plans or objectives of the Company's management for
future operations, products or services;
o forecasts of the Company's future economic performance; and
o descriptions of assumptions underlying or relating to any of the
foregoing.
The Company may make forward-looking statements discussing management's
expectations about:
o future credit losses and nonperforming assets;
o the impact of new accounting standards;
o future short-term and long-term interest rate levels and their
impact on the Company's net interest margin, net income, liquidity
and capital; and
o future capital expenditures.
Forward-looking statements discuss matters that are not historical facts.
Because they discuss future events or conditions, forward-looking statements
often include words such as "anticipate," "might," "believe," "estimate,"
"expect," "plan," "could," "may," "should," "will," "would," or similar
expressions. Do not unduly rely on forward-looking statements. They detail
management's expectations about the future and are not guarantees.
Forward-looking statements speak only as of the date they are made, and
management may not update them to reflect changes that occur after the date the
statements are made.
PART I
Item 1. Business
General
FNB Financial Services Corporation (the "Company") is a North Carolina ("NC")
financial holding company with consolidated assets of $865.3 million, deposits
of $724.3 million and shareholders' equity of $70.4 million, as of December 31,
2004. The Company was organized in 1984 as a North Carolina bank holding
company, although its predecessor and wholly-owned subsidiary, FNB Southeast
(the "Bank"), opened as Rockingham Savings Bank and Trust in 1910, and was then
chartered as a national bank in 1918 under the name of First National Bank of
Reidsville. In May 1997, the Bank changed its name to First National Bank
Southeast to reflect its expansion into new markets. Effective March 15, 1999,
the Bank changed its charter from a national bank to a NC state bank and changed
its name to FNB Southeast. The Company filed an election with the Federal
Reserve Board to become a financial holding company on January 23, 2001, and
became a financial holding company effective February 12, 2001, under the
Gramm-Leach-Bliley Act. A financial holding company is permitted to engage in
activities that are financial in nature or incidental to a financial activity.
The permitted activities of a financial holding company are broader than for a
bank holding company.
Historically, the Company has served the Rockingham County area of NC through
three branches in Reidsville and two in Eden, NC. In 1995, the Company initiated
a new strategic growth plan. On August 31, 1999, the Company acquired Black
Diamond Savings Bank, FSB ("Black Diamond"), a federal savings bank
headquartered in Norton, Virginia ("VA"). By the end of 2004, the Bank's
branching network included offices in the Rockingham County towns of Eden,
Ruffin and Madison and in the new markets of Greensboro, Burgaw and Wilmington
and the number of North Carolina branches had grown from five to thirteen. It
also completed the acquisition of the Harrisonburg, VA branch of Guaranty Bank.
The acquisition of Black Diamond also added branches in Norton, Harrisonburg,
Pennington Gap and Richlands, VA. The Bank of Tazewell purchased selected loans
and assumed the deposits of the Bank's Richlands, VA branch during April 2004.
The Bank transferred $15.0 million in deposit accounts and $7.3 million in loan
accounts in the transaction. The Company recognized approximately $700,000 in
net gain on the sale. Also during April, an approximate $125,000 gain was
realized from the sale of the fixed assets associated with the Bank's Richlands,
VA branch. The Company also relocated its headquarters during the second quarter
of 2004 to Greensboro, NC.
The Bank is community oriented and focuses primarily on offering commercial,
real estate and consumer loans, and deposit and other financial services to
individuals, small to medium-sized businesses and other organizations in its
market areas. It emphasizes individualized services and community involvement,
while at the same time providing its customers with the financial sophistication
and array of products typically offered by larger banks. It competes
successfully with larger banks located within and outside NC and VA by retaining
its personalized approach and community focus.
Under the leadership of Ernest J. Sewell, who became President and Chief
Executive Officer in 1995, the Company adopted the following three-part
strategy: (1) increase market share and geographic reach through opportunistic
acquisitions in markets where the mix of economic, operational, cultural and
other factors are favorable; (2) position the Company to manage its planned
growth by adding experienced personnel and upgrading its internal systems and
procedures; and (3) generate internal growth at its existing banking offices by
offering new and complementary services and products. To accomplish these
objectives, during the past ten years the Company has: (a) increased the number
of its NC banking offices to thirteen; (b) expanded the number of its full-time
personnel by adding new employees, including several senior executives; (c)
completed the merger with Black Diamond to extend the Company's reach into
selected VA markets; (d) completed a systematic review and revision of its loan
administration, loan
4
policy and credit procedures; (e) enhanced its mix of products and services by
forming investment services and mortgage banking subsidiaries; (f) relocated its
corporate headquarters to Greensboro, NC.; and (g) moved forward with its
leadership transition strategy by promoting Pressley A. Ridgill to President of
the Bank. Ridgill joined the Company in 2000 as Executive Vice President and
Chief Operating Officer of the Bank and during his five years with the Company
has directed the operations and planning of numerous areas within the Bank,
including Finance, Deposit Operations, Information Technology, Risk Management,
and Investor Relations. As President, he will continue to manage the investment
portfolio, assist with the strategic direction of the organization, and evaluate
and negotiate acquisitions.
The Company plans to continue to pursue its strategy by strengthening its
presence in existing markets and opportunistically reaching into new markets in
NC and VA. The Company continues to seek qualified personnel to help manage its
planned growth and to develop new products that are consistent with the
Company's customer service orientation. For example, the Company opened a
wholesale mortgage division in the fourth quarter of 2003 and staffed the
division with twelve employees. During 2004, and at the outset of 2005, the
Company also added several members to its management team in light of its
continued growth and to reflect the steps underway to continue its overall
strategy.
Paul McCombie, C. Grayson Whitt and Alan D. Pike joined the Bank as senior vice
presidents and regional executives. McCombie assumed responsibility for our
coastal offices located in Wilmington and Burgaw. Whitt will manage the Bank's
full-service offices in Rockingham County, NC, while Pike will oversee the
banking offices in Guilford County. Kenneth W. Banner joined the Bank as
Executive Vice President of FNB Southeast Mortgage Corporation and will be
responsible for all aspects of the mortgage banking operation. Thomas M. Saitta
joined the Bank in the newly created position of Director of Marketing to
support its expanding sales and marketing efforts.
During 2004, the Company (i) installed a new mainframe computer and related
software, (ii) redesigned commercial and retail products, (iii) expanded online
banking services, and (iv) announced the renovation of the Company's Operations
Center in Reidsville, NC. The Company also plans, where appropriate, to continue
to upgrade its systems and procedures and refine its ability to offer customers
sophisticated services without sacrificing its personalized approach.
Strategy
Expand Banking Operations. Throughout most of its 95-year history, the Company's
banking activities were centered around Reidsville, located in Rockingham County
in the north central part of NC. Beginning in 1995, however, the Company
initiated a growth strategy to further penetrate markets in which it had an
existing market share and expand into and develop new markets, such as
Wilmington and Greensboro in NC and into VA. Management selects its target
markets based on a number of factors, including market size and growth
potential, banking relationships developed by members of management during their
careers and the ability to integrate the targeted market into the Company's
community oriented culture.
The Company's expansion strategy, both within and outside of its existing
markets, involves three key elements: (i) ascertaining which markets may be
underserved by financial institutions whose primary focus is to cater to the
individualized needs of the customer; (ii) installing high-quality, well-trained
management to serve the market; and (iii) locating reasonably priced facilities.
Management believes that it has been successful in implementing these strategic
elements in its expansion program to date.
The Guilford County deposit market is the largest in the Company's market area
and totaled $6.71 billion at June 30, 2004. In April 2004, the Company completed
the relocation of its headquarters to 1501 Highwoods Boulevard, Greensboro. The
Company is the largest financial holding company headquarted in Greensboro, NC.
This move will allow the Company more access to the financial markets and assist
5
the Company in reaching the larger customer base in Guilford County. We continue
to evaluate potential sites for additional branches in Guilford and New Hanover
counties in NC and in Rockingham County, VA.
Seize Market Expansion Opportunities. The Company intends to continue to
capitalize on opportunities to enter new and contiguous markets which it
believes are underserved as a result of banking consolidation and in which the
Company's community oriented philosophy and culture might flourish. The Company
believes that there is value to be added by providing the opportunity for
greater personalized banking relationships that exist with larger commercial
banks in its markets, although the Company also recognizes the need to carefully
analyze markets that are already well served by numerous institutions. The
Company will continue to distinguish itself by emphasizing high quality,
sophisticated services in a hometown environment.
Establish a Platform for Future Growth. The Company seeks to position itself to
manage its expected growth in two fundamental ways: (1) attract, retain and
reward experienced personnel who are committed both to conducting business in a
friendly and personable manner and to serving the communities in which they work
and live; and (2) continue to upgrade, modify and expand its internal systems,
procedures, equipment and software to improve operating efficiencies. The
Company will continue to analyze technological developments in the banking
industry for opportunities to improve or augment its services and products;
however, management will continue to make every effort to maintain the Company's
personalized approach.
Maintain a Friendly Environment for Employees and Customers. The Company has
instituted various programs to instill high morale among its employees, which
the Company believes translate into exceptional customer service. The Company
holds weekly sales meetings to elicit ideas about featured products and services
and to develop and communicate ideas for expanding banking relationships with
existing and potential customers. Management believes that the overall effect of
these type programs is to improve morale, customer service and financial
performance. During the second half of 2004, the Company initiated a program to
develop a team concept at the senior management level. Weekly teleconferences
were held to encourage open and direct communication between members of senior
management and provide regular updates on significant activities within their
respective areas. Periodic off site strategic planning sessions of the senior
management team provide an open forum to address concerns and develop
initiatives for the continued improvement of the Company.
6
Market Areas
For operational purposes, the Company groups its markets into four regions: the
Triad and Wilmington regions of NC, and the Norton and Harrisonburg regions of
VA. The Company's deposit market share in the Rockingham County portion of the
Triad Region as of June 30, 2004, the most recent date for which data are
available, was 27.1%, which ranked first among banks and thrift institutions.
The following table summarizes the banking offices and deposit totals for the
Company's offices, categorized by city.
Region and City Deposits at December 31,
-------------------------------------
2004 2003 2002
--------- -------------- ---------
(In thousands)
Triad Region:
Reidsville (1) ........... $ 174,132 $ 196,292 $ 226,819
Eden (2) ................. 52,935 53,322 45,333
Madison .................. 20,984 20,383 22,482
Ruffin ................... 12,256 10,710 10,872
Greensboro (1) ........... 135,964 97,736 77,548
--------- --------- ---------
Subtotal .............. 396,271 378,443 383,054
--------- --------- ---------
Wilmington Region:
Wilmington (2) ........... 122,330 83,668 55,259
Burgaw ................... 32,094 26,954 25,247
--------- --------- ---------
Subtotal .............. 154,424 110,622 80,506
--------- --------- ---------
Norton Region:
Norton ................... 60,801 53,970 58,551
Pennington Gap ........... 19,735 17,973 22,933
Richlands (4) ............ -- 18,641 22,174
--------- --------- ---------
Subtotal .............. 80,536 90,584 103,658
--------- --------- ---------
Harrisonburg Region:
Harrisonburg (3) ......... 93,054 62,258 37,787
--------- --------- ---------
Total deposits ........ $ 724,285 $ 641,907 $ 605,005
========= ========= =========
- ----------
(1) Includes three banking offices for all years.
(2) Includes two banking offices for all years.
(3) Includes two banking office for 2003 and 2004, and one office for 2002.
(4) Branch sold April 2004.
The following is a summary description of the Company's market areas.
Triad Region - Rockingham County. Rockingham County is located in the north
central area of NC. It has a land area of 565 square miles and a population of
approximately 90,000. The Commonwealth of VA borders the County on the north,
while Guilford County is the neighboring county to the south. Piedmont Triad
International Airport is located twenty miles away, and Norfolk Southern has two
rail connection lines in the County. U.S. Highways 29, 158, and 220 serve the
area. The County, which consists of several community oriented towns, provides a
full range of municipal services and extends financial support to certain
boards, agencies, and commissions to assist its effort to serve its citizens.
The North Carolina Employment Security Commission reported a December 2004
unemployment rate of 8.3% for Rockingham County. Business and government leaders
in the county have made progress in diversifying the area's economy to make up
for job losses primarily in the textile and tobacco industries.
Triad Region - Guilford County. Guilford County has a diverse economy
attributable to a blend of trade, manufacturing and service businesses. Local
industry is characterized by the production of a wide range of products,
including textiles, apparel, furniture, tobacco, machinery, pharmaceuticals,
microchips, and
7
electronics equipment. Guilford County, with a population of 420,000, has access
to major domestic and international markets from Interstate Highways 40 and 85;
U.S. Highways 29, 70, 220 and 421; major rail connections; and the Piedmont
Triad International Airport. According to the NC Employment Security Commission,
Guilford County reported an unemployment rate of 4.8% for December 2004,
compared to a statewide unemployment rate of 5.0%. The planned FedEx hub is on
schedule for completion in 2009 and is expected to have a significant positive
impact on the Triad Region of NC. During 2004, Dell announced plans to locate a
major assembly plant in the Triad, which will bring up to 1,500 jobs to the
region. Additionally, Dell suppliers and other complementary businesses are
expected to contribute positively to the economy of the Triad Region.
Wilmington Region. Wilmington is the county seat and industrial center of New
Hanover County, located on the southeast coast of NC. The total population of
the County is approximately 160,000. Interstate Highway 40 and U.S. Highways 17
and 74, as well as major rail connections serve the County. This area is
serviced by national and regional airlines through facilities at the New Hanover
International Airport located near Wilmington. The New Hanover County area has
experienced extensive industrial development and service/trade sector growth
over the past twenty years. Industries in the Wilmington region produce fiber
optic cables for the communications industry; aircraft engine parts,
pharmaceuticals, nuclear fuel components and various textile products. The New
Hanover County area economy has become broadly diversified and has developed
into a major resort area, a busy sea port (one of North Carolina's two deep
water ports), a light manufacturing center, chemical manufacturing center and
the distribution hub of southeastern North Carolina. The NC Employment Security
Commission reported a December 2004 unemployment rate of 3.5% for New Hanover
County.
Norton Region. Norton is located in southwestern VA in the midst of the
Appalachian Mountains. The mining, retail and service industries of this region
operate from an abundant natural resource base that includes natural gas, coal,
timber and mineral deposits. The area is served by several U.S. Highways and by
major rail connections. The Bank operates branches in Norton (Wise County) and,
Pennington Gap (Lee County). The Company sold the Richlands, VA branch in 2004.
For December 2004, the VA Employment Commission reported the unemployment rate
in Wise County was 4.0%.
Harrisonburg Region. Rockingham County is centrally located in the Shenandoah
Valley in west central VA. Harrisonburg, the county seat with a population of
40,000, is an important educational, industrial, retail, tourism, commercial,
agricultural and governmental center. Interstate Highway 81, several primary
U.S. highways, the Shenandoah Valley Regional Airport and a major rail
connection serve the area. The Bank operates two branches in Harrisonburg,
serving the counties of Rockingham and Augusta. According to the VA Employment
Commission, the December 2004 unemployment rate for Rockingham County was 2.0%
compared to a statewide unemployment rate of 3.0%.
Deposits
The Company offers a variety of deposit products to individuals and to small and
medium-sized businesses and other organizations through the Bank at interest
rates generally competitive with local market conditions. The accompanying table
sets forth the mix of depository accounts at the Company as a percentage of
total deposits at the dates indicated.
As of December 31,
----------------------
2004 2003 2002
----- ---- ------
Noninterest-bearing demand ..... 10.9% 10.9% 10.2%
Savings, NOW, MMI .............. 26.5 18.5 16.5
Certificates of deposit ........ 62.6 70.6 73.3
----- ----- ------
100.0% 100.0% 100.0%
===== ===== ======
8
The Bank accepts deposits at its 17 banking offices, 15 of which have automated
teller machines("ATMs"). Its memberships in the "STAR", "CIRRUS" and "PLUS"
networks allow customers access to their depository accounts from regional ATM
facilities. It charges competitive fees for the use of its ATM facilities by
those who are not depositors with the Bank. Deposit flows are controlled
primarily through the pricing of such deposits and, to a certain extent, through
promotional activities. Such promotional activities include the Company's
"Legacy Banking" and "Presidential Banking" accounts for deposit relationships
of $25,000 and $75,000, respectively, and the "Freedom 50 Club", which extends
special privileges and sponsors group excursions to sites and performances of
interest to account holders in certain markets over the age of 55. At December
31, 2004, the Bank had $126.5 million in certificates of deposit of $100,000 or
more. The Bank has joined an electronic network that allows it to post interest
rates and attract certificates of deposit nationally. The investors are
generally credit unions or commercial banks and amounts are typically just under
$100,000 to assure FDIC insurance coverage. It also utilizes brokered deposits
to supplement in-market deposit growth. The accompanying table presents the
scheduled maturities of time deposits of $100,000 or more at December 31, 2004.
Scheduled maturity of time deposits of $100,000 or more
-------------------------------------------------------
(In thousands)
Less than three months ................................ $ 43,994
Three through six months .............................. 51,478
Seven through twelve months ........................... 21,437
Over twelve months .................................... 9,563
---------
Total time deposits - $100,000 or more ............. $ 126,472
=========
See also Note 7 in the Notes to Consolidated Financial Statements of this Annual
Report on Form 10-K.
Subsidiaries
In April 2000, the Company established FNB Southeast Investment Services, Inc.
(the "Investment Subsidiary") as a wholly owned subsidiary of the Bank. The
Investment Subsidiary employs three investment advisors who are based in the
Company's largest markets of Greensboro and Wilmington, NC and Harrisonburg, VA
and allocate their time among the Company's branches and are available to
current and potential customers. The advisors offer a complete line of
investment products and services. The Company receives commissions based on the
advisors'sales and benefits (i) by earning additional fee income and (ii) by
attracting potential customers to its branches. The Investment Subsidiary
generated revenues of $507,000 in 2004 and $670,000 in 2003. During 2004, the
decision was made to upgrade our services and product portfolio through an
association with Raymond James. We expect this change to provide better service
and more diverse products to our customers while yielding increased fee income
to the Company.
In June 2001, the Company established FNB Southeast Mortgage Corporation (the
"Mortgage Subsidiary") as a wholly owned subsidiary of the Bank. At inception,
the Mortgage Subsidiary purchased selected assets of a successful mortgage
brokerage company operating in the coastal area near Wilmington, NC. The Company
formed a wholesale division of the Mortgage Subsidiary during the fourth quarter
of 2003 as part of a continuing strategy to promote the subsidiary's growth and
expand the variety of mortgage services offered. Fee income generated by the
Mortgage Subsidiary increased to $2,233,000 in 2004, compared to $2,019,000 in
2003.
Marketing
The Company currently markets its services through advertising campaigns and in
printed material, such as newspapers, magazines, billboards, and direct
mailings, as well as through promotional items, such as caps, pens, pencils and
shirts. The Company's officers are also heavily involved in local civic affairs
and
9
philanthropic organizations in order to focus customers on products and services
at a personal level. The Company occasionally sponsors community events and
holds grand opening ceremonies for its new branches to which local dignitaries
are invited to speak and participate in the festivities. The Company engages a
marketing firm to assist with creative design, research, public relations, media
placement, etc., as well as assisting with promoting the overall image of the
Company to the general public and investment community. During 2004, the Company
hired a Director of Marketing to manage this expanding area of the Company and
coordinate the marketing efforts on a full-time basis.
o Value. Among other things, the Company offers attractive rates for
its financial products, including its certificates of deposit and
checking accounts. This pricing structure has been successful in
attracting depositors who are motivated by the Company's rates, as
well as by the variety of individualized services it promotes and
offers.
o Convenience and Service. The Company's personnel focus upon serving
the individual needs of the Company's customers. For example, senior
management personnel are accessible on very short notice, before,
during, and after normal banking hours, by way of mobile phones and
other means.
Management intends to continue to market the Company's services through a
combination of advertising campaigns, public relations activities and local
affiliations. While the key messages of value, convenience, service and
reliability will continue to play a major role in the Company's marketing and
public relations efforts, management may also focus on targeted groups, such as
professionals, in addition to small to medium-sized local businesses.
A vital part of the Company's marketing plan is the execution of a public
relations strategy. Many traditional public relations methods are used in
promoting its services. Management pursues media coverage, including general
press, industry periodicals and other media covering banking and finance,
consumer issues and special interests. Press releases, quarterly shareholder
reports, media alerts and presentations are used to announce new banking
services as they are added.
Competition
Commercial banking in the southeastern United States is extremely competitive,
due in large part to interstate branching. Currently, many of the Company's
competitors are significantly larger and have greater resources. The Company
continues to encounter significant competition from a number of sources,
including bank holding companies, financial holding companies, commercial banks,
thrift institutions, credit unions, and other financial institutions and
financial intermediaries. The Company competes in its market areas with some of
the largest banking organizations in the Southeast, several of which have
numerous branches in NC and VA. The Company's competition is not limited to
financial institutions based in NC and VA. The enactment of federal legislation
authorizing nationwide interstate banking has greatly increased the size and
financial resources of some of the Company's competitors. Consequently, many of
its competitors have substantially higher lending limits due to their greater
total capitalization, and many perform functions for their customers, such as
trust services, that the Company generally does not offer. The Company primarily
relies on providing quality products and services at a competitive price within
the market area. As a result of interstate banking legislation, the Company's
market is open to future penetration by banks located in other states provided
that the other states allow their domestic banking institutions to acquire NC
banking institutions, thereby increasing competition.
In its Triad Region, as of June 2004, the Company competed with 15 commercial
banks and two savings institutions, as well as numerous credit unions. As of
that date, the Company competed with 13 commercial banks, two savings
institution and several credit unions in its Wilmington Region. In its
10
Norton Region, as of June 2004, the Company competed with 8 commercial banks. As
of that date, the Company competed with 13 commercial banks in its Harrisonburg
Region.
Employees
All employees during 2004 were compensated by the Bank or its subsidiaries. On
December 31, 2004, the Company had approximately 255 full-time and 14 part-time
employees. None of the Company's employees are represented by a collective
bargaining unit, and we have not experienced any type of strike or labor
dispute. We consider our relationship with our employees to be very good, as
they are extremely important to our long-term success. The Board and management
continually seek ways to enhance their benefits and well being.
Available Information
The Company makes its Annual Report on Form 10-K, Quarterly Reports on Form
10-Q, Current Reports on Form 8-K and amendments to those reports available free
of charge on its internet website www.fnbsoutheast.com, as soon as reasonably
practicable after the reports are electronically filed or furnished to the SEC.
Any materials that the Company files with the SEC may be read and/or copied at
the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549.
Public information may be obtained by calling the SEC at 1-800-SEC-0330. These
filings are also accessible on the SEC's website at www.sec.gov.
Additionally, the Company's corporate governance policies, including the
charters of the Audit, Compensation, and Nominating and Corporate Governance
committees; and the Code of Business Conduct and Ethics may also be found under
the "Investor Information" section of the Company's website. The Company elects
to disclose any amendments to or waivers of any provisions of its Code of
Business Conduct and Ethics applicable to its principal executive officers and
senior financial officers on its website. A written copy of the foregoing
corporate governance policies is available upon written request to the Company.
Supervision and Regulation
Bank and financial holding companies and commercial banks are extensively
regulated under both federal and state law. The following is a brief summary of
certain statutes and rules and regulations that affect or will affect the
Company, the Bank, and the Bank's subsidiaries. This summary is qualified in its
entirety by reference to the particular statute, and regulatory provisions
referred to below, and is not intended to be an exhaustive description of the
statutes or regulations applicable to the business of the Company and the Bank.
Supervision, regulation and examination of the Company and the Bank by the
regulatory agencies are intended primarily for the protection of depositors
rather than shareholders of the Company. Statutes and regulations which contain
wide-ranging proposals for altering the structures, regulations, and competitive
relationship of financial institutions are introduced regularly. The Company
cannot predict whether or in what form any proposed statute or regulation will
be adopted or the extent to which the business of the Company and the Bank may
be affected by such statute or regulation.
General. There are a number of obligations and restrictions imposed on financial
holding companies and bank holding companies and their depository institution
subsidiaries by law and regulatory policy that are designed to minimize
potential loss to the depositors of such depository institutions and the FDIC
insurance funds in the event the depository institution becomes in danger of
default or in default. For example, to avoid receivership of an insured
depository institution subsidiary, a holding company is required to guarantee
the compliance of any insured depository institution subsidiary that may become
"undercapitalized" with the terms of any capital restoration plan filed by such
subsidiary with its appropriate federal banking agency up to the lesser of (i)
an amount equal to 5% of the bank's total assets
11
at the time the bank became undercapitalized or (ii) the amount which is
necessary (or would have been necessary) to bring the bank into compliance with
all acceptable capital standards as of the time the bank fails to comply with
such capital restoration plan. The Company, as a registered financial holding
company, is subject to the regulation of the Federal Reserve. Under a policy of
the Federal Reserve with respect to holding company operations, a holding
company is required to serve as a source of financial strength to its subsidiary
depository institutions and to commit resources to support such institutions in
circumstances where it might not do so absent such policy. The Federal Reserve
under the BHCA also has the authority to require a holding company to terminate
any activity or to relinquish control of a nonbank subsidiary (other than a
nonbank subsidiary of a bank) upon the Federal Reserve's determination that such
activity or control constitutes a serious risk to the financial soundness and
stability of any bank subsidiary of the holding company.
In addition, insured depository institutions under common control are required
to reimburse the FDIC for any loss suffered by its deposit insurance funds as a
result of the default of a commonly controlled insured depository institution or
for any assistance provided by the FDIC to a commonly controlled insured
depository institution in danger of default. The FDIC may decline to enforce the
cross-guarantee provisions if it determines that a waiver is in the best
interest of the deposit insurance funds. The FDIC's claim for damages is
superior to claims of stockholders of the insured depository institution or its
holding company but is subordinate to claims of depositors, secured creditors
and holders of subordinated debt (other than affiliates) of the commonly
controlled insured depository institutions.
As a result of the Company's ownership of the Bank, the Company is also
registered under the bank holding company laws of North Carolina. Accordingly,
the Company is also subject to regulation and supervision by the Commissioner.
Capital Adequacy Guidelines for Holding Companies. The Federal Reserve has
adopted capital adequacy guidelines for bank holding companies and banks that
are members of the Federal Reserve system and have consolidated assets of $150
million or more. Bank and financial holding companies subject to the Federal
Reserve's capital adequacy guidelines are required to comply with the Federal
Reserve's risk-based capital guidelines. Under these regulations, the minimum
ratio of total capital to risk-weighted assets is 8%. At least half of the total
capital is required to be "Tier I capital," principally consisting of common
stockholders' equity, noncumulative perpetual preferred stock, and a limited
amount of cumulative perpetual preferred stock, less certain goodwill items. The
remainder ("Tier II capital") may consist of a limited amount of subordinated
debt, certain hybrid capital instruments and other debt securities, perpetual
preferred stock, and a limited amount of the general loan loss allowance. In
addition to the risk-based capital guidelines, the Federal Reserve has adopted a
minimum Tier I capital (leverage) ratio, under which a holding company must
maintain a minimum level of Tier I capital to average total consolidated assets
of at least 3% in the case of a holding company which has the highest regulatory
examination rating and is not contemplating significant growth or expansion. All
other holding companies are expected to maintain a Tier I capital (leverage)
ratio of at least 1% to 2% above the stated minimum.
Capital Requirements for the Bank. The Bank, as a NC commercial bank, is
required to maintain a surplus account equal to 50% or more of its paid-in
capital stock. As a NC chartered, FDIC-insured commercial bank that is a member
of the Federal Reserve System, it is also subject to capital requirements
imposed by the Federal Reserve. Under Federal Reserve regulations, member banks
must maintain a minimum ratio of qualifying capital to weighted risk assets
equal to 8%. At least half of the total capital is required to be Tier I
Capital, with the remainder consisting of Tier II Capital. In addition to the
foregoing risk based capital guidelines, member banks which receive the highest
rating in the examination process and are not anticipating or experiencing any
significant growth, must maintain a minimum level of Tier I Capital to total
assets of 3%. Member banks, which do not fall within the
12
foregoing standards, are required to maintain higher capital ratios. The Bank
exceeded all applicable minimum capital requirements as of December 31, 2004.
Dividend and Repurchase Limitations. The Company must obtain Federal Reserve
approval prior to repurchasing common stock for consideration in excess of 10%
of its net worth during any twelve-month period unless the Company (i) both
before and after the redemption satisfies capital requirements for "well
capitalized" state member banks; (ii) received a one or two rating in its last
examination; and (iii) is not the subject of any unresolved supervisory issues.
Although the payment of dividends and repurchase of stock by the Company are
subject to certain requirements and limitations of NC corporate law, except as
set forth in this paragraph, neither the Commissioner nor the FDIC have
promulgated any regulations specifically limiting the right of the Company to
pay dividends and repurchase shares. However, the ability of the Company to pay
dividends or repurchase shares is dependent upon the Company's receipt of
dividends from the Bank.
NC commercial banks, such as the Bank, are subject to legal limitations on the
amounts of dividends they are permitted to pay. The Bank may pay dividends from
undivided profits, which are determined by deducting and charging certain items
against actual profits, including any contributions to surplus required by NC
law. Also, an insured depository institution, such as the Bank, is prohibited
from making capital distributions, including the payment of dividends, if, after
making such distribution, the institution would become "undercapitalized" (as
such term is defined in the applicable law and regulations).
Deposit Insurance Assessments. The Bank is subject to insurance assessments
imposed by the FDIC. Under current law, the insurance assessment to be paid by
members of the Bank Insurance Fund, such as the Bank, shall be as specified in a
schedule required to be issued by the FDIC. FDIC assessments for deposit
insurance range from 0 to 27 basis points per $100 of insured deposits,
depending on the institution's capital position and other supervisory factors.
Federal Home Loan Bank System. The Federal Home Loan Bank ("FHLB") system
provides a central credit facility for member institutions. In December 2004,
the FHLB of Atlanta implemented a new capital plan. As a member of the FHLB of
Atlanta, the Bank is required to own capital stock in the FHLB of Atlanta in an
amount at least equal to 0.20% (or 20 basis points) of the Bank's total assets
at the end of each calendar year, plus 4.5% of its outstanding advances
(borrowings) from the FHLB of Atlanta under the new activity-based stock
ownership requirement. On December 31, 2004, the Bank was in compliance with
this requirement.
Community Reinvestment. Under the Community Reinvestment Act ("CRA"), as
implemented by regulations of the FDIC, an insured institution has a continuing
and affirmative obligation consistent with its safe and sound operation to help
meet the credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions, nor does it limit an institution's
discretion to develop, consistent with the CRA, the types of products and
services that it believes are best suited to its particular community. The CRA
requires the federal banking regulators, in connection with their examinations
of insured institutions, to assess the institutions' records of meeting the
credit needs of their communities, using the ratings of "outstanding,"
"satisfactory," "needs to improve," or "substantial noncompliance," and to take
that record into account in its evaluation of certain applications by those
institutions. All institutions are required to make public disclosure of their
CRA performance ratings. The Bank received a "satisfactory" rating in its last
CRA examination, which was conducted during July 2004.
Prompt Corrective Action. The FDIC has broad powers to take corrective action to
resolve the problems of insured depository institutions. The extent of these
powers will depend upon whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
13
undercapitalized," or "critically undercapitalized." Under the regulations, an
institution is considered "well capitalized" if it has (i) a total risk-based
capital ratio of 10% or greater, (ii) a Tier I risk-based capital ratio of 6% or
greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any
order or written directive to meet and maintain a specific capital level for any
capital measure. An "adequately capitalized" institution is defined as one that
has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I
risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or
greater (or 3% or greater in the case of an institution with the highest
examination rating). An institution is considered (A) "undercapitalized" if it
has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I
risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than
4% (or 3% in the case of an institution with the highest examination rating);
(B) "significantly undercapitalized" if the institution has (i) a total
risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital
ratio of less than 3% or (iii) a leverage ratio of less than 3% and (c)
"critically undercapitalized" if the institution has a ratio of tangible equity
to total assets equal to or less than 2%. At December 31, 2004, the Bank had the
requisite capital levels to qualify as "well capitalized".
Changes in Control. The BHCA prohibits the Company from acquiring direct or
indirect control of more than 5% of the outstanding voting stock or
substantially all of the assets of any bank or savings bank or merging or
consolidating with another bank or financial holding company or savings bank
holding company without prior approval of the Federal Reserve. Similarly,
Federal Reserve approval (or, in certain cases, non-disapproval) must be
obtained prior to any person acquiring control of the Company. Control is
conclusively presumed to exist if, among other things, a person acquires more
than 25% of any class of voting stock of the Company or controls in any manner
the election of a majority of the directors of the Company. Control is presumed
to exist if a person acquires more than 10% of any class of voting stock and the
stock is registered under Section 12 of the Exchange Act or the acquiror will be
the largest shareholder after the acquisition.
Federal Securities Law. The Company has registered its common stock with the SEC
pursuant to Section 12(g) of the Exchange Act. As a result of such registration,
the proxy and tender offer rules, insider trading reporting requirements, annual
and periodic reporting and other requirements of the Exchange Act are applicable
to the Company.
Transactions with Affiliates. Under current federal law, depository institutions
are subject to the restrictions contained in Section 22(h) of the Federal
Reserve Act with respect to loans to directors, executive officers and principal
shareholders. Under Section 22(h), loans to directors, executive officers and
shareholders who own more than 10% of a depository institution (18% in the case
of institutions located in an area with less than 30,000 in population), and
certain affiliated entities of any of the foregoing, may not exceed, together
with all other outstanding loans to such person and affiliated entities, the
institution's loans-to-one-borrower limit (as discussed below). Section 22(h)
also prohibits loans above amounts prescribed by the appropriate federal banking
agency to directors, executive officers and shareholders who own more than 10%
of an institution, and their respective affiliates, unless such loans are
approved in advance by a majority of the board of directors of the institution.
Any "interested" director may not participate in the voting. The FDIC has
prescribed the loan amount (which includes all other outstanding loans to such
person), as to which such prior board of director approval is required, as being
the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further,
pursuant to Section 22(h), the Federal Reserve requires that loans to directors,
executive officers, and principal shareholders be made on terms substantially
the same as offered in comparable transactions with non-executive employees of
the Bank. The FDIC has imposed additional limits on the amount a bank can loan
to an executive officer.
Loans to One Borrower. The Bank is subject to the loans to one borrower limits
imposed by the North Carolina Office of the Commissioner of Banks (the
"Commissioner"), which are substantially the same as those applicable to
national banks. Under these limits, no loans and extensions of credit to any
borrower
14
outstanding at one time and not fully secured by readily marketable collateral
shall exceed 15% of the unimpaired capital and unimpaired surplus of the bank.
Loans and extensions of credit fully secured by readily marketable collateral
may comprise an additional 10% of unimpaired capital and unimpaired surplus.
Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act enacted in 1999 (the
"GLB Act") dramatically changed various federal laws governing the banking,
securities and insurance industries. The GLB Act has expanded opportunities for
banks and bank holding companies to provide services and engage in other
revenue-generating activities that previously were prohibited to them. However,
this expanded authority also may present us with new challenges as our larger
competitors are able to expand their services and products into areas that are
not feasible for smaller, community oriented financial institutions. The GLB Act
likely will have a significant economic impact on the banking industry and on
competitive conditions in the financial services industry generally.
USA Patriot Act of 2001. The USA Patriot Act of 2001 was enacted in response to
the terrorist attacks that occurred in New York, Pennsylvania and Washington,
D.C. on September 11, 2001. The Act is intended to strengthen the ability of
U.S. law enforcement and the intelligence community to work cohesively to combat
terrorism on a variety of fronts. The potential impact of the Act on financial
institutions of all kinds is significant and wide ranging. The Act contains
sweeping anti-money laundering and financial transparency laws and requires
various regulations, including standards for verifying customer identification
at account opening, and rules to promote cooperation among financial
institutions, regulators, and law enforcement entities in identifying parties
that may be involved in terrorism or money laundering.
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 are still in the process of being
implemented.
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 economic and operational effects of this new legislation on public
companies, including us, have been and will continue to be significant in terms
of the time, resources and costs associated with complying with the new law.
Other. Additional regulations require annual examinations of all insured
depository institutions by the appropriate federal banking agency, with some
exceptions for small, well-capitalized institutions and state chartered
institutions examined by state regulators, and establish operational and
managerial, asset quality, earnings and stock valuation standards for insured
depository institutions, as well as compensation standards.
15
The Bank is subject to examination by the Federal Reserve and the Commissioner.
In addition, it is subject to various other state and federal laws and
regulations, including state usury laws, laws relating to fiduciaries, consumer
credit and equal credit, fair credit reporting laws and laws relating to branch
banking. The Bank, as an insured North Carolina commercial bank, is prohibited
from engaging as a principal in activities that are not permitted for national
banks, unless (i) the FDIC or the Federal Reserve, as it is a member bank,
determines that the activity would pose no significant risk to the appropriate
deposit insurance fund and (ii) the Bank is, and continues to be, in compliance
with all applicable capital standards.
Limits on Rates Paid on Deposits and Brokered Deposits. Regulations promulgated
by the FDIC place limitations on the ability of insured depository institutions
to accept, renew or roll-over deposits by offering rates of interest which are
significantly higher than the prevailing rates of interest on deposits offered
by other insured depository institutions having the same type of charter in such
depository institution's normal market area. Under these regulations, "well
capitalized" depository institutions may accept, renew or roll-over such
deposits without restriction, "adequately capitalized" depository institutions
may accept, renew or roll-over such deposits with a waiver from the FDIC
(subject to certain restrictions on payments of rates) and "undercapitalized"
depository institutions may not accept, renew, or roll-over such deposits. The
regulations contemplate that the definitions of "well capitalized," "adequately
capitalized" and "undercapitalized" will be the same as the definitions adopted
by the FDIC to implement the corrective action provisions discussed below.
Only a "well capitalized" (as defined in the statute as significantly exceeding
each relevant minimum capital level) depository institution may accept brokered
deposits without prior regulatory approval. "Adequately capitalized" banks may
accept brokered deposits with a waiver from the FDIC (subject to certain
restrictions on payment of rates), while "undercapitalized" banks may not accept
brokered deposits. The regulations contemplate that the definitions of "well
capitalized," "adequately capitalized" and "undercapitalized" are the same as
the definitions adopted by the agencies to implement the prompt corrective
action provisions discussed below.
The Company does not believe that these regulations have had or will have a
material adverse effect on the Bank's current operations.
Taxation. Federal Income Taxation. Financial institutions such as the Bank are
subject to the provisions of the Internal Revenue Code of 1986, as amended (the
"Code") in the same general manner as other corporations. However, banks which
meet certain definitional tests and other conditions prescribed by the Code may
benefit from certain favorable provisions regarding their deductions from
taxable income for annual additions to their bad debt reserve. The Bank may
compute its addition to the bad debt reserve under the specific charge-off
method or the reserve method. Under the reserve method, the addition to bad
debts from losses on loans is computed by use of the experience method. Use of
the experience method requires minimum additions to the reserve based on the
amount allowable under a six-year moving average. The Code also provides annual
limits on the amount the Bank can add to its reserves for loan losses.
State Taxation. Under NC law, the Bank is subject to corporate income taxes at a
6.90% rate and an annual franchise tax at a rate of 0.15%.
Future Requirements. Statutes and regulations, which contain wide-ranging
proposals for altering the structures, regulations and competitive relationships
of financial institutions, are introduced regularly. Neither the Company nor the
Bank can predict whether or what form any proposed statute or regulation will be
adopted or the extent to which the business of the Company or the Bank may be
affected by such statute or regulation.
16
Item 2. Properties
The Company's executive offices were relocated to 1501 Highwoods Boulevard in
Greensboro, NC during April 2004. The Company's principal support and
operational functions are located at 202 South Main Street in Reidsville, NC.
The Company has 13 banking offices located in NC and four banking offices in VA.
The location of these banking offices, their form of occupancy and deposits as
of December 31, 2004, information about drive-up ATM facilities, and the year
each office was opened is described in the accompanying table:
Location Owned or Leased Deposits ATM Year
-------------------------------------------- --------------- --------- --- ----
202 South Main Street, Reidsville, NC (1) Owned $ 101,524 Yes 1910
1501 Highwoods Boulevard, Greensboro, NC (2) Leased -- Yes 2004
1646 Freeway Drive, Reidsville, NC Owned 37,042 Yes 1972
202 Turner Drive, Reidsville, NC Owned 34,022 Yes 1969
801 South Van Buren Road, Eden, NC Owned 36,896 Yes 1996
151 North Fieldcrest Road, Eden, NC Leased 16,038 No 1996
605 North Highway Street, Madison, NC Owned 20,984 Yes 1997
9570 US 29 Business, Ruffin, NC Leased 12,256 No 1997
2132 New Garden Road, Greensboro, NC Owned 78,423 Yes 1997
4638 Hicone Road, Greensboro, NC Owned 26,000 Yes 2000
3202 Randleman Road, Greensboro, NC Owned 33,084 Yes 2000
704 South College Road, Wilmington, NC Leased 107,653 Yes 1997
7210 Wrightsville Avenue, Wilmington, NC Leased 14,678 Yes 2000
301 East Fremont Street, Burgaw, NC Leased 32,094 Yes 1999
3025 Springbank Lane, Charlotte, NC (3) Leased -- No 2004
19460 Old Jetton Road, Cornelius, NC (3) Leased -- No 2004
600 Trent Street, Norton, VA Owned 60,801 Yes 1973
700 East Morgan Avenue, Pennington Gap, VA Owned 19,735 Yes 1979
440 South Main Street, Harrisonburg, VA Owned 61,883 Yes 1988
1925 Reservoir Street, Harrisonburg, VA Owned 31,172 Yes 2003
----------
(1) Original office opened in a different location in 1910. Current office
opened in 1980. Consists of 27,000 square feet in a two story building;
former headquarters location; scheduled to undergo extensive renovations
in 2005; will continue to serve as a full service branch as well as
becoming the Operations Center for the Company.
(2) The current headquarters office opened in 2004.
(3) Mortgage loan production offices.
Item 3. Legal Proceedings
In the ordinary course of operations, the Company and the Bank are party to
various legal proceedings. In the opinion of management, neither the Company nor
the Bank is involved in any pending legal proceedings other than routine,
non-material proceedings occurring in the ordinary course of business.
Item 4. Submission of Matters To a Vote of Security Holders
There were no matters submitted to a vote of the security holders of the Company
during the fourth quarter of the Company's fiscal year ended December 31, 2004.
17
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Market Prices and Dividend Policies
The Company's common stock is traded on The Nasdaq Stock Market National Market
System under the symbol "FNBF." The following table shows the high and low sale
price of the Company's common stock on The Nasdaq Stock Market National Market
System(1), based on published financial sources, for each of the last two fiscal
years. The table also reflects the per share amount of cash dividends paid for
each share during the fiscal quarter for each of the last two fiscal years. Only
one cash dividend was paid during each of the fiscal quarters listed.(1)
Calendar Period High Low Dividends Paid
-------------------------------- ------- ------- --------------
Quarter ended March 31, 2003 $ 14.88 $ 13.24 $ 0.11
Quarter ended June 30, 2003 16.32 14.10 0.11
Quarter ended September 30, 2003 17.78 14.57 0.11
Quarter ended December 31, 2003 20.90 17.01 0.12
Quarter ended March 31, 2004 $ 20.75 $ 19.53 $ 0.12
Quarter ended June 30, 2004 20.30 16.82 0.12
Quarter ended September 30, 2004 19.47 16.38 0.12
Quarter ended December 31, 2004 23.35 18.79 0.14
----------
(1) For comparative purposes, the sale prices and dividends paid
amounts shown in the accompanying table have been restated to
reflect the 5-for-4 stock split effected as a 25% stock dividend,
effective December 29, 2003.
As of March 14, 2005, there were approximately 1,652 beneficial owners of the
Company's common stock, including 1,248 holders of record of the Company's
common stock. For a discussion as to any restrictions on the Company or the
Bank's ability to pay dividends, reference Item 1 - Supervision and Regulation
of the Company and the Bank.
See also Note 18 in the Notes to Consolidated Financial Statements of this
Annual Report on Form 10-K. See also "Supervision and Regulation - Regulation of
the Company, Dividend and Repurchase Limitations" and "Regulation of the Bank -
Dividends."
The accompanying table details, by month, the information related to the
activity related to the share repurchase program approved by the Company's Board
of Directors in July 2004 authorizing the repurchase of up to 275,124 shares of
the Company's outstanding common stock. The program was publicly announced in
the month of approval.
Stock Repurchase Program - Approved July 2004
-------------------------------------------------------
(a) (b) (c) (d)
Total Number of Maximum Number
Shares Average Price Cumulative Number of of Shares That May Yet Be
Period Purchased Paid Per Share Shares Purchased Purchased
- ------------------- --------------- -------------- -------------------- -------------------------
October 1, 2004 to
October 31, 2004 ... 13,800 $ 19.65 44,203 230,921
November 1, 2004 to
November 30, 2004 .. 18,811 $ 20.46 63,014 212,110
December 1, 2004 to
December 31, 2004 .. 13,400 $ 21.78 76,414 198,710
18
Recent Sales of Unregistered Securities
The Company did not sell any of its securities in the last three fiscal years,
which were not registered under the Securities Act of 1933, as amended, except
that it granted options to employees or directors to acquire an aggregate of
324,033 shares of its common stock at a weighted average exercise price of
$16.14 per share pursuant to the Company's Omnibus Equity Compensation Plan.
Item 6. Selected Financial Data
The annual selected historical financial data presented in the accompanying
table are derived from the audited consolidated financial statements for FNB
Financial Services Corporation and Subsidiary. As this information is only a
summary, you should read it in conjunction with the historical financial
statements (and related notes) of the Company and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere
herein.
19
Selected Consolidated Financial Data
(In thousands, except per share, ratio and other data) At and For the Year Ended December 31,
---------------------------------------------------------
2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
Income Statement Data:
Net interest income $ 29,385 $ 24,822 $ 23,753 $ 21,705 $ 22,659
Provision for credit losses 1,275 1,431 1,300 1,278 2,525
Noninterest income 8,086 7,425 5,285 4,740 2,891
Noninterest expense 23,766 19,567 17,429 15,838 16,100
Net income 8,341 7,460 6,782 6,478 4,602
Balance Sheet Data:
Assets $ 865,335 $ 780,926 $ 734,032 $ 704,825 $ 685,904
Loans (1) 663,425 581,384 563,600 535,345 500,637
Allowance for credit losses 7,353 7,124 7,059 6,731 6,311
Deposits 724,286 641,907 605,005 586,760 569,451
Other borrowings 45,000 55,500 52,500 30,000 41,000
Shareholders' equity 70,430 65,750 64,333 62,708 56,392
Per Common Share Data (5):
Net income, basic $ 1.52 $ 1.35 $ 1.19 $ 1.14 $ 0.83
Net income, diluted (2) 1.46 1.30 1.17 1.13 0.82
Cash dividends declared .50 0.45 0.42 0.41 0.36
Book value 12.69 12.00 11.52 10.98 10.05
Tangible book value 12.53 11.82 11.48 10.92 9.98
Other Data:
Branch offices 17 18 17 17 18
Full-time employees 255 225 188 204 196
Performance Ratios:
Return on average assets 1.02% 0.98% 0.97% 0.91% 0.72%
Return on average equity 12.29 11.55 10.63 10.75 8.96
Net interest margin (tax equivalent) 3.94 3.53 3.57 3.25 3.83
Dividend payout 34.25 33.68 35.55 35.94 44.42
Efficiency (3) 62.28 59.65 59.71 59.05 62.20
Asset Quality Ratios:
Allowance for credit losses to period end loans 1.11% 1.23% 1.25% 1.26% 1.26%
Allowance for credit losses to period end
nonperforming loans (4) 209.16 136.30 191.87 297.04 195.87
Net charge-offs to average loans 0.17 0.24 0.18 0.17 0.14
Nonperforming assets to period end loans
and foreclosed property (4) 1.36 1.78 0.94 0.92 0.84
Capital and Liquidity Ratios:
Average equity to average assets 8.32% 8.52% 9.09% 8.45% 8.07%
Leverage capital 8.20 8.40 8.50 8.60 8.20
Tier 1 risk based capital 10.20 10.70 11.20 11.60 11.30
Total risk based capital 11.30 11.90 12.50 12.80 12.50
Average loans to average deposits 90.98 91.69 96.17 85.96 87.91
Average loans to average deposits and borrowings 83.07 83.39 86.85 79.63 79.22
- ----------
(1) Loans net of unearned income, before allowance for credit losses.
(2) Assumes the exercise of outstanding dilutive options to acquire common
stock. See Note 14 to the Company's consolidated financial statements.
(3) Computed by dividing noninterest expense by the sum of taxable
equivalent net interest income and noninterest income.
(4) Nonperforming loans and nonperforming assets include loans past due 90
days or more that are still accruing interest.
(5) Per share data has been restated to reflect the 5-for-4 stock split,
effected as a 25% stock dividend, effective December 29, 2003.
20
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following presents management's discussion and analysis of our financial
condition and results of operations and should be read in conjunction with the
financial statements and related notes included elsewhere in this annual report.
This discussion contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ significantly from those
anticipated in these forward-looking statements as a result of various factors.
All share data have been adjusted to give retroactive effect to stock splits and
stock dividends. The following discussion is intended to assist in understanding
the financial condition and results of operations of the Company.
Executive Overview
Significant Accomplishments. In the opinion of the management of FNB Financial
Services Corporation, the Company's most significant accomplishments during 2004
were:
o We relocated the Company's headquarters to Greensboro, NC, which
enhanced our ability to employ and retain personnel with the skills
and experience necessary to continue to execute our strategic plan
and to promote our penetration of this significant urban market.
o We began the execution of our management succession plan with the
promotion of Pressley A. Ridgill to President of the Bank.
o We expanded our core management team with the promotion of key
personnel and the addition of several members.
o We continued to execute upon the Company's strategic plan of
expanding our markets, products and services.
o Diluted net income per share increased 12.3%.
o Net interest income increased 18.4%.
o Asset quality continued to improve; all significant credit quality
ratios improved year-to-year.
Challenges. The achievement of the Company's strategic initiatives and long-term
financial goals is subject to many uncertainties. The challenges, which in the
opinion of management are most likely to have a near-term effect on operations,
are presented below:
o Volatility of interest rates.
o Building revenue momentum.
o Improving efficiency.
o The economic environment in our core markets.
o Costs associated with the current heightened regulatory environment.
o Expanding our core management team.
o Volatility in the mortgage banking business.
o Intense price competition.
General
The Company earned $8.34 million in 2004, an 11.8% increase over the $7.46
million earned in 2003. Diluted net income per share of $1.46 for 2004
represents a 12.3% increase over diluted net income per share of $1.30 in 2003.
The Bank of Tazewell purchased selected loans and assumed the deposits of the
Bank's Richlands, VA branch during April 2004. The Bank transferred $15.0
million in deposit accounts and $7.3 million in loan accounts in the
transaction. We recognized approximately $700,000 in net gain on the sale. Also
during April, we realized approximately $125,000 gain from the sale of the fixed
assets associated with the Richlands, VA branch. Total assets at December 31,
2004 stood at $865.3 million compared to $780.9 million one year earlier. The
increase in assets is primarily attributable to an $82.0
21
million increase in gross loans. Gross loans at December 31, 2004 totaled $663.4
million, up from $581.4 million at yearend 2003. Investment securities, which is
the next largest component of assets, totaled $141.6 million at December 31,
2004, a 1.5% decrease from the balance of $143.7 million a year ago.
During 2004, deposits increased 12.8% to $724.3 million at yearend. Borrowings,
comprised of federal funds purchased, retail repurchase agreements, and FHLB
advances, totaled $66.5 million at December 31, 2004, compared to $70.9 million
at the prior yearend. Shareholders' equity increased 7.1% to $70.4 million at
yearend 2004. Book value per share was $12.69 at December 31, 2004.
The Company's subsidiary bank, FNB Southeast, is a NC chartered commercial bank
that, as of December 31, 2004, operated thirteen banking offices in NC and four
banking offices in VA. The Bank operates two wholly owned subsidiaries. FNB
Southeast Investment Services, Inc. was formed in 2000 to provide retail
investment products and services. FNB Southeast Mortgage Corporation was formed
in 2001 to provide mortgage banking services.
Financial Condition at December 31, 2004 and 2003
The Company's consolidated assets of $865.3 million at yearend 2004 reflect an
increase of 10.8% over the previous year, following an increase of 6.4% in 2003.
Total average assets increased 7.6% to $815.6 million in 2004, compared to
$758.1 million in 2003. During 2004, the Company experienced a 6.3% increase in
average earning assets. Average earning assets totaled $764.1 million in 2004,
compared to $718.9 million in 2003. The increase in 2004 was primarily
attributable to a 7.2% growth in average outstanding loans. The increase in
average outstanding loans was funded primarily by an 8.0% rise in average
deposits resulting from successful deposit marketing campaigns during 2004.
Gross loan growth during 2004 was $82.0 million, with outstanding loans up 14.1%
at yearend, which followed increases of 3.2% in 2003 and 5.3% in 2002. Loans
secured by real estate totaled $442.2 million in 2004 and represented 66.7% of
total loans, compared with 64.1% at yearend 2003. Within this category,
commercial real estate loans increased 4.2% during fiscal 2004 to a level of
$166.7 million, while residential real estate loans rose 19.5% to $113.4 million
and construction loans increased 37.7% to $162.1 million. Commercial, financial
and agricultural loans totaled $86.2 million and represented 13.0% of total
loans at the end of 2004, and 15.5% at yearend 2003. Consumer loans increased
15.9% during 2004, led by increased home equity loans. Management believes the
Company is not dependent on any single customer or group of customers
concentrated in a particular industry, the loss of whose deposits or whose
insolvency would have a material adverse effect on operations.
Investment securities (at amortized cost) totaled $142.4 million at yearend
2004, a 1.1% decline from $143.9 million at yearend 2003. U.S. Government agency
and mortgage backed securities continue to represent the major share of the
total portfolio, and totaled $104.9 million, or 58.2% of the portfolio at
yearend 2004, compared to $106.8 million, or 74.2% of the portfolio one year
earlier. Management believes that the additional risk of owning agency
securities over U.S. Treasury securities is negligible and has capitalized on
the favorable spreads available on the former. State and municipal obligations
amounted to $31.9 million at yearend, compared to $32.6 million a year earlier.
The Company's investment strategy is to achieve acceptable total returns, while
investing in securities with relatively short maturity dates as necessary to
fund loan growth. To this end, the Company has consistently categorized the
entire portfolio as "Available for Sale," which it believes offers the greatest
amount of flexibility in managing a total return concept. The table, "Investment
Securities," presents the composition of the securities portfolio for the last
three years, as well as information about cost, fair value and weighted average
yield.
Total deposits increased $82.4 million to $724.3 million at December 31, 2004,
resulting in a 12.8% increase over $641.9 million in deposits one year earlier.
This increase was driven by an $8.8 million, or
22
12.6%, increase in demand deposits and a $73.5 million, or 61.9%, increase in
savings, NOW and MMI accounts; while time deposit growth was relatively flat.
The market for deposits remains fiercely competitive and the Company relies on
appropriate pricing and quality customer service to retain and increase its
retail deposit base. During the year, the Company had several featured products
to generate new deposits and increase the customer base. For commercial
customers, the Company is focused on building a total relationship, which will
foster growth in both loans and deposits. In addition to traditional checking
accounts, the Company offers a cash management sweep account, with outstanding
balances of $7.9 million at yearend.
In order to attract additional deposits when necessary, the Company maintains
membership in an electronic network that allows it to post interest rates and
attract deposits nationally. As of December 31, 2004, FNB Southeast had three of
such certificates of deposit totaling $7.6 million, with an overall rate of
1.74% for this portfolio. This certificate portfolio decreased by $18.4 million
during 2004. The Company also held one brokered certificate of deposit totaling
$7.4 million at December 31, 2004 maturing during 2005, compared to $25.0
million one year earlier. Brokered certificates typically have an original term
of twelve to twenty-four months. The decrease in bulletin board deposits and
brokered deposits is attributable to the increase of in-market deposits
generated in 2004. Brokered deposits may continue to decrease during 2005;
however, these deposits can be utilized for future balance sheet funding as
necessary.
The Company also has a credit facility available with the FHLB of Atlanta.
Borrowing capacity is established at 17% of the Bank's total assets as submitted
on regulatory financial reports. The Company also utilized a portion of its
approximately $145 million line with the FHLB to fund earning assets. FHLB
borrowings totaled $45.0 million at yearend. Management continues to believe
this is a cost effective and prudent alternative to deposit balances, since a
particular amount, term and structure may be selected to meet its current needs.
Financial Condition at December 31, 2003 and 2002
The Company's consolidated assets of $780.9 million at December 31, 2003 reflect
an increase of 6.4% over the previous year. Total average assets increased 8.1%
to $758.1 million in 2003, compared to $701.5 million in 2002. During 2003, the
Company experienced a 7.2% increase in average earning assets. Average earning
assets totaled $718.9 million in 2003, compared to $670.6 million in 2002. The
increase in 2003 was primarily attributable to a 26.1% growth in the average
investment securities balance, combined with an increase in average outstanding
loans. The increase in the average balance of securities was attributable to a
combination of a slightly weaker loan demand and a 9.6% rise in average deposits
resulting from successful deposit marketing campaigns during 2003.
Gross loan growth during 2003 was $17.8 million, with outstanding loans up 3.2%
at yearend, which followed increases of 5.3% in 2002 and 6.9% in 2001. Loans
secured by real estate totaled $372.6 million in 2003 and represented 64.1% of
total loans, compared with 67.1% at yearend 2002. Within this category,
commercial real estate loans decreased 6.3% during fiscal 2003 to a level of
$160.0 million, while residential real estate loans decreased 20.5% to $94.9
million and construction loans increased 34.3% to $117.8 million. Commercial,
financial and agricultural loans totaled $90.2 million and represented 15.5% of
total loans at the end of 2003 and 2002. Consumer loans increased 20.4% during
2003, led by increased home equity loans. Management believes the Company is not
dependent on any single customer or group of customers concentrated in a
particular industry, the loss of whose deposits or whose insolvency would have a
material adverse effect on operations.
Investment securities (at amortized cost) of $143.9 million at yearend 2003 were
up $17.5 million, or 13.9%, from $126.4 million at yearend 2002. U.S. Government
agency securities continue to represent
23
the major share of the total portfolio, and totaled $106.8 million, or 74.2% of
the portfolio at yearend 2003, compared to $115.3 million, or 91.2% of the
portfolio one year earlier. Management believes that the additional risk of
owning agency securities over U.S. Treasury securities is negligible and has
capitalized on the favorable spreads available on the former. State and
municipal obligations increased $25.6 million and amounted to at $32.6 million
at yearend. The increase in municipal securities in 2003 is attributable to the
favorable tax effected yield, compared to other available securities. The
Company's investment strategy is to achieve acceptable total returns, while
investing in securities with relatively short maturity dates as necessary to
fund loan growth. To this end, the Company has consistently categorized the
entire portfolio as "Available for Sale," which it believes offers the greatest
amount of flexibility in managing a total return concept. The table, "Investment
Securities," presents the composition of the securities portfolio for the last
three years, as well as information about cost, fair value and weighted average
yield.
Total deposits increased $36.9 million to $641.9 million at December 31, 2003,
resulting in a 6.1% increase over $605.0 million in deposits one year earlier.
This increase was driven by an $8.3 million, or 13.5% increase in demand
deposits, a $9.7 million, or 2.2% increase in time deposits and an $18.8
million, or 18.8% increase in savings, NOW and MMI accounts.
The market for deposits remains fiercely competitive and the Company relies on
appropriate pricing and quality customer service to retain and increase its
retail deposit base. During the year, the Company had several featured products
to generate new deposits and increase the customer base. For commercial
customers, the Company is focused on building a total relationship, which will
foster growth in both loans and deposits. In addition to traditional checking
accounts, the Company offers a cash management sweep account, with outstanding
balances of $6.7 million at 2003 yearend.
In order to attract additional deposits when necessary, the Company maintains
membership in an electronic network that allows it to post interest rates and
attract deposits nationally. As of December 31, 2003, FNB Southeast had 10 of
such certificates of deposit totaling $989,000, with an overall rate of 3.60%
for this portfolio. This certificate portfolio decreased by $10.5 million during
2003. The Company also held three brokered certificates of deposit totaling
$25.0 million at December 31, 2003, compared to $44.5 million one year earlier.
The brokered certificates have an original term of twelve to twenty-four months
with maturities of $25.0 million in 2004. The decrease in bulletin board
deposits and brokered deposits is attributable to the increase of in market
deposits generated in 2003. Brokered deposits may continue to decrease during
2004.
The Company also has a credit facility available with the FHLB of Atlanta.
Borrowing capacity is established at 17% of the Bank's total assets as submitted
on regulatory financial reports. The Company also utilized a portion of it's
approximately $130 million line with the FHLB to fund earning assets. FHLB
borrowings totaled $55.5 million at yearend. Management continues to believe
this is a cost effective and prudent alternative to deposit balances, since a
particular amount, term and structure may be selected to meet its current needs.
Net Interest Income
Like most financial institutions, the primary component of our earnings is net
interest income. Net interest income is the difference between interest income,
principally from loans and investments, and interest expense, principally on
customer deposits and borrowings. Changes in net interest income result from
changes in volume and changes in interest rates earned and paid. By volume, we
mean the average dollar level of interest-earning assets and interest-bearing
liabilities. Spread refers to the difference between the average yield on
interest-earning assets and the average cost of interest-bearing liabilities,
and margin refers to net interest income divided by average interest-earning
assets. Spread and margin are influenced by the levels and relative mix of
interest-earning assets and interest-bearing liabilities, as well as by levels
of noninterest-bearing liabilities. During the years ended December 31, 2004,
2003 and 2002, our average
24
interest-earning assets were $764.1 million, $718.9 million, and $670.6 million,
respectively. During these same years, our net interest margins were 3.63%,
3.16% and 3.07%, respectively.
Average Balances and Average Rates Earned and Paid. The following table sets
forth, for the years 2002 through 2004, information with regard to average
balances of assets and liabilities, as well as the total dollar amounts of
interest income from interest-earning assets and interest expense on
interest-bearing liabilities, resultant yields or costs, net interest income,
net interest spread, net interest margin and ratio of average interest-earning
assets to average interest-bearing liabilities. Average loans include
nonaccruing loans, the effect of which is to lower the average yield.
Average Balance Sheets and Net Interest Income Analysis
Fully Taxable Equivalent Basis
(Dollars in thousands)
Year Ended December 31,
---------------------------------------------------------------
2004 2003
------------------------------ ------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate
--------- -------- ------- --------- -------- -------
Interest earning assets:
Loans, net (1) $ 613,522 $ 39,609 6.46% $ 572,472 $ 36,196 6.32%
Taxable investment securities 102,139 3,146 3.08 108,863 4,045 3.72
Tax-exempt investment 33,377 2,035 6.10 26,389 1,652 6.26
securities (2)
Other securities 4,414 180 4.08 3,746 172 4.59
Overnight deposits 10,644 194 1.82 7,476 84 1.12
--------- -------- --------- --------
Total earning assets 764,096 45,164 5.91 718,946 42,149 5.86
Non-earning assets:
Cash and due from banks 20,210 16,566
Premises and equipment 13,587 12,630
Other assets 24,918 17,028
Less: Allowance for credit
loss (7,230) (7,116)
--------- ---------
Total assets $ 815,581 $ 758,054
========= =========
Interest bearing liabilities:
Savings and NOW $ 52,263 66 0.13% $ 50,947 125 0.25%
MMI 98,516 2,070 2.10 55,630 791 1.42
Time deposits 447,940 11,423 2.55 452,156 14,274 3.16
Federal funds purchased,
borrowed funds and
securities sold under
agreements to repurchase 64,140 1,528 2.38 62,203 1,575 2.53
--------- -------- --------- --------
Total interest bearing
liabilities 662,859 15,087 2.28 620,936 16,765 2.70
Other liabilities and
shareholder's equity
Demand deposits 75,712 65,592
Other liabilities 9,150 6,938
Shareholders' equity 67,860 64,588
--------- ---------
Total liabilities and
shareholders' equity $ 815,581 $ 758,054
========= =========
Net interest income and net
yield on earning assets (3) $ 30,077 3.94% $ 25,384 3.53%
======== ==== ======== ====
Interest rate spread (4) 3.63% 3.16%
==== ====
- ----------
25
Average Balance Sheets and Net Interest Income Analysis (cont'd)
Fully Taxable Equivalent Basis
(Dollars in thousands)
Year Ended December 31,
------------------------------
2002
------------------------------
Interest Average
Average Income/ Yield/
Balance Expense Rate
--------- -------- -------
Interest earning assets:
Loans, net (1) $ 547,816 $ 37,199 6.79%
Taxable investment securities 100,418 5,375 5.35
Tax-exempt investment 5,766 452 7.84
securities (2)
Other securities 4,082 232 5.68
Overnight deposits 12,548 205 1.63
--------- --------
Total earning assets 670,630 43,463 6.48
Non-earning assets:
Cash and due from banks 14,597
Premises and equipment 11,072
Other assets 12,159
Less: Allowance for credit
loss (6,928)
---------
Total assets $ 701,530
=========
Interest bearing liabilities:
Savings and NOW $ 45,172 231 0.51%
MMI 50,531 1,061 2.10
Time deposits 416,226 16,730 4.02
Federal funds purchased,
borrowed funds and
securities sold under 61,121 1,533 2.51
agreements to repurchase
--------- --------
Total interest bearing
liabilities 573,050 19,555 3.41
Other liabilities and
shareholder's equity
Demand deposits 57,708
Other liabilities 6,982
Shareholders' equity 63,790
---------
Total liabilities and
shareholders' equity $ 701,530
=========
Net interest income and net
yield on earning assets (3) $ 23,908 3.57%
======== =====
Interest rate spread (4) 3.07%
=====
- ----------
(1) The average loan balances include nonaccruing loans and only interest
income actually collected and recognized.
(2) The fully taxable equivalent basis is computed using a federal tax rate of
34%.
(3) Net yield on earning assets is computed by dividing net interest income by
average earning assets.
(4) Earning asset yield minus interest bearing liabilities rate
Rate/Volume Analysis
The following table analyzes the dollar amount of changes in interest income and
interest expense for major components of interest-earning assets and
interest-bearing liabilities. The table distinguishes between (i) changes
attributable to volume (changes in volume multiplied by the prior period's
rate), (ii) changes attributable to rate (changes in rate multiplied by the
prior period's volume), and (iii) net change (the sum of the previous columns).
The change attributable to both rate and volume (changes in
26
rate multiplied by changes in volume) has been allocated equally to both the
changes attributable to volume and the changes attributable to rate.
Analysis of Interest Changes Due To Volume and Rates
Fully Taxable Equivalent Basis
(In thousands)
Year Ended December 31,
-------------------------------------------------------------------
2004 compared with 2003 2003 compared with 2002
-------------------------------- --------------------------------
Volume (2) Rate (2) Total Volume (2) Rate (2) Total
Variance Variance Variance Variance Variance Variance
---------- -------- -------- ---------- -------- --------
Interest Income:
Loans, net $ 2,595 $ 818 $ 3,413 $ 1,674 $ (2,677) $ 1,003)
Taxable investment securities (250) (649) (899) 452 (1,782) (1,330)
Tax-exempt investment securities (1) 437 (54) 383 1,617 (417) 1,200
Other securities 31 (23) 8 (19) (41) (60)
Overnight deposits 36 74 110 (83) (38) (121)
Federal funds sold and securities
purchased under the agreement to
resale -- -- -- -- -- --
-------- -------- -------- -------- -------- --------
Total change 2,849 166 3,015 3,641 (4,955) (1,314)
-------- -------- -------- -------- -------- --------
Interest expense:
Savings and NOW 3 (62) (59) 30 (136) (106)
MMI 610 669 1,279 107 (377) (270)
Time deposits (133) (2,718) (2,851) 1,444 (3,900) (2,456)
Federal funds purchased, borrowed
funds and securities sold under
agreements to repurchase 49 (96) (47) 27 15 42
-------- -------- -------- -------- -------- --------
Total change 530 (2,208) (1,678) 1,609 (4,399) (2,790)
-------- -------- -------- -------- -------- --------
Increase (decrease) in net interest
income $ 2,319 $ 2,374 $ 4,693 $ 2,032 $ (557) $ 1,476
======== ======== ======== ======== ======== ========
- ----------
(1) Yields on nontaxable securities are stated on a fully taxable equivalent
basis, assuming a 34% Federal tax rate.
The adjustments made to convert to a fully taxable equivalent basis were
$692,000 for 2004, $562,000 for 2003, and $155,000 for 2002.
(2) Changes attributable to both volume and rate have been allocated
proportionately.
Results of Operations -- Years Ended December 31, 2004 and 2003
Net Income. Our net income for 2004 was $8.34 million, an increase of $880,000
from net income of $7.46 million earned in 2003. Diluted net income per share
was $1.46, compared to $1.30 a year earlier. We have continued to experience
strong growth, with total assets averaging $815.6 million during the current
year as compared to $758.1 million in 2003, an increase of 7.6%. Our net
interest income after provision for credit losses increased $4.72 million over
the prior year. During 2004, the Federal Reserve began increasing the federal
funds rate at 25 basis point increments at its June meeting and, ultimately,
increased the federal funds rate a total of 125 basis points during the year.
Paralleling this rise in the federal funds rate was an increase in the prime
rate from 4.0% at the beginning of the year to 5.25% at yearend 2004. Our growth
in earning assets, combined with a rising interest rate environment led to an
increase of $4.56 million in net interest income. Our noninterest expense growth
included the completion of a new corporate headquarters building as well as
personnel and other infrastructure costs associated with the expansion of our
business.
Net Interest Income. Net interest income represents the gross profit from the
lending and investment activities of a banking organization and is the most
significant factor affecting the earnings of the Company. Net interest income is
influenced by changes in interest rates, volume and the mix of these various
components. Net interest income on a fully taxable equivalent basis for 2004 was
$30.1 million, which represented an 18.5% increase from the previous year level
of $25.4 million. Actual net interest income for 2004 was $29.4 million, an
18.4% increase from $24.8 million recorded in 2003. Average total earning assets
increased $45.2 million, or 6.3%, during 2004 as compared to 2003, while our
average
27
yield rose 41 points, from 3.53% in 2003 to 3.94% in 2004. The rates earned on a
significant portion of our loans adjust when index rates such as prime rate
changes. Conversely, most of our interest-bearing liabilities, including
certificates of deposit and borrowings, have rates fixed until maturity. As a
result interest rate increases generally result in an immediate positive impact
to interest income on loans, with a more delayed impact on interest expense
because increases in interest costs will occur only upon renewals of
certificates of deposit or borrowings. Average loans outstanding during the 2004
fiscal year were $613.5 million, compared to $572.5 million in 2003, an increase
of 7.2%. Average investment securities during 2004 were $139.9 million, compared
to $139.0 million in 2003.
Trends in interest rates turned upward for the year, as the Federal Reserve
increased the federal funds rate by a total of 125 basis points with 25 basis
point increases coming in June, August, September, November, and December 2004.
As a result, the prime lending rate rose to 5.25% at December 31, 2004 from
4.00% at December 31, 2003. This had the effect of increasing both the earning
asset yield and the interest bearing liability rate. During 2004, the rise in
the earning asset yield outpaced the increase in the interest bearing liability
rate.
The weighted average yield on earning assets increased to 5.91% for 2004,
compared to 5.86% for 2003. This increase in the asset yield in 2004 was
primarily attributable to the increased yield on loans, combined with a
decreased yield on investment securities. During the current year, the yield on
loans increased 14 basis points to 6.46% from 6.32% in 2003. This rise is due to
variable rate loans that repriced higher during the year in response to
increases in the underlying index, and new fixed rate loans originated at higher
rates.
The weighted average rate paid on interest bearing liabilities was 2.28%,
compared to 2.70% in 2003. Average interest bearing deposits for 2004 totaled
$598.7 million, a 7.2% increase from $558.7 million in 2003. The overall rate
for interest bearing deposits declined 46 basis points to 2.26% in 2004,
compared to 2.72% in the prior year. The overall rate on borrowings was 2.38% in
2004, compared to 2.53% a year earlier. Average borrowings totaled $64.1 million
in 2004 and $62.2 million in 2003, an increase of 3.1%.
The table, "Average Balance Sheets and Net Interest Income Analysis," summarizes
net interest income and average yields earned and rates paid for the years
indicated, on a tax equivalent basis. The table, "Analysis of Interest Changes
Due to Volume and Rates," presents the changes in interest income and interest
expense attributable to volume and rate changes between the years indicated.
Provision for Credit Losses. We recorded a $1.3 million provision for credit
losses for the year ended December 31, 2004, compared to a $1.4 million
provision in the prior year. Provisions for credit losses are charged to income
to bring our allowance for credit losses to a level deemed appropriate by
management. See "Asset Quality" for a discussion of the factors relevant to the
provision/allowance for credit losses.
Noninterest Income. Noninterest income of $8.1 million in 2004 was $661,000, or
8.9%, more than the previous year amount of $7.4 million. Net gains on sale of
securities for 2004 totaled $109,000, compared to $564,000 in 2003. Service
charges on deposit accounts increased to $3.8 million from $3.6 million in 2003.
The Company was able to capitalize on increased fees and increased volume of
demand deposits and other accounts with service charges. Revenues from our
mortgage banking operation increased 10.6%, rising from $2.0 million in 2003 to
$2.2 million in 2004 as we began to realize increased revenues from our
wholesale mortgage division. Additionally, we realized approximately $700,000 in
net gains on the sale of our Richlands, VA banking operation and approximately
$125,000 in net gains from the sale of the fixed assets associated with the
branch.
Noninterest Expense. Because of our continued strong growth we have experienced
increases in every major component of our noninterest expenses. For the year
ended December 31, 2004, our noninterest
28
expense increased $4.2 million, or 21.5%. Personnel expense of $12.4 million in
2004 exceeded the previous year expense of $10.5 million by $1.9 million, or
18.0% and reflects the addition of a wholesale mortgage division, increased
staffing costs associated with the relocation of our corporate headquarters,
expansion of our commercial lending staff, and the additional costs arising from
the normal expansion of business, along with normal increases in salaries and
benefits. At December 31, 2004, we had approximately 255 full-time and 14
part-time employees, compared with 225 full-time and 12 part-time employees at
December 31, 2003. Occupancy and equipment expenses totaled $4.3 million for
2004, which was up 20.0% from $3.6 million in 2003, reflecting the expenses
associated with our corporate headquarter relocation and investments in
technology to support our banking operations. Other expenses were $7.1 million,
compared to $5.0 million in 2003, reflecting the increased volume of business
activity, principally increases in lending and growth in deposit accounts.
Provision for Income Taxes. The Company's provision for income taxes totaled
$4.1 million for 2004, an increase of $300,000, or 7.9%, compared to 2003. Our
effective tax rates for the years ended 2004 and 2003 were 32.9% and 33.7%,
respectively. The decline in the effective rate from 2003 to 2004 reflects the
implementation of investment strategies that resulted in a reduction in the
consolidated income tax provision. The increase in the provision for 2004,
compared to the prior year, results from higher pretax income, offset in part by
a lower effective tax rate. Overall, the effective tax rate is attributable to
the current expense required to provide an adequate provision for income taxes
at the end of 2004 and 2003.
Results of Operations -- Years Ended December 31, 2003 and 2002
Net Income. Our net income for 2003 was $7.46 million, an increase of $678,000
from net income of $6.78 million earned in 2002. Diluted net income per share
was $1.30, compared to $1.17 a year earlier. We have continued to experience
strong growth, with total assets averaging $758.1 million during the current
year as compared to $701.5 million in 2002, an increase of 8.1%. Our net
interest income after provision for credit losses increased $938,000 over the
prior year.
Net Interest Income. Net interest income represents the gross profit from the
lending and investment activities of a banking organization and is the most
significant factor affecting the earnings of the Company. Net interest income is
influenced by changes in interest rates, volume and the mix of these various
components. Net interest income on a fully taxable equivalent basis for 2003 was
$25.4 million, which represented a 6.2% increase from $23.9 million in 2002.
Actual net interest income for 2004 was $24.8 million, a 4.5% increase from
$23.8 million recorded in 2003. The increase in net interest income is primarily
attributable to lower overall rates paid on time deposits. The net effect was to
increase the interest rate spread, which is the average yield on earning assets
minus the average rate paid on interest bearing liabilities. While the average
yield on earning assets declined in 2003, that decline was more than offset by
the reduction in average rates paid on interest bearing liabilities. Average
loans outstanding during the 2003 fiscal year were $572.5 million, compared to
$547.8 million in 2002, an increase of 4.5%. Average investment securities
during 2003 were $139.0 million compared to $110.3 million in 2002.
Trends in interest rates remained downward for the year, as the Federal Reserve
decreased the federal funds rate by 25 basis points in July 2003, which followed
a 50 basis point interest rate reduction in November 2002. As a result, the
prime lending rate declined to 4.00% at December 31, 2003 from 4.25% at December
31, 2002. This had the effect of decreasing both the earning asset yield and the
interest bearing liability rate. During 2003, the decline in the interest
bearing liability rate outpaced the decline in the earning asset yield.
Additionally, the decline in interest rates resulted in increases in the fair
market value of the Company's investment portfolio during 2003. The increased
fair value resulted in increased liquidity, due to securities being called and
the sale of securities at a gain.
29
The weighted average yield on earning assets decreased 62 basis points to 5.86%
for 2003 compared to 6.48% for 2002. This decrease in the asset yield in 2003
was primarily attributable to the decreased yield on loans and, to a lesser
degree, to a decreased yield on investment securities. This was partially offset
by an increase of $24.7 million in average loans outstanding, combined with an
increase of $20.6 million in tax-exempt investments. During the current year,
the yield on loans decreased 47 basis points to 6.32% from 6.79% in 2002. This
decline is due to variable rate loans that repriced lower during the year in
response to decreases in the underlying index, and new fixed rate loans
originated at lower rates.
The weighted average rate paid on interest bearing liabilities was 2.70% in 2003
and 3.41% in 2002. Average interest bearing deposits for 2003 totaled $558.7
million, a 9.1% increase from $511.9 million in 2002. The overall rate for
interest bearing deposits declined 80 basis points to 2.72% in 2003, compared to
3.52% in the prior year.
The overall rate on borrowings was 2.53% in 2003, compared to 2.51% a year
earlier. Average borrowings totaled $62.2 million in 2003 and $61.1 million in
2002, an increase of 1.8%.
The table, "Average Balance Sheets and Net Interest Income Analysis," summarizes
net interest income and average yields earned and rates paid for the years
indicated, on a tax equivalent basis. The table, "Analysis of Interest Changes
Due to Volume and Rates," presents the changes in interest income and interest
expense attributable to volume and rate changes between the years indicated.
Provision for Credit Losses. We recorded a $1.4 million provision for credit
losses for the year ended December 31, 2003, compared to a $1.3 million
provision in the prior year. Provisions for credit losses are charged to income
to bring our allowance for credit losses to a level deemed appropriate by
management. See "Asset Quality" for a discussion of the factors relevant to the
provision/allowance for credit losses.
Noninterest Income. Noninterest income of $7.4 million in 2003 was $2.1 million,
or 40.5%, more than the previous year amount of $5.3 million. Gains on sale of
securities for 2003 totaled $564,000, compared to $318,000 in 2002. Service
charges on deposit accounts increased to $3.6 million from $2.8 million in 2002.
The Company was able to capitalize on increased fees and increased volume of
demand deposits and other accounts with service charges.
Noninterest Expense. Personnel expense of $10.5 million in 2003 exceeded the
previous year expense of $9.8 million by $725,000, or 7.4%. At December 31,
2003, we had approximately 225 full-time and 12 part-time employees, compared
with 188 full-time and 10 part-time employees at December 31, 2002. Occupancy
expenses totaled $1.2 million for 2003, which was up 9.2% from $1.1 million in
2002. Furniture and equipment expenses totaled $2.4 million in the current year,
a 24.8% increase from $1.9 million recorded in 2002. The efficiency ratio, which
measures noninterest expense as a percentage of net interest income plus
noninterest income, was 59.7% in 2003 and 2002. Other expenses were $4.2 million
compared to $3.7 million in 2002.
Provision for Income Taxes. The Company's provision for income taxes totaled
$3.8 million for 2003, an increase of $262,000, or 7.4%, compared to the 2002
provision of $3.5 million in 2002. The Company's effective tax rates for the
years ended 2003 and 2002 were 33.7% and 34.2%, respectively. The decline in the
effective rate from 2002 to 2003 reflects the implementation of investment
strategies that resulted in a reduction in the consolidated income tax
provision. The increase in the provision for 2003, compared to the prior year
results from higher pretax income, offset in part by lower effective tax rate.
Overall, the effective tax rate is attributable to the current expense required
to provide an adequate provision for income taxes at the end of 2003 and 2002.
30
Liquidity and Cash Flow
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. Management measures our liquidity position by giving
consideration to both on- and off-balance sheet sources of, and demands for,
funds on a daily and weekly basis. Deposit withdrawals, loan funding and general
corporate activity create a need for liquidity for the Company. Sources of
liquidity include cash and cash equivalents, net of federal requirements to
maintain reserves against deposit liabilities, investment securities eligible
for pledging to secure borrowings from correspondent banks pursuant to
securities sold under repurchase agreements, investments available for sale,
loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan
Bank secured with pledged loans and securities, and from correspondent banks
under overnight federal funds credit lines. In addition to interest
rate-sensitive deposits, the Company's primary demand for liquidity is
anticipated fundings under credit commitments to customers.
The investment portfolio at December 31, 2004, included securities with call
features, whereby the issuer of such a security has the option to repay the
purchaser of said instrument and cancels the instrument before the contractual
maturity date. Due to the interest rate on the original instrument and current
market rates on such instruments, the Company anticipates that very few debt
instruments in the portfolio may be called in the upcoming year.
During 2004, the Company deployed cash flow from operating and financing
activities to fund increases in the loan portfolio. Overall, cash and cash
equivalents declined by $5.1 million, to $24.2 million at December 31, 2004.
As presented in the consolidated statement of cash flows, the Company generated
$3.0 million in operating cash flow during 2004, a decrease from $7.5 million in
2003. The increase in loans held for sale was a primary contributor to this
change, offset somewhat by a net increase in other liabilities, combined with a
net decrease in other assets. In 2004, interest received in excess of interest
paid was $32.5 million, while in 2003, interest received in excess of interest
paid was $26.2 million. This change resulted from the growth in earning assets
and continued improvement in net interest margin in 2004.
In 2004, the Company had a net increase of $82.4 million in loans, compared to
$19.7 million in 2003. During 2004, the Company received $31.1 million from
sales, calls, and maturities of securities, while purchasing $29.6 million. The
lower turnover in the security portfolio was attributable to the continuing
upward trend in interest rates during the year. In 2003, the Company purchased
$130.6 million of securities, while receiving $105.0 million from sales, calls,
and maturities.
Net increases in deposits totaling $82.4 million, offset somewhat by a $4.3
million combined net decrease in other borrowings and federal funds purchased
and retail repurchase agreements, comprised the Company's major financing
sources during 2004, amounting to a net $78.1 million versus a combined total of
$47.0 million during 2003 and $40.7 million in 2002. In total, cash flows from
growth in deposits were $82.4 million in 2004, versus $36.9 million in 2003 and
$18.2 million in 2002. Partially offsetting these cash inflows was the
repurchase of $3.5 million of the Company's outstanding common stock in 2004,
compared to the repurchase of $2.3 million in 2003; and in 2002 a decrease of
$11.4 million in federal funds and repurchase agreements, combined with
repurchases of $4.1 million of the Company's common stock.
Liquidity is further enhanced by an approximately $145 million line of credit
with the FHLB collateralized by FHLB stock, investment securities, qualifying 1
to 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
31
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 $38 million
available through five financial institutions. These lines are used to manage
the day-to-day, short-term liquidity needs of the Company. Each overnight line
has a requirement to repay the line in full on a frequent basis, typically
within five to ten business days. The Company also established a $15 million
wholesale repurchase agreement with a regional brokerage firm. The Company can
access this additional source of liquidity by pledging investment securities
with the brokerage firm.
The Company also projects future cash flow requirements based on scheduled loan
and deposit maturities, borrowing maturities, capital expenditures and other
factors. At December 31, 2004 and for the upcoming twelve-month period, the
Company had scheduled loan maturities of $227.0 million, securities maturities
of $10.5 million and $324.3 million in maturing time deposits. The Company also
has $192.3 million in deposits with no contractual maturity, and $78.8 million
in demand deposit accounts that are subject to withdrawal during 2005. The
Company has $20.0 million of borrowings that are scheduled for repayment in
2005. Anticipated capital expenditures during 2005 are approximately $1.9
million. Internal analysis indicated the Company is positioned to meet expected
liquidity requirements during the upcoming twelve-month period.
Contractual Obligations and Commitments
In the normal course of business there are various outstanding contractual
obligations of the Company that will require future cash outflows. In addition,
there are commitments and contingent liabilities, such as commitments to extend
credit, that may or may not require future cash outflows. Payments for
borrowings do not include interest. Payments related to leases are based on
actual payments specified in the underlying contracts. The accompanying table
reflects contractual obligations of the Company outstanding as of December 31,
2004.
Contractual Obligations
(In thousands)
Payments Due by Period
One Year Three Years After
Within One to Three to Five Five
Year Years Years Years Total
---------- --------- ----------- -------- ---------
Other borrowings $ 20,000 $ 15,000 $ -- $ 10,000 $ 45,000
Federal funds purchased and retail repurchase
agreements 21,534 -- -- -- 21,534
Operating lease obligations 686 1,502 1,198 545 3,931
Purchase obligations 2,365 789 73 -- 3,227
Other long-term liabilities 26 1,011 520 831 2,388
--------- --------- -------- -------- ---------
Total contractual cash obligations
excluding deposits 44,611 18,302 1,791 11,376 76,080
Deposits 595,357 108,439 20,155 334 724,285
--------- --------- -------- -------- ---------
Total contractual cash obligations $ 639,968 $ 126,741 $ 21,946 $ 11,710 $ 800,365
========= ========= ======== ======== =========
Capital Resources
Banks, bank holding companies, and financial holding companies, as regulated
institutions, must meet required levels of capital. The Federal Reserve has
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 its assets in accordance with the guidelines. As shown
in the table, "Regulatory Capital" the Company and the Bank both maintained
capital levels exceeding the minimum levels to be "well capitalized" for the
three years presented. The Bank will continue to be required to meet certain
levels of capital.
32
Regulatory Capital
(Dollars in thousands)
As of / for year ended December 31,
---------------------------------------------------
2004 2003 2002
--------------- --------------- ---------------
Total capital to risk
weighted assets
Consolidated $ 77,738 11.3% $ 72,055 11.9% $ 69,614 12.4%
Subsidiary Bank 75,469 11.0 70,726 11.7 68,241 12.2
Tier 1 capital to risk
weighted assets
Consolidated 70,025 10.2 64,931 10.7 62,622 11.2
Subsidiary Bank 68,116 10.0 63,602 10.5 61,253 11.0
Tier 1 capital to average
assets
Consolidated 70,025 8.2 64,931 8.4 62,622 8.5
Subsidiary Bank 68,116 8.0 63,602 8.3 61,253 8.4
Lending Activities
General. The Company offers a broad array of lending services, including real
estate, commercial and consumer loans, to individuals and small to medium-sized
business and other organizations that are located in or conduct a substantial
portion of their business in the Company's market areas. The Company has also
established niche markets such as residential construction lending in local
markets. The Company's total loans at December 31, 2004, were $663.4 million, or
76.7% of total assets. It also makes secured construction loans to homebuilders
and residential mortgages, which are often secured by first and second real
estate mortgages. At December 31, 2004, the Company had no large loan
concentrations (exceeding 10% of its portfolio) in any particular industry.
Loan Composition. The accompanying table summarizes, at the dates indicated, the
composition of the Company's loan portfolio and the related percentage
composition.
Loan Portfolio Composition
(Dollars in thousands)
As of December 31,
---------------------------------------
2004 2003
------------------ ------------------
Real Estate:
Commercial $ 166,685 25.1% $ 159,953 27.5%
Residential 113,407 17.1 94,864 16.3
Construction 162,143 24.5 117,786 20.3
--------- ------ --------- ------
Total real estate 442,235 66.7 372,603 64.1
Commercial, financial and
Agricultural 86,184 13.0 90,224 15.5
--------- ------ --------- ------
Consumer:
Direct 40,741 6.1 39,276 6.7
Home equity 75,435 11.4 65,563 11.3
Revolving 18,831 2.8 13,718 2.4
--------- ------ --------- ------
Total consumer 135,007 20.3 118,557 20.4
--------- ------ --------- ------
Total $ 663,426 100.0% $ 581,384 100.0%
========= ====== ========= ======
33
Loan Portfolio Composition (cont'd)
(Dollars in thousands)
As of December 31,
------------------------------------------------------------
2002 2001 2000
------------------ ------------------ ------------------
Real Estate:
Commercial $ 170,657 30.3% $ 168,419 31.5% $ 119,584 23.9%
Residential 119,316 21.2 130,264 24.4 150,825 30.1
Construction 87,696 15.6 55,861 10.4 66,148 13.2
--------- ------ --------- ------ --------- ------
Total real estate 377,669 67.1 354,544 66.3 336,557 67.2
Commercial, financial and
Agricultural 87,458 15.5 90,858 17.0 74,981 15.0
--------- ------ --------- ------ --------- ------
Consumer:
Direct 34,074 6.0 37,112 6.9 46,463 9.3
Home equity 54,073 9.6 46,169 8.6 39,204 7.8
Revolving 10,326 1.8 6,662 1.2 3,432 0.7
--------- ------ --------- ------ --------- ------
Total consumer 98,473 17.4 89,943 16.7 89,099 17.8
--------- ------ --------- ------ --------- ------
Total $ 563,600 100.0% $ 535,345 100.0% $ 500,637 100.0%
========= ====== ========= ====== ========= ======
Loan Portfolio - Maturities and Interest Rate Sensitivities
(In thousands)
Maturity Maturity
---------------------------------------------- ---------------------------
Over One Over Predetermined Floating or
One Year Year to Five Interest Adjustable
or Less Five Years Years Total Rate Rate
--------- ---------- --------- --------- ------------- -----------
Commercial, financial $ 35,304 $ 38,420 $ 12,460 $ 86,184 $ 19,514 $ 31,366
and agricultural
Real estate - construction 110,620 49,903 1,619 162,142 30,050 21,472
Real estate - residential 16,727 71,412 25,268 113,407 80,939 15,741
Real estate - commercial 47,382 98,463 20,839 166,684 35,973 83,329
Consumer 16,988 42,138 75,882 135,008 69,161 48,858
--------- --------- --------- --------- --------- ----------
Total $ 227,021 $ 300,336 $ 136,068 $ 663,425 $ 235,637 200,767
========= ========= ========= ========= ========= ==========
Real Estate Loans. Loans secured by real estate for a variety of purposes
constituted $442.4 million, or 66.7%, of the Company's total loans at December
31, 2004. At yearend, the Company held real estate loans of various sizes
ranging up to $7.9 million, secured by office buildings, retail establishments,
warehouses, motels, restaurants and other types of property. Loan terms are
typically limited to five years, with payments through the date of maturity
generally based on a 15-year amortization schedule. Interest rates may be fixed
or adjustable, based on market conditions, and the Company generally charges an
origination fee. Management has attempted to reduce credit risk in the real
estate portfolio by emphasizing loans on owner-occupied office and retail
buildings where the loan to value ratio, established by independent appraisals,
does not exceed 80%, and net projected cash flow available for debt service
amounts to at least 120% of the debt service requirement. The Company also often
requires personal guarantees of the principal owners of the property and obtains
personal financial statements of the principal owners in such cases. The Company
experienced net chargeoffs on commercial real estate loans of $298,000 in 2004,
no net chargeoffs in 2003, and net recoveries of $18,000 in 2002.
The Company originates residential loans for its portfolio on single and
multi-family properties, both owner-occupied and non owner-occupied, and at
December 31, 2004, it held $113.4 million of such loans. Loan terms are
typically limited to five years, with payments through the date of maturity
generally based on a 15 or 30 year amortization schedule. Rates may be fixed or
variable, and the Company typically charges an origination fee. The Company
attempts to minimize credit risk by requiring a loan to value ratio of 80% or
less. The Company experienced net recoveries on residential real estate loans of
$1,000 in 2004 and net chargeoffs of $20,000 in 2003 and $43,000 in 2002.
34
The Company also originates residential mortgage loans for sale into the
secondary market. Through its mortgage banking activities, the Company
originates both fixed and variable rate residential mortgage loans for sale with
servicing released. The Company is able to generate loan origination fees,
typically ranging from 1.0% to 1.5% of the loan balance, which are recognized as
income when the loan is sold. At December 31, 2004, the Company held $10.3
million of such loans for sale, and during 2004 the Company sold an aggregate of
$101.8 million of such loans. The Company sells these loans on a non-recourse
basis.
The Company's current lending strategy is for the majority of construction and
development loans on commercial and residential projects to be in the range of
$300,000 to $4.0 million. At December 31, 2004, 2003, and 2002, the Company held
$162.1 million, $117.8 million, and $87.7 million, respectively, of such loans.
To reduce credit risk associated with such loans, the Company limits its lending
to projects involving small commercial centers that have strong anchor tenants
and are substantially pre-leased, or residential projects built in strong,
proven markets. The leases on commercial projects must generally result in a
loan to appraised value of 80% or less and a net cash flow to debt service at no
less than 120%. The Company historically has required a personal guarantee from
the developer or builder. Loan terms are typically twelve to fifteen months,
although the Company occasionally will make a "mini-permanent" loan for purposes
of construction and development of up to a five year term. Rates are typically
variable, and the Company typically charges an origination fee. The Company
experienced no net chargeoffs from construction and development loans during
2004, 2003, or 2002.
Commercial Loans. The Company makes loans for commercial purposes to various
types of businesses. At December 31, 2004, the Company held $166.7 million of
commercial loans, or 25.1% of its total loan portfolio. Equipment loans are
typically made on terms up to five years at fixed or variable rates, with the
financed equipment pledged as collateral to the Company. The Company attempts to
reduce its credit risk on these loans by limiting the loan to value ratio to
80%. Working capital loans are made on terms typically not exceeding one year.
These loans may be secured or unsecured, but the Company attempts to limit its
credit risk by requiring the borrower to demonstrate its capacity to produce net
cash flow available for debt service equal to 110% to 150% of its debt service
requirements. The Company experienced net charge-offs from commercial loans of
$248,000 in 2004, $1,035,949 in 2003, and $803,000 in 2002.
Consumer Loans. The Company makes a variety of loans to individuals for personal
and household purposes, including (i) secured and unsecured installment and term
loans originated directly by the Company; (ii) home equity revolving lines of
credit; and (iii) unsecured revolving lines of credit. The home equity loans and
certain of the direct loans are secured by the borrowers' residences. At
December 31, 2004, the Company held $135.0 million of consumer loans, including
home equity lines of credit. During 2004, 2003, and 2002, respectively, the
Company experienced net consumer chargeoffs of $501,000, $310,612, and $133,000.
Loan Approval and Review. The Company has adopted various levels of officer
lending authority in connection with its loan approval policies. When the
aggregate outstanding loans to a single borrower exceed that individual
officer's lending authority, the loan request must be considered and approved by
an officer with a higher lending limit. Branch loan officers typically have
retail lending limits ranging from $75,000 to $250,000. Community executives can
generally approve commercial relationships up to $750,000. If the lending
request exceeds the community executive's lending limit, the loan must be
submitted to and approved by the senior credit officer. The senior credit
officer has authority to approve commercial relationships up to $1,000,000.
Under joint approval, the senior credit officer and selected regional executives
may approve loans up to $1,750,000 million. All loans in excess of $1,750,000
must be approved by the Chief Executive Officer, who may approve loans
35
up to $2,500,000. Loans exceeding $2,500,000 must be approved by the Credit
Management Committee of the Board.
The Company has a loan review procedure involving multiple officers of the
Company that is designed to promote early identification of credit quality
problems through its credit management committee. All loan officers are charged
with the responsibility of reviewing on an annual basis all credit relationships
in excess of $250,000 in their respective portfolios. Loan officers also review
all criticized and classified assets in their portfolio quarterly with the
senior credit officer of the Company. The loan officers are responsible for
implementing, where appropriate, approved action plans with respect to such
criticized and classified assets which are designed to improve the Company's
credit position and lead to a favorable resolution of the problem loan. As part
of its overall strategy to improve policies and procedures, the Company also
periodically engages a third party consultant to review its loan portfolio. The
Company has used the findings of these examinations to further enhance credit
quality through improved credit administration policies and procedures.
The Company's credit review system supplements its loan rating system, pursuant
to which the Company may place a loan on its criticized asset list or may
classify a loan in one of various other classification categories. A specified
minimum percentage of loans in each adverse asset classification category, based
on the historical loss experience of the Company in each such category, is used
to determine the adequacy of the Company's allowance for credit losses
quarterly. These loans are also individually reviewed by the senior credit
officer of the Company to determine whether a greater allowance allocation is
justified due to the facts and circumstances of a particular adversely
classified loan.
See also Note 4 in the Notes to Consolidated Financial Statements of this Annual
Report on Form 10-K.
Asset Quality
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.
Allocation of the Allowance for Credit Losses
(Dollars in thousands)
2004 2003
-------------- --------------
$ % (1) $ % (1)
------ ----- ------ -----
Balance at end of period applicable to:
Commercial 5,166 13 5,116 16
Real estate-construction 1 24 5 20
Real estate-mortgage 43 42 49 44
Consumer 2,143 21 1,954 20
------ ---- ------ ----
Total allocation 7,353 100 7,124 100
====== ==== ====== ====
2002 2001 2000
-------------- -------------- --------------
$ % (1) $ % (1) $ % (1)
------ ----- ------ ----- ------ -----
Balance at end of period applicable to:
Commercial 5,201 16 4,773 17 4,523 15
Real estate-construction 7 16 18 10 28 13
Real estate-mortgage 180 51 104 56 125 54
Consumer 1,671 17 1,836 17 1,635 18
----- --- ----- --- ----- ---
Total allocation 7,059 100 6,731 100 6,311 100
===== === ===== === ===== ===
- ----------
(1) Percent of loans in each category to total loans.
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
36
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. 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."
Summary of Allowance for Credit Losses
(Dollars in thousands)
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
Balance, beginning of period $ 7,124 $ 7,059 $ 6,731 $ 6,311 $ 4,436
Charge-offs:
Commercial 253 890 1,017 510 65
Real estate-construction -- -- -- -- --
Real estate-mortgage 348 207 32 43 359
Consumer 522 450 220 448 380
------- ------- ------- ------- -------
Total charge-offs 1,123 1,547 1,269 1,001 804
------- ------- ------- ------- -------
Recoveries:
Commercial 5 7 188 25 --
Real estate-construction -- -- -- -- --
Real estate-mortgage 31 16 7 -- --
Consumer 41 158 102 118 154
------- ------- ------- ------- -------
Total recoveries 77 181 297 143 154
------- ------- ------- ------- -------
Net charge-offs 1,046 1,366 972 858 650
Provision charged to operations 1,275 1,431 1,300 1,278 2,525
------- ------- ------- ------- -------
Balance, end of period 7,353 $ 7,124 $ 7,059 $ 6,731 $ 6,311
======= ======= ======= ======= =======
Ratio of net chargeoffs to average loans 0.17% 0.24% 0.18% 0.17% 0.14%
======= ======= ======= ======= =======
Ratio of allowance to yearend loans 1.11% 1.23% 1.25% 1.26% 1.26%
======= ======= ======= ======= =======
Commercial loans. All commercial loans within the portfolio are risk graded
among nine risk grades based on management's evaluation of the overall credit
quality of the loan, including the payment history, the financial position of
the borrower, the underlying collateral value, an internal credit risk
assessment and examination results. There is an increased reserve percentage for
each successively higher risk grade. As a result, the allowance is adjusted upon
any migration of a loan to a higher risk grade within the commercial loan
portfolio. The accompanying table, "RISK GRADE CATEGORIES," details the
risk-graded portfolio at December 31, 2004 and 2003.
The reserve percentages utilized have been determined by management to be
appropriate based on historical loan loss levels and the risk for each
corresponding risk grade. Reserve percentages for risk grade 6, risk grade 7,
risk grade 8 and risk grade 9 remained constant in 2004. The Company had 94.3%
of total commercial loans in risk grade 1 through 5 in 2004, compared to 96.2%
in 2003.
Mortgage, home equity, and credit lines. Reserves are calculated on mortgage,
home equity, and credit lines based on historical loss experience and current
economic conditions. The average rolling eight-quarter net loss percentage is
calculated for each of these loan categories. The reserve requirement also
includes a reserve percentage for current economic conditions. The sum of these
two components is applied to the dollar balance of loans in each of these
categories to determine the required reserve.
37
Retail loans. The retail loans are pooled together to determine the reserve
requirement. The average rolling twelve-quarter net loss percentage is
calculated for this loan category. The reserve requirement also includes a
reserve percentage for current economic conditions. The sum of these two
components is applied to the dollar balance of retail loans to determine the
required reserve for current loans and loans past due less than 90 days. A
separate reserve is calculated for loans past due 90 days or more. A reserve
amount equal to 25.0% of all retail loans past due 90 days or more is added to
the above mentioned requirement to determine the total reserve requirement for
retail loans.
Risk Grade Categories
Risk Percent of Commercial
Grade Description Loans by Risk Grade General Reserve Percentage
- ------ -------------------- ---------------------- --------------------------
2004 2003 2004 2003
--------- ---------- ------------ -----------
Risk 1 Low Risk 0.67% 1.08% 0.00% 0.00%
Lower Than
Risk 2 Average Risk 0.87 0.51 0.25 0.40
Risk 3 Average Risk 7.02 10.01 0.50 0.65
Moderately Higher
Risk 4 Than Average Risk 82.61 80.78 1.00 1.00
Higher Than
Risk 5 Average Risk 3.10 3.79 1.50 1.50
Risk 6 Special Mention 2.33 1.25 2.50 2.50
Risk 7 Substandard 3.41 2.53 15.00 15.00
Risk 8 Doubtful 0.04 0.00 50.00 50.00
Risk 9 Loss 0.00 0.05 100.00 100.00
Specific impairment under SFAS No. 114. Management evaluates individually
significant loans in risk grade 7 and risk grade 8 on an individual basis for
impairment. The specific allowance is calculated based upon a review of these
loans and the estimated losses at the balance sheet date. At December 31, 2004
and 2003, the recorded investment in loans considered impaired was approximately
$14,417,000 and $10,615,000, respectively. Impaired loans at December 31, 2004
consisted of $892,000 of retail loans past due 90 days or more, and $13,377,000
of risk grade 7 commercial loans and $148,000 of risk grade 8 commercial loans.
Calculated reserves for impaired loans at December 31, 2004 totaled $915,000,
compared to $2,085,000 a year ago.
Watch list review. Specific allowances may be determined based on a review of
specific watch list loans. Specific losses are estimated at each measurement
date. The Company has established a monthly procedure to review all loans placed
on the watch list. The watch list primarily consist of loans classified as
special mention, substandard and doubtful. An estimated loss amount and action
plan is established for each watch list loan. By reviewing these watch list
loans, the Company is able to update original probable loss amounts in light of
developing conditions. This serves to reduce the differences between estimated
and actual observed losses.
The 2004 provision for credit losses of $1.3 million represented a 10.9%
decrease from the level in 2003. As of December 31, 2004, nonperforming assets
totaled $10.4 million, primarily comprised of $3.5 million in nonaccrual loans
and $5.6 million in other real estate owned. Those figures compare to $5.2
million in nonaccrual loans and $5.2 million in other real estate owned at the
end of 2003, comprising $10.4 million in nonperforming assets. Net charge-offs
decreased in 2004 to $1.0 million, or 0.17% of
38
average loans outstanding, compared with $1.4 million, or 0.24% of average loans
outstanding in the prior year. At December 31, 2004 and 2003 the allowance for
credit losses as a percentage of yearend loans was 1.11% and 1.23%,
respectively.
During 2004 and at December 31, 2004, the commercial loan portfolio experienced
a migration to risk grades indicative of higher credit risk as reflected in the
table, "Risk Grade Categories." Risk grade loans classified special mention,
substandard, doubtful increased from $13.5 million at yearend 2003 to $22.7
million at yearend 2004. The reserve requirement for this category of loans
totaled $920,000 and $1.7 million for 2004 and 2003, respectively. A migration
to lower credit risk occurred within the retail portfolio as retail loans past
due 90 days or more decreased to $892,000 at December 31, 2004, compared to $1.4
million at the end of 2003. The reserve requirements for the retail loans past
due 90 days or more were $223,000 and $350,000 at December 31, 2004 and 2003,
respectively.
Nonperforming assets include nonaccrual loans, accruing loans contractually past
due 90 days or more, restructured loans, and other real estate. Loans are placed
on nonaccrual status when: (i) management has concerns relating to the ability
to collect the loan principal and interest and (ii) generally when such loans
are 90 days or more past due. No assurance can be given, however, that economic
conditions will not adversely affect borrowers and result in increased credit
losses.
Nonperforming Assets
(In thousands)
As of December 31,
-----------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
Nonperforming assets:
Nonaccrual loans $ 3,450 $ 5,174 $ 3,614 $ 2,266 $ 3,222
Loans past due 90 days or more
and still accruing interest 65 53 65 6 --
Other real estate 5,559 5,191 1,662 2,707 1,007
Investment Activities
Our investment portfolio plays a primary role in management of liquidity and
interest rate sensitivity and, therefore, is managed in the context of the
overall balance sheet. The securities portfolio generates a substantial
percentage of our interest income and serves as a necessary source of liquidity.
Management attempts to deploy investable funds into instruments that are
expected to increase the overall return of the portfolio given the current
assessment of economic and financial conditions, while maintaining acceptable
levels of capital, and interest rate and liquidity risk.
The accompanying table presents the carrying values, fair values, and weighted
average yields of our investment portfolio at December 31, 2004, 2003, and 2002;
and the intervals of maturities or repricings at December 31, 2004:
39
Investment Securities
(Dollars in thousands)
As of December 31, 2004 As of December 31, 2003
-------------------------------- --------------------------------
Weighted Weighted
Amortized Fair Average Amortized Fair Average
Cost Value Yield Cost Value Yield
--------- --------- -------- --------- --------- --------
U.S. government agencies and
mortgage backed $ 104,896 $ 103,777 3.09% $ 106,771 $ 106,281 3.32%
State and municipal obligations (1) 31,936 32,285 5.69 32,617 32,850 5.77
Other debt securities -- -- 0.00 95 109 7.00
Other equity 5,547 5,541 3.26 4,444 4,442 4.00
--------- --------- --------- ---------
Total investment securities (1) $ 142,379 $ 141,603 3.70% $ 143,927 $ 143,682 3.90%
========= ========= ========= =========
As of December 31, 2002
--------------------------------
Weighted
Amortized Fair Average
Cost Value Yield
--------- --------- --------
U.S. government agencies and
mortgage backed $ 115,309 $ 117,412 4.58%
State and municipal obligations (1) 7,036 7,351 7.44
Other debt securities 306 321 6.83
Other equity 3,732 3,732 5.58
--------- ---------
Total investment securities (1) $ 126,383 $ 128,816 4.58%
========= =========
As of December 31, 2004
-------------------------------------
After One
Within Year to
One Year Five Years
----------------- -----------------
Amount Yield Amount Yield
-------- ------ -------- ------
U.S. government agencies and
mortgage backed $ 10,381 2.14% $ 64,600 2.82%
State and municipal obligations (1) 81 6.85 1,298 4.66
-------- --------
Total debt securities (1) $ 10,462 2.18% $ 65,898 2.86%
======== ========
As of December 31, 2004
------------------------------------------------------------
After Five
Years to After
Ten Years Ten Years Weighted
----------------- ----------------- Average
Amount Yield Amount Yield Total Yield(1)
-------- ----- -------- ------ --------- --------
U.S. government agencies and
mortgage backed $ 23,509 3.92% $ 5,287 4.48% $ 103,777 3.09%
State and municipal obligations (1) 6,997 4.10 23,909 3.93 32,285 4.00
-------- -------- ---------
Total debt securities (1) $ 30,506 3.96% $ 29,196 4.03% $ 136,062 3.31%
======== ======== =========
- ----------
(1) Yields stated on a tax equivalent basis.
See also Note 3 in the Notes to Consolidated Financial Statements of this Annual
Report on Form 10-K.
Off-Balance Sheet Arrangements
Information about the Company's off-balance sheet risk exposure is
presented in Note 16 to the accompanying consolidated financial statements.
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.
40
For a complete discussion on market risk and how the Company addresses this
risk, see Item 7A of this Annual Report on Form 10-K.
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. Noninterest expense, such as salaries and wages, occupancy and
equipment cost, are also negatively affected by inflation.
Application of 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 of the Company's 2004 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.
Item 7A. 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.
Interest rate risk management is a 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, which is comprised of senior
management and members of the Company's Board of Directors. The committee meets
on a regular basis to review the asset/liability management activities of the
Company and monitor compliance with established policies. An independent member
of the Board of Directors chairs the committee and reports on its activities to
the full Board.
A primary objective of interest rate sensitivity management is to ensure the
stability and quality of the Company's primary earnings component, net interest
income. This process involves monitoring the Company's balance sheet in order to
determine the potential impact that changes in the interest rate environment may
have on net interest income. Rate sensitive assets and liabilities have interest
rates that are subject to change within a specific time period, due to either
maturity or to contractual agreements which allow the instruments to reprice
prior to maturity. Interest rate sensitivity management seeks to
41
ensure that both assets and liabilities react to changes in interest rates
within a similar time period, thereby minimizing the risk to net interest
income.
Interest Sensitivity Analysis
(Dollars in thousands)
Total Total
1 - 90 91 - 365 Sensitive Sensitive
Day Day Within Over
Sensitive Sensitive One Year One Year Total
--------- --------- --------- --------- ---------
Interest earning assets:
Loans, net of nonaccruals $ 465,208 $ 33,980 $ 499,188 $ 160,722 $ 659,910
U. S. government agency 4,500 5,795 10,295 94,601 104,896
State and municipal obligations -- 80 80 31,856 31,936
Other investment securities 4,442 -- 4,442 1,105 5,547
Overnight deposits 5,193 -- 5,193 -- 5,193
--------- --------- --------- --------- ---------
Total interest earning assets 479,343 39,855 519,198 288,284 807,482
--------- --------- --------- --------- ---------
Interest bearing liabilities:
NOW 19,912 -- 19,912 13,275 33,187
MMI 69,832 -- 69,832 69,832 139,664
Savings 11,655 -- 11,655 7,770 19,425
Time deposits 214,520 109,613 324,133 129,066 453,199
Overnight borrowings 21,534 -- 21,534 -- 21,534
Other borrowings 20,000 -- 20,000 25,000 45,000
--------- --------- --------- --------- ---------
Total interest bearing liabilities 357,453 109,613 467,066 244,943 712,009
--------- --------- --------- --------- ---------
Interest sensitivity gap $ 121,890 $ (69,758) $ 52,132 $ 43,341 $ 95,473
========= ========= ========= ========= =========
Ratio of interest sensitive assets to
liabilities 1.34 0.37 1.11 1.18 1.13
The measurement of the Company's interest rate sensitivity, or "gap", is a
technique traditionally used in asset/liability management. The interest
sensitivity gap is the difference between repricing assets and repricing
liabilities for a particular time period. The table, "Interest Sensitivity
Analysis," indicates a ratio of rate sensitive assets to rate sensitive
liabilities within one year at December 31, 2004, to be 1.11%. This ratio
indicates that a larger balance of assets compared to liabilities, could
potentially reprice during the upcoming twelve-month period. Included in rate
sensitive liabilities are certain deposit accounts (NOW, MMI, and savings) that
are subject to immediate withdrawal and repricing, yet have no stated maturity.
These balances are presented in the category that management believes best
identifies their actual repricing patterns. This analysis assumes 60.0% of NOW
and savings accounts, and 50.0% of MMI accounts, reprice within one year, and
the remaining balances reprice after one year. The overall risk to net interest
income is also influenced by the Company's level of variable rate loans. These
are loans with a contractual interest rate tied to an index, such as the prime
rate. A portion of these loans may reprice on multiple occasions during a
one-year period due to changes in the underlying rate index. Approximately 64.2%
of the total loan portfolio has a variable rate and reprices in accordance with
the underlying rate index subject to terms of individual note agreements.
In addition to the traditional gap analysis, the Company also utilizes a
computer based interest rate risk simulation model. This comprehensive model
includes rate sensitivity gap analysis, rate shock net interest margin analysis,
and asset/liability term and rate analysis. The Company uses this model to
monitor interest rate risk on a quarterly basis and to detect trends that may
affect the overall net interest income for the Company. This simulation
incorporates the dynamics of balance sheet and interest rate changes and
calculates the related effect on net interest income. As a result, this analysis
more accurately
42
projects the risk to net interest income over the upcoming 12-month period. The
Company's asset/liability policy provides guidance for levels of interest
rate risk and potential remediations, if necessary, to mitigate excessive levels
of risk. The modeling results indicate the Company is subject to an acceptable
level of interest rate risk.
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 Company is not subject to other
types of market risk, such as foreign currency exchange rate risk, commodity or
equity price risk.
The table, "Market Sensitive Financial Instruments Maturities," presents the
Company's financial instruments that are considered to be sensitive to changes
in interest rates, categorized by contractual maturities, average interest rates
and estimated fair values as of December 31, 2004.
Market Sensitive Financial Instruments Maturities
(Dollars in thousands)
Contractual Maturities as of December 31, 2004
------------------------------------------------------------------------------
After
Five
2005 2006 2007 2008 2009 Years Total
--------- -------- -------- -------- --------- --------- ---------
Financial assets:
Debt securities $ 10,462 $ 18,888 $ 20,370 $ 16,550 $ 10,090 $ 59,702 $ 136,062
Loans:
Fixed rate 74,924 31,389 22,890 23,408 36,864 48,160 237,635
Variable rate 152,097 42,252 30,812 43,777 68,944 87,909 425,791
--------- -------- -------- -------- --------- --------- ---------
Total $ 237,483 $ 92,529 $ 74,072 $ 83,735 $ 115,898 $ 195,771 $ 799,488
========= ======== ======== ======== ========= ========= =========
Financial liabilities:
NOW $ 33,187 $ -- $ -- $ -- $ -- $ -- $ 33,187
MMI 139,663 -- -- -- -- -- 139,663
Savings 19,425 -- -- -- -- -- 19,425
Time deposits 324,272 88,685 19,754 10,500 9,655 334 453,200
Other borrowings 20,000 -- 15,000 -- -- 10,000 45,000
Federal funds
purchased and
retail repurchase 21,534 -- -- -- -- -- 21,534
--------- -------- -------- -------- --------- --------- ---------
Total $ 558,081 $ 88,685 34,754 $ 10,500 $ 9,655 $ 10,334 $ 712,009
========= ======== ======== ======== ========= ========= =========
Average
Interest Estimated
Rate Fair Value
-------- ----------
Financial assets:
Debt securities 3.30% 136,041
Loans:
Fixed rate 7.29 248,134
Variable rate 6.06 414,314
-------
Total 798,489
=======
Financial liabilities:
NOW 0.10 28,986
MMI 2.58 138,142
Savings 0.18 17,012
Time deposits 2.61 456,616
Other borrowings 3.30 45,215
Federal funds
purchased and retail
repurchase 2.55 21,534
-------
Total 707,505
=======
43
QUARTERLY FINANCIAL INFORMATION
The following table sets forth, for the periods indicated, certain of our
consolidated quarterly financial information. This information is derived from
our unaudited financial statements, which include, in the opinion of management,
all normal recurring adjustments which management considers necessary for a fair
presentation of the results for such periods. This information should be read in
conjunction with our consolidated financial statements included elsewhere in
this report. The results for any quarter are not necessarily indicative of
results for any future period.
Quarterly Financial Data
(Dollars in thousands, except per share data)
2004 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr
---- -------- -------- -------- --------
Interest income $ 12,317 $ 11,275 $ 10,441 $ 10,438
Interest expense 4,211 3,891 3,396 3,589
-------- -------- -------- --------
Net interest income 8,106 7,384 7,045 6,849
Provision for credit losses 330 285 272 388
-------- -------- -------- --------
Net interest income after provision
for credit losses 7,776 7,099 6,773 6,461
-------- -------- -------- --------
Noninterest income 1,945 1,695 2,604 1,841
Noninterest expense 6,760 5,969 5,590 5,446
-------- -------- -------- --------
Income before income taxes 2,961 2,825 3,787 2,856
Provision for income taxes 941 913 1,274 961
-------- -------- -------- --------
Net income $ 2,020 $ 1,912 $ 2,513 $ 1,895
======== ======== ======== ========
Earnings per share:
Basic $ 0.37 $ 0.35 $ 0.45 $ 0.35
Diluted $ 0.35 $ 0.34 $ 0.44 $ 0.33
2003 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr
---- -------- -------- -------- --------
Interest income $ 10,330 $ 10,323 $ 10,382 $ 10,552
Interest expense 3,733 4,118 4,382 4,532
-------- -------- -------- --------
Net interest income 6,597 6,205 6,000 6,020
Provision for credit losses 351 303 282 495
-------- -------- -------- --------
Net interest income after provision
for credit losses 6,246 5,902 5,718 5,525
-------- -------- -------- --------
Noninterest income 1,853 2,011 1,767 1,794
Noninterest expense 5,185 5,012 4,758 4,612
-------- -------- -------- --------
Income before income taxes 2,914 2,901 2,727 2,707
Provision for income taxes 914 965 953 957
-------- -------- -------- --------
Net income $ 2,000 $ 1,936 $ 1,774 $ 1,750
======== ======== ======== ========
Earnings per share:
Basic $ 0.37 $ 0.35 $ 0.32 $ 0.31
Diluted $ 0.35 $ 0.34 $ 0.31 $ 0.30
44
MANAGEMENT'S REPORT ON INTERNAL
CONTROL OVER FINANCIAL REPORTING
Management of FNB Financial Services Corporation (the Company) is responsible
for preparing the Company's annual consolidated financial statements and for
establishing and maintaining adequate internal control over financial reporting
for the Company. Management has evaluated the effectiveness of the Company's
internal control over financial reporting, including controls over the
preparation of financial statements in accordance with the instructions to the
Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C), as
of December 31, 2004 based on criteria established in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on this assessment, management believes that the
Company maintained effective internal control over financial reporting as of
December 31, 2004.
The Company's registered public accounting firm that audited the Company's
consolidated financial statements included in this annual report has issued an
attestation report on management's assessment of internal control over financial
reporting.
Management is also responsible for compliance with laws and regulations relating
to safety and soundness which are designated by the FDIC and the appropriate
federal banking agency. Management assessed its compliance with these designated
laws and regulations relating to safety and soundness and believes that the
Company complied, in all significant respects, with such laws and during the
year ended December 31, 2004.
FNB Financial Services Corporation
March 9, 2005
/s/ ERNEST J. SEWELL
- -----------------------
Ernest J. Sewell
President and Chief Executive Officer
/s/ PRESSLEY A. RIDGILL
- -----------------------
Pressley A. Ridgill
Executive Vice President and Chief Operating Officer
/s/ MICHAEL W. SHELTON
- ---------------------------
Michael W. Shelton
Senior Vice President and Chief Financial Officer
45
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
FNB Financial Services Corporation
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that FNB
Financial Services Corporation (the "Company") maintained effective internal
control over financial reporting as of December 31, 2004, based on criteria
established in Internal Control -- Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. The Company's management
is responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the Company's internal control
over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. Because management's assessment
and our audit were conducted to also meet the reporting requirements of Section
112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA),
management's assessment and our audit of the Company's internal control over
financial reporting included controls over the preparation of financial
statements in accordance with the instructions to the Consolidated Financial
Statements for Bank Holding Companies (form FR Y-9 C). A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that FNB Financial Services Corporation
maintained effective internal control over financial reporting as of December
31, 2004, is fairly stated, in all material respects, based on criteria
established in Internal Control -- Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Also in our opinion, FNB
Financial Services Corporation maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2004, based on
criteria established in Internal Control -- Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet of
FNB Financial Services Corporation as of December 31, 2004 and the related
consolidated statements of income and comprehensive income, changes in
shareholders' equity and cash flow for the year then ended, and our report dated
March 9, 2005, expressed an unqualified opinion on these consolidated financial
statements.
We do not express an opinion or any other form of assurance on management's
statement referring to compliance with designated laws and regulations related
to safety and soundness.
/s/ Dixon Hughes PLLC
Sanford, North Carolina
March 9, 2005
46
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors
FNB Financial Services Corporation and Subsidiary
Greensboro, North Carolina
We have audited the accompanying consolidated balance sheet of FNB Financial
Services Corporation and Subsidiary as of December 31, 2004, and the related
consolidated statements of income and comprehensive income, changes in
shareholders' equity and cash flows for the year then ended. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of FNB Financial
Services Corporation and Subsidiary as of December 31, 2004 and the results of
their operations and their cash flows for the year then ended in conformity with
accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of FNB Financial
Services Corporation's internal control over financial reporting as of December
31, 2004, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission,
and our report dated March 9, 2005 expressed unqualified opinions on both
management's assessment of the Company's internal control over financial
reporting and the effectiveness of the Company's internal control over financial
reporting.
/s/ Dixon Hughes PLLC
Sanford, North Carolina
March 9, 2005
47
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of FNB Financial Services
Corporation:
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of income and comprehensive income, of changes in
shareholders' equity, and of cash flows present fairly, in all material
respects, the financial position of FNB Financial Services Corporation and its
subsidiaries at December 31, 2003, and the results of their operations and their
cash flows for each of the two years in the period ended December 31, 2003 in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Raleigh, North Carolina
March 1, 2004
48
FNB Financial Services Corporation and Subsidiary
Consolidated Balance Sheets
December 31, 2004 and 2003
(Dollars in thousands, except per share data)
2004 2003
--------- ---------
ASSETS
Cash and due from banks ....................................................... $ 24,246 $ 29,319
Investment securities:
Available for sale ......................................................... 137,161 139,799
Federal Home Loan Bank and Federal Reserve Bank Stock, at cost ............. 4,442 3,882
Loans, net of allowance for credit losses of $7,353 in 2004 and $7,124 in
2003 ....................................................................... 656,073 574,260
Premises and equipment, net ................................................... 13,144 13,031
Accrued income and other assets ............................................... 30,269 20,635
--------- ---------
Total assets ............................................................ $ 865,335 $ 780,926
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing ......................................................... $ 78,810 $ 69,982
Interest-bearing ............................................................ 645,475 571,925
--------- ---------
Total deposits ......................................................... 724,285 641,907
Federal funds purchased and retail repurchase agreements ...................... 21,534 15,363
Other borrowings .............................................................. 45,000 55,500
Accrued expenses and other liabilities ........................................ 4,086 2,406
--------- ---------
Total liabilities ...................................................... 794,905 715,176
--------- ---------
Commitments and Contingent Liabilities: See Note 16.
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 -
5,550,326 in 2004 and 5,478,664 in 2003 .................................... 5,550 5,479
Paid-in capital ............................................................... 21,367 22,025
Retained earnings ............................................................. 43,986 38,395
Accumulated other comprehensive loss .......................................... (473) (149)
--------- ---------
Total shareholders' equity .............................................. 70,430 65,750
--------- ---------
Total liabilities and shareholders' equity .............................. $ 865,335 $ 780,926
========= =========
See notes to consolidated financial statements
49
FNB Financial Services Corporation and Subsidiary
Consolidated Statements of Income and Comprehensive Income
Years ended December 31, 2004, 2003 and 2002
(Dollars in thousands, except per share data)
2004 2003 2002
-------- -------- --------
Interest income
Loans ................................................. $ 39,609 $ 36,196 $ 37,199
Federal funds sold and overnight deposits ............. 194 84 205
Investment securities
Taxable ............................................ 3,146 4,059 5,375
Tax exempt ......................................... 1,343 1,076 297
Other ................................................. 180 172 232
-------- -------- --------
Total interest income ........................... 44,472 41,587 43,308
-------- -------- --------
Interest expense
Deposits .............................................. 13,559 15,190 18,022
Short-term borrowings ................................. 151 157 247
Long-term debt ........................................ 1,377 1,418 1,286
-------- -------- --------
Total interest expense .......................... 15,087 16,765 19,555
-------- -------- --------
Net interest income ...................................... 29,385 24,822 23,753
Provision for credit losses .............................. 1,275 1,431 1,300
-------- -------- --------
Net interest income after provision for credit losses .... 28,110 23,391 22,453
-------- -------- --------
Noninterest income
Service charges on deposit accounts ................... 3,769 3,585 2,819
Mortgage banking fees ................................. 2,233 2,019 1,144
Investment services fees .............................. 507 670 308
Net gain on securities available for sale ............. 109 564 318
Net gain on disposition of branch ..................... 700 -- --
Other noninterest income .............................. 768 587 696
-------- -------- --------
Total noninterest income ........................ 8,086 7,425 5,285
-------- -------- --------
Noninterest expense
Salaries and employee benefits ........................ 12,401 10,512 9,787
Occupancy expense ..................................... 1,392 1,150 1,053
Furniture and equipment expense ....................... 2,873 2,403 1,926
Telecommunications expense ............................ 616 635 461
Marketing expense ..................................... 942 682 289
Printing and supply expense ........................... 533 427 443
Other noninterest expense ............................. 5,009 3,758 3,470
-------- -------- --------
Total noninterest expenses ...................... 23,766 19,567 17,429
-------- -------- --------
Income before provision for income taxes ................. 12,430 11,249 10,309
Provision for income taxes ............................... 4,090 3,789 3,527
-------- -------- --------
Net income ............................................... 8,340 7,460 6,782
Other comprehensive loss ................................. (324) (1,633) (12)
-------- -------- --------
Comprehensive income ..................................... $ 8,016 $ 5,827 $ 6,770
======== ======== ========
Net income per share, basic .............................. $ 1.52 $ 1.35 $ 1.19
======== ======== ========
Net income per share, diluted ............................ $ 1.46 $ 1.30 $ 1.17
======== ======== ========
See notes to consolidated financial statements
50
FNB Financial Services Corporation and Subsidiary
Consolidated Statements of Changes in Shareholders' Equity
Years ended December 31, 2004, 2003 and 2002
(Dollars in thousands)
2004 2003 2002
-------- -------- --------
Common stock
Balance at beginning of period .......................... $ 5,479 $ 4,467 $ 4,569
Stock repurchase ........................................ (184) (126) (246)
Stock split effected in the form of a stock dividend .... -- 1,097 --
Exercise of stock options ............................... 255 41 144
-------- -------- --------
Balance at end of period ................................ 5,550 5,479 4,467
-------- -------- --------
Paid-in capital
Balance at beginning of period .......................... 22,025 23,833 26,465
Stock repurchase ........................................ (3,266) (2,204) (3,883)
Exercise of stock options ............................... 2,332 392 1,249
Tax benefit from exercise of stock options .............. 276 -- --
Employee stock awards ................................... -- 4 2
-------- -------- --------
Balance at end of period ................................ 21,367 22,025 23,833
-------- -------- --------
Retained earnings
Balance at beginning of period .......................... 38,395 34,549 30,178
Net income .............................................. 8,340 7,460 6,782
Cash dividends paid ..................................... (2,749) (2,512) (2,411)
Cash paid for fractional shares ......................... -- (5) --
Stock split effected in the form of a stock dividend .... -- (1,097) --
-------- -------- --------
Balance at end of period ................................ 43,986 38,395 34,549
-------- -------- --------
Accumulated other comprehensive income (loss)
Balance at beginning of period .......................... (149) 1,484 1,496
Other comprehensive loss ................................ (324) (1,633) (12)
-------- -------- --------
Balance at end of period ................................ (473) (149) 1,484
-------- -------- --------
Total shareholders' equity ........................... $ 70,430 $ 65,750 $ 64,333
======== ======== ========
See notes to consolidated financial statements
51
FNB Financial Services Corporation and Subsidiary
Consolidated Statements of Cash Flows
Years ended December 31, 2004, 2003 and 2002
(Dollars in thousands)
2004 2003 2002
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ........................................................................... $ 8,340 $ 7,460 $ 6,782
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, accretion, and amortization ......................................... 1,455 2,401 1,490
Provision for credit losses ....................................................... 1,275 1,431 1,300
Gain on sale of securities available for sale ..................................... (109) (564) (318)
Gain on disposal of premises and equipment ........................................ (106) (4) (104)
Gain on sale of branching operation ............................................... (700) -- --
Deferred income taxes ............................................................. (397) (329) 324
Net change in loans held for sale ................................................. (9,233) (557) (2,190)
Changes in assets and liabilities:
(Increase) decrease in other assets ............................................ 476 (1,672) 34
Increase (decrease) in other liabilities ....................................... 1,956 (649) (1,744)
--------- --------- ---------
Net cash provided by operating activities ................................... 2,957 7,517 5,574
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales, calls, and maturities of securities available for sale........... 31,059 108,015 92,311
Purchase of securities available for sale ............................................ (29,632) (130,562) (92,354)
Purchase of premises and equipment ................................................... (2,084) (3,617) (599)
Proceeds from disposal of premises and equipment ..................................... 292 -- --
Proceeds from sale of branch, net of cash transferred ................................ 700 -- --
(Increase) decrease in other real estate owned ....................................... (367) 561 (480)
Net increase in loans ................................................................ (82,435) (19,708) (27,781)
--------- --------- ---------
Net cash used in investing activities ....................................... (82,467) (45,311) (28,903)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits ............................................................. 82,379 36,898 18,244
Net increase (decrease) in other borrowings .......................................... (10,500) 3,000 22,500
Net increase (decrease) in federal funds purchased and retail repurchase agreements .. 6,171 7,105 (11,419)
Repurchase of common stock ........................................................... (3,450) (2,330) (4,129)
Proceeds from issuance of common stock ............................................... 2,589 433 1,395
Cash dividends paid and cash paid in lieu of fractional shares ....................... (2,752) (2,517) (2,411)
--------- --------- ---------
Net cash provided by financing activities ................................... 74,437 42,589 24,180
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents ................................. (5,073) 4,795 851
Cash and cash equivalents, beginning of year ......................................... 29,319 24,524 23,673
--------- --------- ---------
Cash and cash equivalents, end of year ............................................... $ 24,246 $ 29,319 $ 24,524
========= ========= =========
Supplemental disclosures
Transfer of loans to other real estate .................................................. $ 2,312 $ 4,254 $ 1,526
Increase (decrease) in fair value of securities available for sale, net of tax .......... (324) (1,633) (12)
Interest paid on deposits and borrowed funds ............................................ 15,104 17,559 19,915
Income taxes paid ....................................................................... 4,680 3,651 3,854
See notes to consolidated financial statements
52
FNB Financial Services Corporation and Subsidiary
Notes to Consolidated Financial Statements
December 31, 2004, 2003 and 2002
Note 1 - Summary of significant accounting policies
Principles of consolidation
The accompanying consolidated financial statements include the accounts of FNB
Financial Services Corporation (the "Company") and its wholly owned subsidiary
FNB Southeast (the "Bank"). Also included are the accounts of FNB Southeast
Mortgage Corporation, and FNB Southeast Investment Services, Inc., both of which
are wholly owned subsidiaries of FNB Southeast. All significant intercompany
balances and transactions have been eliminated in consolidation.
Nature of operations
FNB Southeast provides a variety of financial services to individual and
corporate customers in North Carolina through its thirteen full-service branches
in Reidsville, Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North
Carolina. A majority of the Bank's North Carolina customers are located in
Rockingham, Guilford, and New Hanover Counties. The Bank also provides a variety
of financial services to customers in Virginia through its four full-service
branches in Norton, Harrisonburg, and Pennington Gap, Virginia. A majority of
the Bank's Virginia customers are located in Wise, Russell, Lee, Rockingham, and
Augusta Counties. FNB Southeast's primary deposit products are interest-bearing
checking accounts, certificates of deposit and individual retirement accounts.
Its primary lending products are commercial, real estate, and consumer loans.
Use of estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and their reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for credit losses on loans. A
majority of the Bank's loan portfolio consists of loans in the geographic areas
cited above. The local economies of these areas depend heavily on the
industrial, agricultural, and service sectors. Accordingly, the ultimate
collectibility of a large portion of the Bank's loan portfolio would be affected
by changes in local economic conditions.
Cash and cash equivalents
Cash and cash equivalents include cash and due from banks and interest-bearing
bank deposits. Cash and cash equivalents are defined as cash and short-term
investments with maturities of three months or less.
Investment securities
The Company classifies its investment securities at the time of purchase into
three categories as follows:
- Held to Maturity - reported at amortized cost,
- Trading - reported at fair value with unrealized gains and losses
included in earnings, or
- Available for Sale - reported at fair value with unrealized gains
and losses reported in other comprehensive income.
The Company is required to maintain certain levels of Federal Reserve Bank
("FRB") and Federal Home Loan Bank of Atlanta ("FHLB") stock based on various
criteria established by the individual issuer.
53
Gains and losses on sales of securities are recognized when realized on a
specific identification basis. Premiums and discounts are amortized into
interest income using the level yield method.
Loans
Interest on loans is accrued and credited to income based on the principal
amount outstanding. The accrual of interest on impaired loans is discontinued
when, in management's opinion, the borrower may be unable to meet payments as
they become due. When interest accrual is discontinued, all unpaid accrued
interest is reversed. Loans are placed on nonaccrual status when: (i) management
has concerns relating to the ability to collect the loan principal and interest
and (ii) generally when such loans are ninety days or more past due. Interest
income is subsequently recognized only to the extent cash payments are received.
Mortgage loans held for sale are valued at the lower of cost or market as
determined by outstanding commitments from investors or current investor yield
requirements, calculated on the aggregate loan basis.
Loan origination fees and costs
Loan origination fees and certain direct origination costs are capitalized and
recognized as an adjustment of the yield on the related loan.
Allowance for credit losses
The Company's allowance for credit losses is based on management's best estimate
of probable loan losses incurred as of the balance sheet date. Factors impacting
estimated probable loan losses include credit quality trends, past loan loss
experience, current economic conditions, and loan volume among loan categories.
While management uses the best available information to establish the allowance
for credit losses, future additions to the allowance may be necessary based on
the factors cited above. In addition, the allowance is reviewed by regulatory
agencies as an integral part of their examination processes. Such agencies may
require the Company to recognize changes to the allowance based on their
judgments about information available to them at the time of their examination.
Other real estate
Other real estate, acquired through partial or total satisfaction of loans, is
carried at the lower of cost or fair market value, less estimated costs to sell,
which becomes the property's new basis. At the date of acquisition, losses are
charged to the allowance for credit losses. Subsequent write-downs are charged
to expense in the period they are incurred.
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation and
amortization. The provision for depreciation and amortization is computed
principally by the straight-line method over the estimated useful lives of the
assets. Useful lives are estimated at 20 to 40 years for buildings and 3 to 10
years for equipment. Leasehold improvements are amortized over the expected
terms of the respective leases or the estimated useful lives of the
improvements, whichever is shorter. Expenditures for maintenance and repairs are
charged to operations, and the expenditures for major replacements and
betterments are added to the premises and equipment accounts. The cost and
accumulated depreciation of the premises and equipment retired or sold are
eliminated from the appropriate asset accounts at the time of retirement or sale
and the resulting gain or loss is reflected in current operations.
Income taxes
Provisions for income taxes are based on taxes payable or refundable for the
current year (after exclusion of non-taxable income such as interest on state
and municipal securities and non-deductible expenses) and deferred taxes on
temporary differences between the tax bases of assets and liabilities and their
reported
54
amounts in the financial statements at currently enacted income tax rates
applicable to the period in which the deferred tax assets and liabilities are
expected to be realized or settled. As changes in tax laws or rates are enacted,
deferred tax assets and liabilities are adjusted through the provision for
income taxes.
Common stock
A five-for-four stock split was effected in the form of a 25% stock dividend,
effective December 29, 2003, with the issuance of 1,096,890 shares of stock and
the transfer of $1,096,890 from retained earnings to the common stock account.
All per share amounts in the financial statements have been recomputed to
reflect this split.
Per share data
The Company follows Statement of Financial Accounting Standards ("SFAS") No.
128, "Earnings per Share". SFAS No. 128 requires disclosure of two earnings per
share amounts: basic net income per share of common stock and diluted net income
per share of common stock. Basic net income per share of common stock is
computed by dividing net income available to common shareholders by the weighted
average number of shares of common stock outstanding during each year. Diluted
net income per share of common stock is computed by dividing net income plus any
adjustments to net income related to the issuance of dilutive potential common
shares, comprised solely of outstanding options to purchase shares of common
stock, by the weighted average number of shares of common stock outstanding
during each year plus the number of potential dilutive common shares.
Sales of loans
Gains and losses on the sale of loans are accounted for by imputing gain or loss
on those sales where a yield rate guaranteed to the buyer is more or less than
the contract interest rate being collected. Such gains or losses are recognized
in the financial statements during the year of sale.
Off balance sheet arrangements
In the ordinary course of business, the Bank enters into off balance sheet
financial instruments consisting of commitments to extend credit, commitments
under credit card arrangements, commercial letters of credit and standby letters
of credit. Such financial instruments are recorded in the financial statements
when they are funded or related fees are incurred or received.
Segment information
The Company follows the provisions of SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." SFAS No. 131 requires that public
business enterprises report certain information about operating segments in
their annual financial statements and in condensed financial statements for
interim periods issued to stockholders. It also requires that public business
enterprises report related disclosures and descriptive information about
products and services provided by significant segments, geographic areas, and
major customers, differences between the measurements used in reporting segment
information and those used in the enterprise's general-purpose financial
statements, and changes in the measurement of segment amounts from period to
period.
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 financial services, including
banking, mortgage, and investment services, to customers located in Reidsville,
Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North Carolina;
Norton, Harrisonburg, and Pennington Gap, Virginia; and surrounding communities.
The various products 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 branches or products.
There are no differences between the measurements used in reporting segment
information and those used in the Company's general-purpose financial
statements.
55
Stock based compensation
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 No.
123 and SFAS No. 148, is disclosed as follows.
(Dollars in thousands, except per share data) 2004 2003 2002
--------------------------------------------- ------- ------- -------
Net income, as reported $ 8,340 $ 7,460 $ 6,782
Less: Stock based compensation as calculated
per fair value method, net of tax effect (346) (254) (349)
------- ------- -------
Proforma net income $ 7,994 $ 7,206 $ 6,433
Earnings per share:
Basic - as reported $ 1.52 $ 1.35 $ 1.19
Basic - proforma $ 1.46 $ 1.30 $ 1.13
Diluted - as reported $ 1.46 $ 1.30 $ 1.17
Diluted - proforma $ 1.41 $ 1.26 $ 1.10
Recent accounting pronouncements
In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based
Compensation (SFAS No. 123(R)). SFAS No. 123(R) establishes standards for the
accounting for transactions in which an entity exchanges its equity instruments
for goods or services. This Statement focuses primarily on accounting for
transactions in which an entity obtains employee services in share-based payment
transactions. SFAS No. 123(R) requires that the fair value of such equity
instruments be recognized as an expense in the historical financial statements
as services are performed. Prior to SFAS No. 123(R), only certain proforma
disclosures of fair value were required. The provisions of this Statement are
effective for the first interim reporting period that begins after June 15,
2005. Accordingly, we will adopt SFAS No. 123(R) commencing with the quarter
ending September 30, 2005. If we had included the cost of employee stock option
compensation in our consolidated financial statements, our net income for the
fiscal years ended December 31, 2004, 2003 and 2002 would have decreased by
approximately $346,000, $254,000, and $349,000, respectively. Accordingly, the
adoption of SFAS No. 123(R) is expected to have a material effect on our
consolidated financial statements.
In December 2003, the American Institute of Certified Public Accountants (AICPA)
issued Statement of Position (SOP) 03-3, Accounting for Loans or Certain Debt
Securities Acquired in a Transfer. The SOP addresses accounting for differences
between contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities acquired in a transfer
if those differences relate to a deterioration of credit quality. The SOP also
prohibits companies from "carrying over" or creating a valuation allowance in
the initial accounting for loans acquired that meet the scope criteria of the
SOP. The SOP is effective for loans acquired in fiscal years beginning after
December 15, 2004. The adoption of this SOP is not expected to have a material
impact on the Company's financial position or results of operations.
In March 2004, the Emerging Issues Task Force ("EITF") released EITF Issue
03-01, The Meaning of Other-Than-Temporary Impairment and its Application to
Certain Investments. The Issue provides guidance for determining whether an
investment is other-than-temporarily impaired and requires certain disclosures
with respect to these investments. The recognition and measurement guidance for
other-than-temporary impairment has been delayed by the issuance of FASB Staff
Position EITF 03-1-1 on September 30, 2004. The adoption of Issue 03-1 did not
result in any other-than-temporary impairment.
56
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105,
Application of Accounting Principles to Loan Commitments ("SAB 105"). SAB 105
clarifies existing accounting practices relating to the valuation of issued loan
commitments, including interest rate lock commitments ("IRLC"), subject to SFAS
No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a
Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105
disallows the inclusion of the values of a servicing component and other
internally developed intangible assets in the initial and subsequent IRLC
valuation. The provisions of SAB 105 were effective for loan commitments entered
into after March 31, 2004. The adoption of SAB 105 did not have a material
impact on the consolidated financial statements.
Reclassification
Certain items for 2003 and 2002 have been reclassified to conform to the 2004
presentation. Such reclassifications had no effect on net income or
shareholders' equity as previously reported.
Note 2 - Restriction on cash and due from banks
The Bank maintains average required reserve balances with the Federal Reserve.
The average amounts of these reserve balances for the years ended December 31,
2004 and 2003 were $1,922,000 and $1,943,000, respectively.
Note 3 - Investment securities
Investment securities at December 31 consist of the following:
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- ---------
(In thousands)
2004:
Available for sale:
U.S. government agency securities ... $ 82,889 $ 113 $ (1,200) $ 81,802
Mortgage backed securities .......... 22,007 92 (124) 21,975
State and municipal obligations ..... 31,936 586 (237) 32,285
Other ............................... 1,105 -- (6) 1,099
--------- ------- -------- ---------
Total available for sale ............ 137,938 791 (1,567) 137,161
Federal Home Loan Bank and Federal
Reserve Bank stock .................. 4,442 -- -- 4,442
--------- ------- -------- ---------
Total investment securities ...... $ 142,379 $ 791 $ (1,567) $ 141,603
========= ======= ======== =========
2003:
Available for sale:
U.S. government agency securities $ 88,534 $ 489 $ (972) $ 88,051
Mortgage backed securities .......... 18,237 153 (160) 18,230
State and municipal obligations ..... 32,617 561 (328) 32,850
Other ............................... 656 14 (2) 668
--------- ------- -------- ---------
Total available for sale ............ 140,044 1,217 (1,462) 139,799
Federal Home Loan Bank and Federal
Reserve Bank stock .................. 3,882 -- -- 3,882
--------- ------- -------- ---------
Total investment securities ...... $ 143,926 $ 1,217 $ (1,462) $ 143,681
========= ======= ======== =========
The aggregate cost of the Company's cost method equity investment, Federal Home
Loan Bank stock and Federal Reserve Bank stock, totaled $4,442,000 at December
31, 2004. The Company estimated that the fair value equaled the cost of the
investment (that is, the investment was not impaired) with an aggregate cost of
$4,442,000.
57
The following table shows our investments' gross unrealized losses and fair
value, aggregated by investment category and length of time that the individual
securities have been in a continuous unrealized position, at December 31, 2004
and 2003. The unrealized losses relate to debt securities that have incurred
fair value reductions due to higher market interest rates since the securities
were purchased. The unrealized losses are not likely to reverse unless and until
market interest rates decline to the levels that existed when the securities
were purchased. Since none of the unrealized losses relate to the marketability
of the securities or the issuer's ability to honor redemption obligations, none
of the securities are deemed to be other than temporarily impaired.
2004 Less than 12 months 12 months or more Total
---- --------------------- --------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
value losses value losses value losses
-------- ---------- -------- ---------- -------- ----------
(In thousands)
Investment securities:
U.S. government agency
securities $ 40,076 $ 340 $ 29,800 $ 860 $ 69,876 $ 1,200
Mortgage backed securities 6,467 24 6,623 100 13,090 124
State and municipal obligations 5,602 55 4,984 182 10,586 237
Other 1,099 6 -- -- 1,099 6
-------- ----- -------- ------- -------- -------
Total temporarily impaired
securities $ 52,145 $ 425 $ 41,407 $ 1,142 $ 93,552 $ 1,567
======== ===== ======== ======= ======== =======
2003 Less than 12 months 12 months or more Total
---- --------------------- --------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
value losses value losses value losses
-------- ---------- -------- ---------- -------- ----------
(In thousands)
Investment securities:
U.S. government agency
securities $ 52,990 $ 972 $ -- $ -- $ 52,990 $ 972
Mortgage backed securities 11,761 162 -- -- 11,761 162
State and municipal obligations 14,529 328 -- -- 14,529 328
-------- ------- ---- ---- -------- -------
Total temporarily impaired
securities $ 79,280 $ 1,462 $ -- $ -- $ 79,280 $ 1,462
======== ======= ==== ==== ======== =======
The amortized cost and estimated market value of debt securities at December 31,
2004, by contractual maturities, are shown in the accompanying schedule.
Expected maturities may differ from contractual maturities because borrowers may
have the right to call or prepay obligations with or without call or prepayment
penalties.
Amortized Estimated
Cost Fair Value
--------- ----------
(In thousands)
Due in one year or less ............ $ 10,482 $ 10,462
Due after one through five years ... 66,852 65,898
Due after five through ten years ... 30,342 30,506
Due after ten years ................ 29,156 29,196
--------- ---------
Total debt securities ........... $ 136,832 $ 136,062
========= =========
Proceeds from the sale of investment securities available for sale, gross
realized gains, and gross realized losses for the years ended December 31 were
as follows:
2004 2003 2002
-------- --------- -------
(In thousands)
Proceeds from sales ................. $ 15,195 $ 104,715 $ 3,913
Gross realized gains ................ 150 564 318
Gross realized losses ............... 41 -- --
58
At December 31, 2004 and 2003, investment securities with a carrying value of
approximately $69,479,000 and $68,027,000, respectively, were pledged as
collateral to secure public deposits and for other purposes.
Note 4 - Loans
Major classifications of loans at December 31, are as follows:
2004 2003
--------- ---------
(In thousands)
Commercial, financial and agricultural......... $ 83,332 $ 90,224
Consumer....................................... 137,332 118,557
Real estate:
Residential mortgage........................ 124,436 95,939
Commercial mortgage......................... 166,491 159,953
Construction................................ 162,143 117,786
--------- ---------
Subtotal loans................................. 673,734 582,459
Loans held for sale............................ 10,308 1,075
--------- ---------
Gross loans....................... $ 663,426 $ 581,384
========= =========
A loan is considered impaired, based on current information and events, if it is
probable that the Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Generally, a loan will be considered impaired if it exhibits the same
level of underlying weakness and probability of loss as loans classified
doubtful or loss.
The impairment evaluation compares the recorded book value of the loan, or loan
relationship, to the present value of the expected future principal, interest
and collateral value (if applicable) cash flows. The expected cash flows are
discounted at the contractual interest rate for the individual note. A specific
reserve is established if the present value of expected future cash flows is
less than the recorded book value of the loan.
At December 31, 2004 and 2003, the recorded investment in loans considered
impaired was approximately $14,417,000 and $10,615,000, respectively. The
related allowance for credit losses on these impaired loans was approximately
$915,000 and $2,085,000, respectively. The average recorded investment in
impaired loans for the years ended December 31, 2004, 2003 and 2002 was
approximately $11,851,000, $12,437,000, and $9,881,000 respectively.
Nonperforming loans include nonaccrual loans and loans past due 90 days or more
and still accruing interest. Nonperforming loans at December 31, 2004 consisted
of $3,450,000 of nonaccrual loans and $65,000 of loans 90 days or more past due
and still accruing interest. Nonperforming loans at December 31, 2003 consisted
of $5,174,000 of nonaccrual loans and $53,000 of loans 90 days or more past due
and still accruing interest. Nonperforming loans at December 31, 2002 consisted
of $3,314,000 of nonaccrual loans and $65,000 of loans 90 days or more past due
and still accruing interest. The amount of interest income recorded on
nonperforming loans during 2004, 2003 and 2002 amounted to $186,000, $142,000
and $475,000, respectively. Interest income on nonperforming loans is recorded
when cash is actually received.
The amount of potential problem loans totaled $14,417,000 at December 31, 2004.
These loans are considered impaired by the Company. There are no other
identified potential problem loans at December 31, 2004.
Certain 1 to 4 family residential mortgage loans are held as collateral under a
blanket floating lien to secure a portion of the Bank's borrowings (see Note 9).
59
Note 5 - Allowance for credit losses
Changes in the allowance for credit losses for the years ended December 31 were
as follows:
2004 2003 2002
-------- -------- --------
(In thousands)
Balance at beginning of year ... $ 7,124 $ 7,059 $ 6,731
Provision for credit losses .... 1,275 1,431 1,300
Recoveries ..................... 77 181 298
Losses charged off ............. (1,123) (1,547) (1,270)
-------- -------- --------
Balance at end of year ......... $ 7,353 $ 7,124 $ 7,059
======== ======== ========
Note 6 - Premises and equipment
Premises and equipment at December 31 is summarized as follows:
2004 2003
-------- --------
(In thousands)
Land ............................................. $ 3,192 $ 3,724
Building and leasehold improvements .............. 8,241 8,385
Equipment ........................................ 14,790 12,549
-------- --------
Subtotal ......................................... 26,223 24,658
Less accumulated depreciation and amortization ... 13,079 11,627
-------- --------
Total premises and equipment, net ............. $ 13,144 $ 13,031
======== ========
Note 7 - Deposits
The aggregate amount of jumbo certificates of deposit, each with a minimum
denomination of $100,000, was approximately $126,472,000 and $194,802,000 in
2004 and 2003, respectively. The accompanying table presents the scheduled
maturities of time deposits at December 31, 2004.
Year ending December 31, (In thousands)
-------------------------- --------------
2005 ..................... $ 324,272
2006 ..................... 88,685
2007 ..................... 19,754
2008 ..................... 10,500
2009 ..................... 9,655
Thereafter ............... 334
---------
Total time deposits ... $ 453,200
=========
60
Note 8 - Federal funds purchased, retail repurchase agreements and other
borrowings
The following is a schedule of federal funds purchased, securities sold under
agreements to repurchase and FHLB borrowings:
Maximum
Balance Interest Rate Average Outstanding
as of as of Average Interest at Any
(dollars in thousands) December 31 December 31 Balance Rate Monthend
----------- ------------- -------- -------- -----------
2004
Federal funds purchased and securities
sold under agreements to repurchase $ 21,534 1.82% $ 16,747 0.91% $ 25,992
FHLB borrowings ...................... 45,000 3.30% 47,393 2.91% 57,500
-------- -------- --------
Total .......................... $ 66,534 $ 64,140 $ 83,492
======== ======== ========
2003
Federal funds purchased and securities
sold under agreements to repurchase $ 15,363 1.24% $ 14,479 1.41% $ 18,131
FHLB borrowings ...................... 55,500 2.65% 47,724 2.28% 67,500
-------- -------- --------
Total $ 70,863 $ 62,203 $ 85,631
======== ======== ========
At December 31, 2004, the Bank had an approximately $130 million line of credit
with the FHLB under which $45.0 million was outstanding. This line of credit is
secured with FHLB stock and a blanket floating lien on qualifying 1 to 4 family
residential mortgage loans and qualifying commercial real estate. The
outstanding amounts consist of $20.0 million maturing in 2005, $15.0 million
maturing in 2007, and $10.0 million maturing in 2011. The borrowings maturing in
2007 and 2011 both have one time call features, and may be converted to a
floating rate based on the three month LIBOR rate at their respective call date.
Federal funds purchased represent unsecured overnight borrowings from other
financial institutions by the Bank. Securities sold under agreements to
repurchase represent short-term borrowings by the Bank, with overnight
maturities collateralized by securities of the United States government or its
agencies.
Note 9 - Income taxes
The components of income tax expense for the years ended December 31 are as
follows:
2004 2003 2002
------- ------- -------
(In thousands)
Current tax expense
Federal .......................... $ 3,864 $ 3,721 $ 2,928
State ............................ 623 397 275
------- ------- -------
Total current ................. 4,487 4,118 3,203
------- ------- -------
Deferred tax (benefit) expense
Federal .......................... (290) (299) 282
State ............................ (107) (30) 42
------- ------- -------
Total deferred ................ (397) (329) 324
------- ------- -------
Total income tax expense ... $ 4,090 $ 3,789 $ 3,527
======= ======= =======
61
The significant components of deferred tax assets at December 31 are as follows:
2004 2003
------- ------
(In thousands)
Deferred tax assets:
Allowance for credit losses ............................ $ 2,855 $ 2,671
Non-qualified deferred compensation plans .............. 616 285
Deferred loan fees ..................................... 484 272
Nonaccrual interest .................................... 216 178
Net unrealized gain on securities available for sale ... 303 96
Other .................................................. 200 67
------- -------
Total ............................................... 4,674 3,569
Deferred tax liabilities:
Depreciable basis of property and equipment ............ 911 636
Prepaid expenses ....................................... 180 --
Other .................................................. 46 --
------- -------
Total ............................................... 1,137 636
------- -------
Net deferred tax assets ................................... $ 3,537 $ 2,933
======= =======
There is no valuation allowance for deferred tax assets, as management believes
that realization of the deferred tax assets will more likely than not be
realized. The provision for income taxes differs from that computed by applying
the federal statutory rate of 34% as indicated in the following analysis:
2004 2003 2002
------- ------- -------
(In thousands)
Tax based on statutory rates .................... $ 4,350 $ 3,825 $ 3,505
Increase (decrease) resulting from:
Effect of tax-exempt income .................. (427) (326) (101)
State income taxes, net of federal benefit ... 335 218 229
Other, net ................................... (168) 72 (106)
------- ------- -------
Total provision for income taxes ............. $ 4,090 $ 3,789 $ 3,527
======= ======= =======
Note 10 - Lease commitments
The minimum annual lease commitments under noncancelable operating leases in
effect at December 31, 2004, are as follows:
Year Ending December 31 (In thousands)
- ------------------------------ --------------
2005 ......................... $ 686
2006 ......................... 748
2007 ......................... 754
2008 ......................... 608
2009 ......................... 590
Thereafter ................... 545
-------
Total lease commitments ... $ 3,931
=======
Rental expense was $722,000 in 2004, $458,000 in 2003, and $429,000 in 2002.
62
Note 11 - Related party transactions
The Bank had loans outstanding to principal officers and directors and their
affiliated companies during each of the past three years. Such loans were made
substantially on the same terms, including interest rates and collateral, as
those prevailing at the time for comparable transactions with other borrowers
and do not involve more than the normal risks of collectibility. The following
table summarizes the transactions for the past two years.
(In thousands) 2004 2003
-------- --------
Balance, beginning of year $ 4,695 $ 4,936
Advances during year 1,251 1,990
Repayments during year (2,355) (2,231)
-------- --------
Balance, end of year $ 3,591 $ 4,695
======== ========
----------
NOTE: Unused credit available at December 31, 2004 totaled $3,252,000.
Note 12 - Stock based compensation
The Company follows SFAS No. 123, "Accounting for Stock-Based Compensation."
Under SFAS No. 123, the Company has elected to continue using the measurement
prescribed in Accounting Principles Board ("APB") Opinion No. 25, and
accordingly, SFAS No. 123 had no effect on the Company's financial position or
results of operations. The Company has issued stock under both incentive and
non-qualified stock options. The following is a summary of stock option activity
and related information for the years ended December 31:
2004 2003 2002
--------------------- -------------------- ----------------------
Weighted Weighted Weighted
Avg. Avg. Avg.
Exercise Exercise Exercise
Options Price Options Price Options Price
---------- -------- --------- -------- ----------- --------
Outstanding -
Beginning of year ... 901,409 $ 12.44 787,014 $ 12.11 1,016,691 $ 11.57
Granted ............. 140,000 19.94 218,125 13.44 6,250 13.38
Exercised ........... (257,597) 10.04 (54,812) 9.44 (180,479) 7.81
Forfeited ........... (14,170) 15.80 (48,918) 14.94 (55,448) 15.89
---------- --------- -----------
Outstanding - End
of year ............. 769,642 $ 14.55 901,409 $ 12.44 787,014 $ 12.11
========== ========= ===========
Exercisable - End
of year ............. 472,755 $ 13.68 630,167 $ 12.37 618,573 $ 12.57
========== ========= ===========
Weighted average fair
value of options granted
during the year ........ $ 3.79 $ 2.08 $ 1.83
========== ========= ===========
63
The following is a summary of information on outstanding and exercisable options
at December 31, 2004:
Options Outstanding Options Exercisable
- -------------------------------------------------------------------- -------------------------
Weighted Average Weighted Weighted
Range of Remaining Contractual AverageExercise Average
Exercise Prices Number Life (Years) Price Number Exercise Price
- --------------- -------- --------------------- --------------- -------- --------------
$ 5.76 -
9.65 90,018 4.78 $ 9.45 82,833 $ 9.44
$ 10.01 -
10.64 183,300 3.37 10.30 161,321 10.29
$ 13.44 -
14.00 224,533 6.10 13.53 85,306 13.67
$ 18.15 -
20.40 271,791 5.76 19.94 143,295 19.94
-------- --------
769,642 5.07 $ 14.55 472,755 $ 13.68
======== ========.
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 2004, 2003, and 2002: dividend yield of 3.07% for 2004,
2.75% for 2003, and 3.30% for 2002; expected volatility of 16.0% for 2004, 15.0%
for 2003, and 16.0% for 2002; risk free interest rates of 3.68% for 2004, 3.75%
for 2003, and 3.47% for 2002, and expected lives of seven years for all years.
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 1996 and thereafter vest
ratably over a four-year period. No option will be exercisable after ten years
from the date granted.
Note 13 - Other comprehensive income
The Company follows the provisions of SFAS No. 130, "Reporting Comprehensive
Income". SFAS No. 130 establishes requirements for the disclosure of
comprehensive income in the Company's consolidated financial statements.
Comprehensive income is defined as net income plus transactions and other
occurrences, which are the result of non-owner changes in equity.
Other comprehensive income is defined as comprehensive income exclusive of net
income. Unrealized gains (losses) on available for sale investment securities
represent the sole component of the Company's other comprehensive income. Other
comprehensive income (loss) at December 31 consists of the following:
2004 2003 2002
------ -------- ------
(In thousands)
Unrealized holding gains (losses) on securities AFS .......... $ (423) $ (2,624) $ 299
Tax effect ................................................... 165 1,024 (110)
------ -------- ------
Unrealized holding gains (losses) on AFS, net of tax ......... (258) (1,600) 189
------ -------- ------
Reclassification adjustment for realized gains ............... (109) (54) (318)
Tax effect ................................................... 43 21 117
------ -------- ------
Reclassification adjustment for realized gains, net of tax ... (66) (33) (201)
------ -------- ------
Other comprehensive income (loss), net of tax ................ $ (324) $ (1,633) $ (12)
====== ======== ======
64
Note 14 - Net income per share
The following is a reconciliation of the numerator and denominator of basic
common stock and diluted net income per share of common stock as required by
SFAS No. 128:
For the year ended December 31,
---------------------------------------
2004 2003 2002
----------- ----------- -----------
Basic:
Net income available to common shareholders ........... $ 8,340,000 $ 7,460,000 $ 6,782,000
=========== =========== ===========
Weighted average shares outstanding ................... 5,497,628 5,531,323 5,700,693
=========== =========== ===========
Net income per share, basic ........................... $ 1.52 $ 1.35 $ 1.19
=========== =========== ===========
Diluted:
Net income available to common shareholders ........... $ 8,340,000 $ 7,460,000 $ 6,782,000
=========== =========== ===========
Weighted average shares outstanding ................... 5,497,628 5,531,323 5,700,693
Effect of dilutive securities:
Stock options ................................... 219,505 193,289 120,504
----------- ----------- -----------
Weighted average shares outstanding and dilutive
potential shares outstanding ................... 5,717,133 5,724,612 5,821,197
=========== =========== ===========
Net income per share, diluted ...................... $ 1.46 $ 1.30 $ 1.17
=========== =========== ===========
For the years ended December 31, 2004, 2003, and 2002, there were 138,542
options, 131,489 options, and 163,524 options, respectively, that were
antidilutive since the exercise price exceeded the average market price for the
year.
65
Note 15 - FNB Financial Services Corporation (Parent Company)
The parent company's principal asset is its investment in its subsidiary, FNB
Southeast. The principal source of income of the parent company is dividends
received from its subsidiary.
2004 2003 2002
-------- -------- --------
(In thousands)
Condensed balance sheets
Assets
Cash and due from banks ........................................ $ 1,543 $ 132 $ 1,070
Securities ..................................................... -- -- 11
Investment in wholly-owned subsidiary .......................... 68,521 64,421 62,964
Other assets ................................................... 366 1,212 288
-------- -------- --------
Total assets ................................................... $ 70,430 $ 65,765 $ 64,333
======== ======== ========
Shareholders' equity and other liabilities ........................ $ 70,430 $ 65,765 $ 64,333
======== ======== ========
Condensed statements of income
Dividends from subsidiary ......................................... $ 4,255 $ 4,297 $ 4,421
Management fees ................................................... 300 300 300
Noninterest income ................................................ 37 152 --
Noninterest expense ............................................... (430) (342) (437)
-------- -------- --------
Income before tax benefit ......................................... 4,162 4,407 4,284
Income tax (provision) benefit .................................... 30 (37) --
-------- -------- --------
Income before equity in undistributed net income of subsidiary .... 4,192 4,370 4,284
Equity in undistributed net income of subsidiary .................. 4,148 3,090 2,498
-------- -------- --------
Net income ........................................................ $ 8,340 $ 7,460 $ 6,782
======== ======== ========
Condensed statements of cash flows
Cash flows from operating activities
Dividends received from subsidiary ............................. $ 4,255 $ 4,297 $ 4,421
Management fees received ....................................... 300 300 300
Cash paid for franchise tax, registration cost, acquisition cost
and other ...................................................... (362) (212) (435)
Change in other assets and liabilities, net .................... 831 (913) 1,113
-------- -------- --------
Net cash provided by operating activities ................... 5,024 3,472 5,399
-------- -------- --------
Cash flows from investing activities
Investment in subsidiary ....................................... -- -- --
-------- -------- --------
Net cash provided (used in) by investing activities ......... -- -- --
-------- -------- --------
Cash flows from financing activities
Repurchase of common stock ..................................... (3,450) (2,335) (4,129)
Dividends paid, net of DRIP .................................... (2,752) (2,512) (2,411)
Exercise of stock options ...................................... 2,589 437 1,393
-------- -------- --------
Net cash (used in) financing activities ..................... (3,613) (4,410) (5,147)
-------- -------- --------
Increase (decrease) in cash ....................................... 1,411 (938) 252
Cash at beginning of year ......................................... 132 1,070 818
-------- -------- --------
Cash at end of year ............................................... $ 1,543 $ 132 $ 1,070
======== ======== ========
Reconciliation of net income to cash provided by operating
activities
Net income ........................................................ $ 8,340 $ 7,460 $ 6,782
Adjustments to reconcile net income to net cash provided
by operating activities:
Change in other assets and liabilities, net ................. 831 (898) 1,111
Equity in undistributed net income of subsidiary ............ (4,147) (3,090) (2,494)
-------- -------- --------
Net cash provided by operating activities ......................... $ 5,024 $ 3,472 $ 5,399
======== ======== ========
66
Note 16 - Off-balance sheet arrangements
The Company's consolidated financial statements do not reflect various
commitments and contingent liabilities which arise in the normal course of
business and which involve elements of credit risk, interest rate risk and
liquidity risk. These commitments and contingent liabilities are commitments to
extend credit and standby letters of credit. A summary of the contract amount of
the Bank's exposure to off-balance sheet risk at December 31, is as follows:
Contract or
Notional Amount
---------------------
2004 2003
--------- ---------
(In thousands)
Commitments to extend credit ......................... $ 167,405 $ 135,552
Commercial letters of credit ......................... 635 354
--------- ---------
Total commitments and contingent liabilities ...... $ 168,040 $ 135,906
========= =========
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend is represented by
the contractual notional amount of those instruments. The Bank uses the same
credit policies in making commitments and conditional obligations as it does for
on-balance-sheet instruments.
Note 17 - Employee benefit plans
The Company's non-contributory defined benefit pension plan covers substantially
all of its employees. The plan calls for benefits to be paid to eligible
employees at retirement based primarily upon years of service with the Company
and a percentage of qualifying compensation during final years of employment.
Contributions to the plan are based upon the projected unit credited actuarial
funding method and comply with the funding requirements of the Employee
Retirement Income Security Act. Contributions are intended to provide not only
for benefits attributed to service to date but also for those expected to be
earned in the future. Plan assets consist primarily of cash and cash
equivalents, U.S. government securities, and common stocks. The following table
outlines the changes in the Company's pension obligations, assets and funded
status for the years ended December 31, 2004 and 2003, and the assumptions and
components of net periodic pension cost for the two years in the period ended
December 31, 2004.
2004 2003
-------- ---------
(Dollars in thousands)
Change in benefit obligation
Benefit obligation at beginning of year .............................. $ 5,901 $ 4,520
Service cost ......................................................... 508 371
Interest cost ........................................................ 361 301
Actuarial loss ....................................................... 183 783
Benefits paid ........................................................ (74) (74)
-------- -------
Benefit obligation at end of year .................................... 6,879 5,901
-------- -------
Change in plan assets
Fair value of plan assets at beginning of year ....................... 5,458 3,859
Actual return on plan assets ......................................... 431 799
Employer contribution ................................................ 32 874
Benefits paid ........................................................ (74) (74)
-------- -------
Fair value of plan assets at end of year ............................. 5,847 5,458
-------- -------
Funded status
Plan assets less than projected benefit obligation ................... (1,032) (443)
Unrecognized net actuarial loss ...................................... 1,926 1,777
Unrecognized prior service charge .................................... 133 153
-------- -------
Pension asset ........................................................ $ 1,027 $ 1,488
======== =======
67
2004 2003
-------- -------
Amounts recognized in the statement of financial position consists of: (Dollars in thousands)
Pension asset......................................................... $ 1,027 $ 1,488
Accrued benefit liability............................................. -- --
Intangible asset -- --
Accumulated comprehensive income -- --
-------- -------
Net amount recognized $ 1,027 $ 1,488
======== =======
2004 2003 2002
------ ------ ------
Components of net periodic pension cost (Dollars in thousands)
Service $ 508 $ 371 $ 384
Interest 361 301 291
Expected return on plan (430) (799) (255)
Amortization of prior service 54 528 55
------ ------ ------
Net periodic pension $ 493 $ 401 $ 475
====== ====== ======
Weighted-average assumptions
Discount 6.00% 6.00% 7.25%
Expected return on plan 9.00% 9.00% 9.00%
Rate of compensation increase 5.00% 5.00% 5.00%
Market
Weighted-average asset allocations @ December 31, 2004 Value Percent
------- --------
Debt securities:
Federated US Government $ 931 15.9%
Pimco Total 886 15.2
First Trust Institutional Money ................... 65 1.1
First Trust Money Market .......................... 1 --
------- -----
1,883 32.2
Equity securities:
American Funds Washington 2,242 38.3
American Growth Fund .............................. 1,344 23.0
Fidelity Advisor MidCap ........................... 378 6.5
------- -----
3,964 67.8
------- -----
Net $ 5,847 100.0%
======= =====
Target allocations are established based on periodic evaluation of risk/reward
under various economic scenarios and with varying asset class allocations. The
near-term and long-term impact on obligations and asset values are projected and
evaluated for funding and financial accounting implications. Actual allocation
and investment performance is reviewed quarterly. The current target allocation
ranges, along with the actual allocation as of December 31, 2004 is included in
the accompanying table.
68
Long-Term Actual
Plan Assets Allocation Allocation @
Target December 31,
2004
---------- ------------
Equity securities .................. 49% - 71% 67.8%
Debt securities .................... 18% - 28% 32.2%
Real estate ........................ 0% - 10% --
Other (primarily cash).............. 2% - 3% --
---------- ----
Total ........................... 100% 100%
========== ====
The assumed expected return on assets considers the current level of expected
returns on risk-free investments (primarily government bonds), the historical
level of risk premium associated with the other asset classes in the portfolio
and the expectation for future returns of each asset class. The expected return
of each asset class is weighted based on the target allocation to develop the
expected long-term rate of return on assets. This resulted in the selection of
the 9.00% rate used in 2004 and to be used for 2005. There was no minimum
required contribution for 2004 and no minimum contribution is expected for 2005.
The expected benefit payments for the next five years are as follows: (1) 2005 -
$175,953, (2) 2006 - $174,386, (3) 2007 - $219,085, (4) 2008 - $218,915, and (5)
2009 - $224,636.
The Company has a Supplemental Executive Retirement Plan ("SERP") that allows
the Company to supplement the level of certain executives' retirement income
over the amount obtainable through the tax-qualified retirement plan.
Contributions to the SERP totaled $313,000 for 2004, $237,000 for 2003, and
$234,000 for 2002. The net periodic pension cost for the years ended December
31, 2004, 2003, and 2002 was $431,000, 303,000, and 292,000, respectively. The
corresponding liability related to this plan was $1,897,000 and $1,492,000 as of
December 31, 2004 and 2003, respectively.
The Bank also has a separate contributory 401(k) savings plan covering
substantially all employees. The plan allows eligible employees to contribute up
to a fixed percentage of their compensation, with the Bank matching a portion of
each employee's contribution. The Bank's contributions were $162,000 for 2004,
$122,000 for 2003, and $130,000 for 2002.
A deferred compensation plan allows the directors and certain senior officers of
the Company and the Bank to defer the compensation they earn for performance of
their appointed duties for the Company and the Bank. Each plan participant makes
an annual election to either receive that year's compensation currently or to
defer receipt until his or her death, disability or retirement. Effective
November 1, 1999, the deferred compensation balances were transferred to a Rabbi
trust.
Note 18 - Regulatory matters
The primary source of funds for the dividends paid by the Company to its
shareholders is dividends received from the Bank. The Bank is restricted as to
dividend payout by state laws applicable to banks and may pay dividends only out
of undivided profits. Additionally, dividends paid by the Company may be limited
due to maintaining minimum capital requirements imposed by banking regulators.
Management does not expect any of these restrictions to materially limit its
ability to pay dividends comparable to those paid in the past. At December 31,
2004, the Bank had undivided profits of approximately $44.3 million.
The Bank is subject to various regulatory capital requirements administered by
federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory - and possible additional discretionary - actions by
regulators that, if undertaken, could have a direct material effect on the
Bank's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of
69
assets, liabilities, and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Bank's capital amounts and classification
are also subject to qualitative judgments by the regulators about components,
risk weighting, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the table
below) of total and Tier 1 capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier 1 capital to average assets (as
defined). Management believes, as of December 31, 2004, that the Bank meets all
capital adequacy requirements to which they are subject.
The most recent notification from the North Carolina Commissioner of Banks
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized the Bank must
maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
as set forth in the accompanying table. Since that notification, the Bank has
continued to experience asset growth.
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
---------------- ----------------- -----------------
Amount Ratio Amount Ratio Amount Ratio
-------- ----- -------- ------ -------- ------
(Dollars in thousands)
December 31, 2004
Total Capital (To Risk Weighted Assets)
Consolidated ........................ $ 77,738 11.3% $ 54,796 >/=8.0% $ N/A
Bank ................................ 75,469 11.0 54,773 >/=8.0 68,466 >/=10.0%
Tier 1 Capital (To Risk Weighted Assets)
Consolidated ........................ 70,025 10.2 27,398 >/=4.0 N/A
Bank_ ............................... 68,116 10.0 27,387 >/=4.0 41,078 >/=6.0
Tier 1 Capital (To Average Assets)
Consolidated ........................ 70,025 8.2 34,050 >/=4.0 N/A
Bank ................................ 68,116 8.0 34,038 >/=4.0 42,548 >/=5.0
December 31, 2003
Total Capital (To Risk Weighted Assets)
Consolidated ........................ $ 72,055 11.9% $ 48,525 >/=8.0% $ N/A
Bank ................................ 70,726 11.7 48,428 >/=8.0 60,535 >/=10.0%
Tier 1 Capital (To Risk Weighted Assets)
Consolidated ........................ 64,931 10.7 24,262 >/=4.0 N/A
Bank ................................ 63,602 10.5 24,214 >/=4.0 36,321 >/=6.0
Tier 1 Capital (To Average Assets)
Consolidated ........................ 64,931 8.4 30,770 >/=4.0 N/A
Bank ................................ 63,602 8.3 30,727 >/=4.0 38,409 >/=5.0
Note 19 - Fair value of financial instruments
The following methods and assumptions were used to estimate the fair value for
each class of the Company's financial instruments.
Cash and cash equivalents. The carrying amounts for cash and due from banks
approximate fair value because of the short maturities of those instruments.
Investment securities. The fair value of investment securities is based on
quoted market prices, if available. If a quoted market price is not available,
fair value is estimated using quoted market prices for similar securities. The
fair value of equity investments in the restricted stock of the Federal Reserve
Bank and Federal Home Loan Bank equals the carrying value.
70
Loans. The fair value of fixed rate loans is estimated by discounting the future
cash flows using the current rates at which similar loans would be made to
borrowers with similar credit ratings and for the same remaining maturities.
Substantially all residential mortgage loans held for sale are pre-sold and
their carrying value approximates fair value. The fair value of variable rate
loans with frequent repricing and negligible credit risk approximates book
value.
Deposits. The fair value of noninterest-bearing demand deposits and NOW,
savings, and money market deposits is the amount payable on demand at the
reporting date. The fair value of time deposits is estimated using the rates
currently offered for deposits of similar remaining maturities.
Federal Funds Purchased and Retail Repurchase Agreements. The carrying value of
federal funds purchased and retail repurchase agreements is considered to be a
reasonable estimate of fair value.
Other borrowings. Other borrowings consist of FHLB borrowings with varying
maturities. The fair values of these liabilities are estimated using the
discounted values of the contractual cash flows. The discount rate is estimated
using the rates currently in effect for similar borrowings.
Financial instruments with off-balance sheet risk. The fair value of financial
instruments with off-balance sheet risk is considered to approximate carrying
value, since the large majority of these future financing commitments would
result in loans that have variable rates and/or relatively short terms to
maturity. For other commitments, generally of a short-term nature, the carrying
value is considered to be a reasonable estimate of fair value. The various
financial instruments were disclosed in Note 16.
The estimated fair values of financial instruments at December 31 are as
follows:
2004 2003
---------------------- ---------------------
Carrying Estimated Carrying Estimated
Value Fair Value Value Fair Value
--------- ---------- --------- ----------
(In thousands)
Financial assets:
Cash and cash equivalents ................... $ 24,246 $ 24,246 $ 29,319 $ 29,319
Investment securities
Available for sale ....................... 137,161 137,161 139,799 139,799
Other equity securities .................. 4,442 4,442 3,882 3,882
Loans held for sale ......................... 10,308 10,308 1,075 1,075
Loans ....................................... 663,425 662,448 581,384 577,405
Financial liabilities:
Deposits .................................... 724,286 709,364 641,907 642,869
Federal funds purchased and retail repurchase
agreements ............................... 21,534 21,534 15,363 15,363
Other borrowings ............................ 45,000 45,215 55,500 56,391
The fair value estimates are made at a specific point in time based on relevant
market and other information about the financial instruments. Because no market
exists for a significant portion of the Company's financial instruments, fair
value estimates are based on current economic conditions, risk characteristics
of various financial instruments, and such other factors. These estimates are
subjective in nature and involve uncertainties and matters of significant
judgment and therefore cannot be determined with precision. Changes in
assumptions could significantly affect the estimates. In addition, the tax
ramifications related to the realization of the unrealized gains and losses can
have a significant effect on fair value estimates and have not been considered
in the estimates.
71
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
For information on the Company's change in independent accountants on June 30,
2004, from PricewaterhouseCoopers LLP ("PwC") to Dixon Hughes PLLC ("DH"), see
the Form 8-K filed with the SEC on July 7, 2004 and Form 8-K/A filed with the
SEC on July 23, 2004.
During the fiscal years ended December 31, 2004, 2003 and 2002, there were no
disagreements with DH or PwC on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedures which
disagreements, if not resolved to the satisfaction of DH or PwC, would have
caused DH or PwC to make reference thereto in their reports on the financial
statements for such years.
During the fiscal years ended December 31, 2004, 2003 and 2002, there have been
no "reportable events,"as that term is described in Item 304(a)(1)(v) of
Regulation S-K.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company's management, under the supervision and with the participation of
the Chief Executive Officer and the Chief Financial Officer of the Company (its
principal executive officer and principal financial officer, respectively), has
concluded based on its evaluation as of the end of the period covered by this
Report, that the Company's disclosure controls and procedures are effective to
ensure that information required to be disclosed by the Company in the reports
filed or submitted by it under the Securities Exchange Act of 1934, as amended,
is recorded, processed, summarized and reported within the time periods
specified in the applicable rules and forms, and include controls and procedures
designed to ensure that information required to be disclosed by the Company in
such reports is accumulated and communicated to the Company 's management,
including the Chief Executive Officer and the Chief Financial Officer of the
Company, as appropriate to allow timely decisions regarding required disclosure.
Management's Report on Internal Control over Financial Reporting
Management, including the Company's chief executive officer, principal financial
officer, and principal accounting officer, is responsible for establishing and
maintaining adequate internal control over the Company's financial reporting.
Management conducted an evaluation of the effectiveness of internal control over
financial reporting based on the "Internal Control -- Integrated Framework"
issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on this evaluation, management concluded that the Company's internal
control over financial reporting was effective as of December 31, 2004.
Management's assessment of the effectiveness of internal control over financial
reporting as of December 31, 2004, was audited by Dixon Hughes PLLC, an
independent registered public accounting firm, as stated in their report
beginning on page 46 of this report.
Changes in Internal Control over Financial Reporting
There have been no significant changes in internal control over financial
reporting during the fourth quarter that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Item 9B. Other Information
Not applicable.
72
PART III
Item 10. Directors and Executive Officers of the Registrant
(a) Directors and Executive Officers - The information required by this Item
regarding directors and executive officers of the Company, the Company's Audit
Committee and procedures for shareholder nominations is set forth under the
sections captioned "Election of Directors," "Executive Officers," "Report of
Audit Committee" and "Our Board of Directors and its Committees - How can a
shareholder nominate someone for election to the Board?" in the Company's
definitive proxy statement, to be filed with the Securities and Exchange
Commission with respect to the Annual Meeting of Shareholders to be held on May
19, 2005, which sections are incorporated by reference.
(b) Section 16(a) Compliance - The information required by this item regarding
compliance with Section 16(a) of the Securities Exchange Act of 1934 is set
forth under the section "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 19, 2005, which section is incorporated by
reference.
(c) Audit Committee Financial Expert - The Board of Directors of the Company has
determined that Barry Z. Dodson, a member of the Audit Committee, qualifies as
an " audit committee financial expert" and is "independent" as defined under
applicable SEC and NASD rules and regulations.
(d) Code of Ethics - The Company has adopted its "Code of Business Conduct and
Ethics", a code of ethics that applies to its directors, officers, and
employees. The Code of Business Conduct and Ethics is accessible on the
Company's website under the "Investor Information" section. The Company elects
to disclose any amendments to or waivers of any Provisions of its Code of
Business Conduct and Ethics applicable to its principal executive officers and
senior financial officers on its website.
Item 11. Executive Compensation
Director compensation, executive compensation and executive compensation plan
information are incorporated by reference to the sections captioned "Our Board
of Directors and its Committees - How are our directors compensated?" and
"Executive Compensation" in the Company's definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 19, 2005.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
Incorporated by reference to the sections captioned "Stock Ownership" and
"-Equity Compensation Plan Information" in the Company's definitive proxy
statement, to be filed with the Securities and Exchange Commission with respect
to the Annual Meeting of Shareholders to be held on May 19, 2005.
Item 13. Certain Relationships and Related Transactions
Incorporated by reference to the section captioned "Transactions with
Management" in the Company's definitive proxy statement, to be filed with the
Securities and Exchange Commission with respect to the Annual Meeting of
Shareholders to be held on May 19, 2005.
73
Item 14. Principal Accountant Fees and Services
Incorporated by reference to the section captioned "Information About Our
Independent Auditors in 2004" in the Company's definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 19, 2005.
PART IV
Item 15. Exhibits and Financial Statement Schedules
(a)(1) Financial Statements. The following financial statements and
supplementary data are included in Item 8 of this report.
Financial Statements Form 10-K Page
-------------------- --------------
Report of Independent Registered Public Accounting Firm ....................... 46
Consolidated Balance Sheets as of December 31, 2004 and 2003 .................. 49
Consolidated Statements of Income and Comprehensive Income for the years ended 50
December 31, 2004, 2003 and 2002 ..............................................
Consolidated Statements of Changes in Shareholders' Equity for the years ended 51
December 31, 2004, 2003 and 2002 ..............................................
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 52
2003 and 2002 .................................................................
Notes to Consolidated Financial Statements .................................... 53
(a)(2) Financial Statement Schedules. All applicable financial statement
schedules required under Regulation S-X have been included in the Notes to the
Consolidated Financial Statements.
(a)(3) Exhibits. The exhibits required by Item 601 of Regulation S-K are listed
below.
Exhibit No. Description
- ----------- -----------
3.01(1) Amended and Restated Articles of Incorporation.
3.02(1) Bylaws of Company, as amended.
4.01(1) Specimen Common Stock Certificate.
10.01(3) 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(4) Omnibus Equity Compensation Plan of the Registrant.
10.03(5) Severance Policy for Senior Officers of the Registrant (employed for five years or more).
10.04(6) Revised Severance Plan for Senior Officers of the Registrant (employed for five years or more).
10.05(4) Severance Policy for Senior Officers of the Registrant (employed for less than five years).
10.06 1998 Split-Dollar Agreement.
10.07(8) Benefit Equivalency Plan of the Registrant effective January 1, 1994.
10.08(8) Annual Management Incentive Plan of the Registrant.
10.09(8) Long Term Incentive Plan of the Registrant.
10.10(11) Long Term Incentive Plan of the Registrant for certain senior management employees.
10.11(8) 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(9) Split-Dollar Agreement dated January 27, 1995, between the Registrant and Ernest J. Sewell.
10.13(9) Split-Dollar Agreement dated January 27, 1995, between the Registrant and C. Melvin Gantt.
10.14(9) Split-Dollar Agreement dated December 8, 1995, between the Registrant and Richard L. Powell.
74
10.15(2) Amendment to Benefit Equivalency Plan of the Registrant effective January 1, 1998.
10.16 2005 Annual Incentive Bonus Plan.
10.17 Third Amendment to Employment Agreement and First Amendments to Split-Dollar Agreements
and Collateral Assignments
21.01 Schedule of Subsidiaries.
23.01 Consent of PricewaterhouseCoopers LLP.
23.02 Consent of Dixon Hughes PLLC.
31.01 Certification of Ernest J. Sewell
31.02 Certification of Michael W. Shelton
32.01 Certification of Periodic Financial Report Pursuant to 18 USC Section 1350.
Exhibit references:
(1) Incorporated herein by reference to the Registrant's Quarterly
Report on Form 10-Q for the fiscal quarter ended March 31, 1998,
filed with the Securities and Exchange Commission.
(2) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 1998, filed with
the Securities and Exchange Commission.
(3) Incorporated herein by reference to the Registrant's Statement on
Form S-8 (No. 33-33186), filed with the Securities and Exchange
Commission.
(4) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1996, filed
with the Securities and Exchange Commission.
(5) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 1989, filed with
the Securities and Exchange Commission.
(6) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1994, filed
with the Securities and Exchange Commission.
(7) Incorporated herein by reference to the Registrant's Quarterly
Report, on Form 10-QSB for the fiscal quarter ended June 30, 1995,
filed with the Securities and Exchange Commission.
(8) Incorporated herein by reference to the Registrant's Statement on
Form S-2 (File No. 333-47203) filed with the Securities and Exchange
Commission on March 3, 1998.
(9) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1997, filed
with the Securities and Exchange Commission.
(10) Incorporated herein by reference to the Registrant's Annual Report
on Form 10-K for the fiscal year ended December 31, 2002, filed with
the Securities and Exchange Commission
75
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
FNB FINANCIAL SERVICES CORPORATION
Date: February 17, 2005 By:/s/ ERNEST J. SEWELL
----------------------------------
Ernest J. Sewell,
Vice Chairman, President and Chief Executive
Officer
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
Signature Capacity Date
- --------- -------- ----
Vice Chairman, President, Chief Executive
/s/ ERNEST J. SEWELL Officer and Director February 17, 2005
- ---------------------------- (Principal Executive Officer)
Ernest J. Sewell
Executive Vice President, Chief Operating
/s/ PRESSLEY A. RIDGILL Officer and Director February 17, 2005
- ---------------------------- (Principal Operating Officer)
Pressley A. Ridgill
Senior Vice President, Chief Financial Officer,
/s/ MICHAEL W. SHELTON Secretary, and Treasurer February 17, 2005
- ---------------------------- (Principal Financial and Accounting Officer)
Michael W. Shelton
/s/ BARRY Z. DODSON Chairman of the Board February 17, 2005
- ----------------------------
Barry Z. Dodson
/s/ GARY G. BLOSSER Director February 17, 2005
- ----------------------------
Gary G. Blosser
/s/ CHARLES A. BRITT Director February 17, 2005
- ----------------------------
Charles A. Britt
/s/ JOSEPH H. KINNARNEY Director February 17, 2005
- ----------------------------
Joseph H. Kinnarney
/s/ E. REID TEAGUE Director February 17, 2005
- ----------------------------
E. Reid Teague
/s/ KENAN C. WRIGHT Director February 17, 2005
- ----------------------------
Kenan C. Wright
76
EXHIBIT INDEX
Exhibit Description
- ------- -----------
10.06 1998 Split-Dollar Agreement
10.16 2005 Annual Incentive Bonus Plan
10.17 Third Amendment to Employment Agreement and First Ammendments to
Split-Dollar Agreements and Collateral Assignments
21.01 Schedule of Subsidiaries
23.01 Consent of PricewaterhouseCoopers LLP
23.02 Consent of Dixon Hughes PLLC
31.01 Certification of Ernest J. Sewell
31.02 Certification of Michael W. Shelton
32.01 Certification of Periodic Financial Report Pursuant to 18 U.S.C.
Section 1350
77