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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10 - Q

x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2004
 
or
o
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from ______________________ to ______________________

Commission File Number 1-018166


STATE FINANCIAL SERVICES CORPORATION
(Exact name of registrant as specified in its charter)
 
WISCONSIN
(State or other jurisdiction of incorporation or organization)
39-1489983
(I.R.S. Employer identification No.)

815 NORTH WATER STREET, MILWAUKEE, WISCONSIN 53202-3526
(Address and Zip Code of principal executive offices)
 
(414) 223-8400
(Registrant's telephone number, including area code)

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X]

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).
Yes [X]   No [ ]

As of November 8, 2004, there were 6,891,822 shares of Registrant's $0.10 Par Value Common Stock outstanding.

 
     
 
 
 
FORM 10-Q
  
     
 
STATE FINANCIAL SERVICES CORPORATION
  
     
 
INDEX
  
     
 
PART I - FINANCIAL INFORMATION
  
   
Page No.
     
Item 1.
  
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
Item 2.
11
     
Item 3.
20
     
Item 4.
20
     
   
Item 1.
21
     
Item 2.
21
     
Item 3.
22
     
Item 4.
22
     
Item 5.
22
     
Item 6.
22
     
 
23
     
 
24

 
  2  
Table of Contents

Part I.     Financial Information
Item 1.    Financial Statements.

State Financial Services Corporation And Subsidiaries
Consolidated Statements of Financial Condition
   
September 30,
2004
(unaudited)
  
December 31,
2003
(audited)
  
Assets
          
Cash and due from banks
  
$
39,734,936
  
$
55,824,050
  
Interest-bearing bank balances
    
3,554,914
    
4,399,723
  
Federal funds sold
    
3,241,517
    
18,144,353
  
Cash and cash equivalents
    
46,531,367
    
78,368,126
  
Investment securities
              
Available-for-sale (at fair value)
    
564,863,070
    
397,061,108
  
Held-to-maturity (fair value of $594,393 - 2004 and $988,006 - 2003)
    
584,656
    
964,662
  
Loans (net of allowance for loan losses of $12,277,817-2004 and $10,706,350-2003)
    
913,960,585
    
863,323,685
  
Loans held for sale
    
3,513,102
    
1,900,438
  
Premises and equipment
    
33,121,822
    
32,918,853
  
Accrued interest receivable
    
5,816,811
    
5,246,660
  
Goodwill
    
37,646,354
    
37,626,045
  
Core deposit intangible
    
4,771,673
    
5,158,565
  
Bank owned life insurance
    
21,694,279
    
21,029,985
  
Other assets
    
4,944,736
    
9,331,295
  
Total Assets
  
$
1,637,448,455
  
$
1,452,929,422
  
               
Liabilities And Shareholders' Equity
              
Deposits:
              
Demand
    
184,072,935
    
180,872,397
  
Savings
    
257,082,200
    
253,202,071
  
Money market
    
266,875,567
    
233,003,329
  
Time deposits in excess of $100,000
    
143,272,049
    
126,127,203
  
Other time deposits
    
211,192,170
    
235,908,124
  
Total deposits
 
    
1,062,494,921
    
1,029,113,124
 
               
Federal Home Loan Bank advances
    
67,300,000
    
67,800,000
  
Notes payable
    
32,258,000
    
30,200,000
  
Trust preferred securities
    
30,000,000
    
15,000,000
  
Securities sold under agreements to repurchase
    
325,071,456
    
175,592,887
  
Federal funds purchased
    
-
    
-
  
Accrued expenses and other liabilities
    
5,688,562
    
21,071,418
  
Accrued interest payable
    
2,154,936
    
1,957,473
  
Total Liabilities
    
1,524,967,875
    
1,340,734,902
  
               
Shareholders' Equity:
 
              
Preferred stock, $1 par value; authorized-100,000 shares; issued and outstanding-none
    
-
    
-
  
Common stock, $0.10 par value; authorized-25,000,000 shares; issued 9,610,492 shares in 2004 and 9,527,489 shares in 2003, outstanding 6,887,652 shares in 2004 and 7,043,149 shares in 2003
    
961,049
    
952,749
  
Additional paid in capital
    
85,922,123
    
84,739,420
  
Retained earnings
    
70,568,141
    
63,152,966
  
Accumulated other comprehensive income
    
2,150,067
    
3,763,835
  
Unearned shares held by ESOP
    
(3,767,610
)
  
(3,981,360
)
Treasury Stock - 2,722,840 shares in 2004 and 2,484,340 in 2003
    
(43,353,190
)
  
(36,433,090
)
Total Shareholders' Equity
    
112,480,580
    
112,194,520
  
Total Liabilities And Shareholders' Equity
  
$
1,637,448,455
  
$
1,452,929,422
  

See notes to unaudited consolidated financial statements.

 
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Table of Contents

State Financial Services Corporation And Subsidiaries
Consolidated Statements of Income (Unaudited)

   
Three Months Ended September 30,
  
   
2004
  
2003
  
Interest income:
          
Loans
  
$
13,580,148
  
$
11,427,984
  
Investment securities:
              
Taxable
    
3,913,152
    
3,293,913
  
Tax-exempt
    
554,508
    
553,689
  
Federal funds sold and other short-term investments
    
24,653
    
38,714
  
Total interest income
    
18,072,461
    
15,314,300
  
               
Interest expense:
              
Deposits
    
3,804,915
    
3,003,273
  
Notes payable and other borrowings
    
1,676,064
    
1,623,110
  
Total interest expense
    
5,480,979
    
4,626,383
  
Net interest income
    
12,591,482
    
10,687,917
  
               
Provision for loan losses
    
656,000
    
600,000
  
Net interest income after provision for loan losses
    
11,935,482
    
10,087,917
  
               
Other income:
 
              
Service charges on deposit accounts
    
801,610
    
730,450
  
ATM and merchant service fees
    
260,698
    
406,395
  
Security commissions and management fees
    
130,797
    
131,986
  
Investment securities gains, net
    
161,580
    
187,210
  
Gain on sale of loans
    
350,482
    
1,406,750
  
Other
    
758,182
    
722,209
  
Total other income
    
2,463,349
    
3,585,000
  
               
Other expenses:
              
Salaries and employee benefits
    
4,514,327
    
4,918,055
  
Net occupancy expense
    
777,565
    
663,356
  
Equipment rentals, depreciation and maintenance
    
1,037,948
    
982,621
  
Data processing
    
606,097
    
505,097
  
Legal and professional
    
243,364
    
398,603
  
ATM and merchant services
    
70,351
    
219,837
  
Advertising
    
327,107
    
224,738
  
Other
    
1,731,842
    
1,233,426
  
Total other expenses
    
9,308,601
    
9,145,733
  
               
Income before income taxes
    
5,090,230
    
4,527,184
  
Income tax expense
    
1,366,891
    
1,406,104
  
Net income
$
3,723,339
  
$
3,121,080
  
               
Basic earnings per common share
  
$
0.56
  
$
0.47
  
Diluted earnings per common share
    
0.55
    
0.46
  
Dividends per common share
    
0.15
    
0.13
  

See notes to unaudited consolidated financial statements.

 
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Table of Contents

State Financial Services Corporation And Subsidiaries
Consolidated Statements of Income (Unaudited)

   
Nine Months Ended September 30,
  
   
2004
  
2003
  
Interest income:
          
Loans
  
$
39,361,478
  
$
35,092,350
  
Investment securities:
              
Taxable
    
11,241,927
    
10,327,351
  
Tax-exempt
    
1,647,740
    
1,739,515
  
Federal funds sold and other short-term investments
    
101,527
    
100,780
  
Total interest income
    
52,352,672
    
47,259,996
  
               
Interest expense:
              
Deposits
    
9,797,638
    
9,415,102
  
Notes payable and other borrowings
    
6,283,597
    
5,291,821
  
Total interest expense
    
16,081,235
    
14,706,923
  
Net interest income
    
36,271,437
    
32,553,073
  
               
Provision for loan losses
    
1,856,000
    
2,025,000
  
Net interest income after provision for loan losses
    
34,415,437
    
30,528,073
  
               
Other income:
 
              
Service charges on deposit accounts
    
2,448,229
    
2,121,757
  
ATM and merchant service fees
    
734,831
    
1,857,241
  
Security commissions and management fees
    
496,595
    
327,297
  
Investment securities gains, net
    
684,368
    
322,680
  
Gain on sale of loans
    
1,279,892
    
4,053,950
  
Gain on sale of merchant processing
    
-
    
1,300,000
  
Other
    
2,538,336
    
2,456,535
  
Total other income
 
    
8,182,251
    
12,439,460
  
               
Other expenses:
              
Salaries and employee benefits
    
13,401,701
    
15,058,052
  
Net occupancy expense
    
2,311,587
    
2,052,527
  
Equipment rentals, depreciation and maintenance
    
3,104,076
    
2,939,402
  
Data processing
    
1,798,949
    
1,424,830
  
Legal and professional
    
930,471
    
1,212,789
  
ATM and merchant services
    
214,244
    
1,185,273
  
Advertising
    
977,108
    
842,655
  
Provision for merchant chargebacks
    
-
    
300,000
  
Merchant processing exit fee
    
-
    
150,000
  
Efficiency consulting expense
    
-
    
570,000
  
Severance charges
    
-
    
180,114
  
Other
    
4,928,250
    
4,366,262
  
Total other expenses
    
27,666,386
    
30,281,904
  
               
Income before income taxes
    
14,931,302
    
12,685,629
  
Income tax expense
    
4,528,837
    
3,675,750
  
Net income
  
$
10,402,465
  
$
9,009,879
  
               
Basic earnings per common share
  
$
1.56
  
$
1.35
  
Diluted earnings per common share
    
1.52
    
1.33
  
Dividends per common share
    
0.45
    
0.39
  

See notes to unaudited consolidated financial statements.

 
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Table of Contents

State Financial Services Corporation And Subsidiaries
Consolidated Statements of Cash Flows (Unaudited)
   
Nine Months Ended
September 30,
  
   
2004
  
2003
  
Operating Activities
          
Net income
  
$
10,402,465
  
$
9,009,879
  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
              
Provision for loan losses
    
1,856,000
    
2,025,000
  
Depreciation
    
2,237,124
    
2,114,838
  
Amortization of premiums and accretion of discounts on investment securities
    
555,162
    
934,318
  
Income from bank owned life insurance
    
(664,294
)
  
(546,145
)
Decrease (increase) in accrued interest receivable
    
(570,151
)
  
2,372,542
  
Increase (decrease) in accrued interest payable
    
197,463
    
(408,001
)
Realized investment securities gains
    
(684,368
)
  
(322,680
)
Payment to Lakes Region Bancorp’s shareholders for acquisition
    
(13,416,729
)
  
0
  
Other, net
    
3,618,348
    
(5,546,485
)
Net cash provided by operating activities
    
3,531,020
    
9,633,266
 
               
Investing Activities
              
Proceeds from maturities of investment securities held-to-maturity
    
380,000
    
390,000
  
Purchases of securities available-for-sale
    
(695,609,690
)
  
(698,147,945
)
Proceeds from maturities and sales of investment securities available-for-sale
    
525,491,836
    
719,693,474
  
Net increase in loans
    
(54,105,564
)
  
(42,804,075
)
Net purchases of premises and equipment
    
(2,440,093
)
  
(1,255,666
)
Net cash used in investing activities
    
(226,283,511
)
  
(22,124,212
)
               
Financing Activities
              
Net (decrease) increase in deposits
    
33,381,797
    
(34,092,325
)
Repayment of notes payable
    
(21,600,000
)
  
(10,710,000
)
Proceeds of notes payable
    
23,658,000
    
11,110,000
  
Proceeds from trust preferred securities offering
    
15,000,000
    
0
  
Increase in securities sold under agreements to repurchase
    
149,478,569
    
51,180,745
  
Repayment of Federal Home Loan Bank advances
    
(500,000
)
  
(15,000,000
)
Decrease in guaranteed ESOP obligation
    
213,750
    
213,750
  
Cash dividends
    
(2,987,290
)
  
(2,600,586
)
Repayment of federal funds purchased
    
0
    
(6,500,000
)
Purchase of treasury stock
    
(6,920,100
)
  
(92,000
)
Proceeds from exercise of stock options
    
1,191,006
    
1,090,501
  
Net cash provided by (used in) financing activities
    
190,915,732
    
(5,399,915
)
Decrease in cash and cash equivalents
    
(31,836,759
)
  
(17,890,861
)
Cash and cash equivalents at beginning of period
    
78,368,126
   
67,516,805
 
Cash and cash equivalents at end of period
  
$
46,531,367
  
$
49,625,944
  
Supplemental information:
              
Interest paid
  
$
15,883,772
  
$
15,114,924
  
Income taxes paid
    
4,631,843
    
3,318,092
  

See notes to unaudited consolidated financial statements.

 
  6  
Table of Contents

State Financial Services Corporation And Subsidiaries
Notes to Unaudited Consolidated Financial Statements
September 30, 2004

NOTE A - BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of State Financial Services Corporation (the "Company" or “State”) and its subsidiaries. The Company owns State Financial Bank, National Association (the “Bank”). All significant intercompany balances and transactions have been eliminated. The unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP for complete financial s tatements have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim operating results are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003.

NOTE B - ACCOUNTING CHANGES

On March 9, 2004, the SEC issued Staff Accounting Bulletin (“SAB”) 105, "Application of Accounting Principles to Loan Commitments" to advise registrants of the staff's view that fair value of the recorded loan commitments, that are required to follow derivative accounting under Statement of Financial Accounting Standards (“SFAS”) 133, Accounting for Derivative Instruments and Hedging Activities, should not take into consideration the expected future cash flows related to the associated servicing of the future loan. The staff indicated its belief that incorporating expected futu re cash flows related to the associated servicing of the loan essentially results in the immediate recognition of a servicing asset, which is only appropriate once the servicing asset has been contractually separated from the underlying loan by sale or by securitization of the loan with servicing retained. Furthermore, no other internally-developed intangible assets, such as customer relationship intangibles, should be recorded as part of the loan commitment derivative. The staff noted that recognition of such assets is only appropriate in the event of a third-party transaction, such as the purchase of a loan commitment either individually, in a portfolio, or in a business combination.

In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments pursuant to Accounting Principles Board (“APB”) Opinion No. 22, including methods and assumptions used to estimate fair value and any associated hedging strategies, as required by SFAS 107, SFAS 133 and Item 305 of Regulation S-K (Quantitative and Qualitative Disclosures About Market Risk).

SAB 105 does not explicitly require banks that apply derivative accounting to their loan commitments to treat the loan commitments only as liabilities. Rather, the staff appears to be deferring to the Financial Accounting Standards Board (“FASB”) to address this aspect of the fair value issue in its loan commitment project.

The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The staff has stated that it will not object to the application of existing accounting practices to loan commitments accounted for as derivatives that are entered into on or before March 31, 2004, with appropriate disclosures.

The issuance of SAB 105 has not had a material impact on the Company as the loan commitments are generally not accounted for as derivatives.

In March 2004, the Financial Accounting Standards Board (“FASB”) ratified the consensus reached by the Emerging Issues Task Force in Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 provides guidance for determining when an investment is considered impaired, whether that impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless: (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the cost of the investmen t; and (b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss is recognized equal to the difference between the investment’s cost and its fair value. The guidance also includes accounting considerations subsequent to recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments.

 
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With the release of EITF Issue 03-1-1on September 30, 2004, the FASB staff delayed the effective date of the other-than-temporary impairment evaluation guidance of EITF 03-1 (which was initially to be applied prospectively to all current and future investments in interim and annual reporting periods beginning after June 15, 2004). EITF 03-1-1 delays the effective date of the measurement and recognition guidance until certain implementation issues are addressed and a final FASB Staff Position (“FSP”) providing implementation guidance is issued. The final FSP providing implementation guidance is expected to be issued early in December 2004. The disclosure requirements of the EITF 03-1 remain in effect. The amount of any other-than-temporary impairment that may need to be recognized in the future will be depend ent on market conditions, the occurrence of certain events or changes in circumstances relative to an investee, and the Company’s intent and ability to hold the impaired investments at the time of the valuation.

In January 2003, the FASB issued FASB Interpretation No 46 (“FIN 46”), which provides guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE are to be included in an entity's consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur.

In December 2003, the FASB reissued FIN 46 with certain modifications and clarifications. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. The application of FIN 46 to any of the Company’s investments or interests has not had a material impact on the Company’s financial condition, results of operations, or liquidity.

NOTE C - EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unearned Employee Stock Option Plan (ESOP) shares. Diluted earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unallocated ESOP shares plus the assumed conversion of all potentially dilutive securities. The denominators for the earnings per share amounts are as follows:

   
Three months ended
September 30,
  
Nine months ended
September 30,
  
   
2004
  
2003
  
2004
  
2003
  
Basic:
                  
Weighted-average number of shares outstanding
    
6,896,307
    
7,014,434
    
6,954,418
    
6,978,545
  
Less: weighted-average number of unearned ESOP shares
    
(281,288
)
  
(322,599
)
  
(285,668
)
  
(322,599
)
Denominator for basic earnings per share
    
6,615,019
    
6,691,835
    
6,668,750
    
6,655,946
  
Fully diluted:
                         
Denominator for basic earnings per share
    
6,615,019
    
6,691,835
    
6,668,750
    
6,655,946
  
Add: assumed conversion of stock options using treasury stock method
    
169,642
    
147,066
    
190,431
    
121,357
  
Denominator for fully diluted earnings per share
    
6,784,661
    
6,838,901
    
6,859,181
    
6,777,303
  

NOTE D - COMPREHENSIVE INCOME

Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under accounting principles generally accepted in the United States are not included in reported net income but are instead reflected directly in shareholders’ equity.
 
 
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Three months ended
September 30,
  
Nine months ended
September 30,
  
   
2004
  
2003
  
2004
  
2003
  
Net Income
  
$
3,723,339
  
$
3,121,080
  
$
10,402,465
  
$
9,009,879
  
Other comprehensive income:
                          
Change in unrealized securities gains (losses), net of tax
    
2,297,231
    
(1,842,117
)
  
(1,197,741
)
  
(2,370,232
)
Reclassification adjustment for realized gains included in net income, net of tax
    
(98,224
)
  
(113,805
)
  
(416,027
)
  
(196,157
)
Total comprehensive income (loss)
  
$
5,922,346
  
$
1,165,158
  
$
8,788,697
  
$
6,443,490
  


NOTE E - STOCK REPURCHASE PROGRAM

On April 28, 2003, the Company’s Board of Directors authorized the repurchase of up to 5%, or approximately 348,000 shares, of the Company’s Common Stock. As of September 30, 2004, 238,500 shares have been repurchased at an average price of $29.02 per share.

NOTE F - STOCK-BASED COMPENSATION

The Company follows APB Opinion No. 25 under which no compensation expense is recorded when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. The Company’s pro forma information regarding net income and net income per share has been determined as if these options had been accounted for since January 1, 1995, in accordance with the fair value method SFAS No. 123, “Accounting for Stock-Based Compensation”.

The Black-Scholes option valuation model is commonly used in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

In determining compensation expense in accordance with SFAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Schole’s option pricing model with the following weighted average assumptions for the nine months ended September 30, 2004 and September 30, 2003.
 
 
Three months ended
September 30,
Nine months ended
September 30,
 
2004
2003
2004
2003
Expected life of options
4.44 years
6.75 years
4.44 years
6.75 years
Risk-free interest rate
3.11%
3.60%
3.11%
3.60%
Expected dividend yield
2.19%
2.20%
2.19%
2.20%
Expected volatility factor
35.36%
26.90%
35.36%
26.90%


For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period, which is generally six months. The Company’s pro forma information is as follows:

 
  9  
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Three months ended
September 30,
  
Nine months ended
September 30,
  
(Thousands, except per share data)
  
2004
  
2003
  
2004
  
2003
  
Net income, as reported
  
$
3,723
  
$
3,121
  
$
10,402
  
$
9,010
  
Compensation expense, net of taxes, as reported
    
3,302
    
3,391
    
9,337
    
10,695
  
Pro forma compensation expense in accordance with SFAS No. 123, net of tax
    
(3,456
)
  
(3,444
)
  
(9,670
)
  
(10,832
)
Pro forma net income
  
$
3,569
  
$
3,068
  
$
10,069
  
$
8,873
  
                           
Net income per common share, as reported:
                          
Basic
  
$
0.56
  
$
0.47
  
$
1.56
  
$
1.35
  
Diluted
  
$
0.55
  
$
0.46
  
$
1.52
  
$
1.33
  
                           
Pro forma net income per common share:
                          
Basic
  
$
0.54
  
$
0.46
  
$
1.51
  
$
1.33
  
Diluted
  
$
0.53
  
$
0.45
  
$
1.47
  
$
1.31
  

NOTE G - ACQUISITIONS

On December 6, 2003, the Company acquired Hawthorn Corporation (“Hawthorn”) and its wholly owned subsidiary Hawthorn Bank, Mundelein, Illinois. The Company purchased all of the outstanding common stock of Hawthorn for $6.4 million in cash. This “in-market” acquisition increased the Company’s share of the Illinois banking market. Hawthorn Bank has been merged into State Financial Bank, N.A.

On December 6, 2003, the Company also acquired Lakes Region Bancorp, Inc. (“Lakes Region”) and its wholly owned subsidiary Anchor Bank, Grayslake, Illinois. The Company purchased all of the outstanding common stock of Lakes Region for $13.4 million in cash. This “in-market” acquisition increased the Company’s share of the Illinois banking market. Anchor Bank has been merged into State Financial Bank, N.A.

Application of purchase accounting requires the inclusion of Hawthorn’s and Lake Region’s operating results in the consolidated statements of income from the date of acquisition. Accordingly, Hawthorn’s and Lakes Region’s operating results for the period January 1, 2004 through September 30, 2004 are included in the Company’s unaudited consolidated statements of income for three and nine months ended September 30, 2004. Hawthorn’s and Lakes Region’s financial condition is included in the Company’s consolidated statements of financial condition as of September 30, 2004 (unaudited) and December 31, 2003.

On a pro forma basis, the Company’s total income, net income, basic and fully diluted earnings per share for the three and nine months ended September 30, 2004 and September 30, 2003, after giving effect to the acquisition of Hawthorn and Lakes Region as if they had occurred on January 1, 2003 are as follows (dollars in thousands):

   
Three months ended
September 30,
  
Nine months ended
September 30,
  
   
2004
  
2003
  
2004
  
2003
  
Interest income
  
$
18,072
  
$
17,267
  
$
52,353
  
$
53,055
  
Interest expense
    
5,481
    
5,324
    
16,081
    
16,826
  
Net interest income
    
12,591
    
11,943
    
36,272
    
36,229
  
Provision for loan losses
    
656
    
577
    
1,856
    
2,074
  
Other income
    
2,463
    
3,706
    
8,182
    
12,792
  
Other expense
    
9,308
    
10,173
    
27,667
    
33,601
  
Net income before tax
    
5,090
    
4,899
    
14,931
    
13,346
  
Income taxes
    
1,367
    
1,529
    
4,529
    
4,239
  
Net income
  
$
3,723
  
$
3,370
  
$
10,402
  
$
9,107
  
Basic earnings per share
  
$
0.56
  
$
0.50
  
$
1.56
  
$
1.37
  
Diluted earnings per share
  
$
0.55
  
$
0.49
  
$
1.52
  
$
1.34
  

 
  10  
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

State’s net interest income increased 17.8% in the third quarter of 2004, compared to the third quarter of 2003. In the third quarter of 2004, State’s net interest margin was 3.73%, compared to 3.62% in the second quarter of 2004 and 3.56% in the third quarter of 2003. This margin increase occurred despite the continuing effects of a low margin local governmental seasonal tax collection program, which resulted in repurchase agreements (and corresponding short term investments) of $164 million at September 30, 2004. State’s core commercial/commercial real estate loans grew at an annualized rate of 20.1% in the third quarter of 2004, and total loans grew at an annualized rate of 15.1%. In the twelve-month period ended September 30, 2004, total loans increased by 18.2%.

State’s asset quality ratios continued to improve. The ratio of nonperforming loans to total loans declined to 0.84% as of September 30, 2004, from 1.40% on September 30, 2003 and 0.94% on June 30, 2004. On September 30, 2004, nonperforming assets equaled 0.53% of total assets, compared to 1.24% on September 30, 2003 and 0.59% as of June 30, 2004.

Revenues from mortgage originations continued to be significantly lower in the three months and nine months ended September 30, 2004 than in the respective three months and nine months ended September 30, 2003. Mortgage origination related revenue in the third quarter of 2004 declined by 75.1% from the third quarter of 2003 and mortgage origination revenue for the first nine months of 2004 is 68.4% lower than in the first nine months of 2003.

Non-interest expenses in the third quarter of 2004 increased 1.8% over the third quarter of 2003, but declined 0.5% from the second quarter of 2004. For the nine months ended September 30, 2004, non-interest expenses were 8.6% lower than in the nine months ended September 30, 2003.

Application of Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

All significant accounting policies are presented in Note 1 to the consolidated financial statements in the Company’s 2003 Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

Management has determined that its accounting policies with respect to the allowance for loan losses is the accounting area requiring subjective or complex judgments to the Company’s financial position and results of operations, and therefore, is its most important critical accounting policy. The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of curr ent economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statements of financial condition. Note 1 to the consolidated financial statements in the Company’s 2003 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Provision for Loan Losses section of management’s discussion.

Effective January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS 142, the Company is required to perform annual impairment tests of its goodwill and intangible assets and more frequently in certain circumstances. The Company has elected to test for goodwill impairment in the fourth quarter of each year. The goodwill impairment test is a two-step process, which requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each reporting unit based on a discounted cash flow model using revenue and profit forecasts and comparing those estimated fair values with the carrying values, which includes the allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment by determining an “implied fair value” of goodwill. The determination of a reporting unit’s “implied fair value” of goodwill requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is compared to its corresponding carrying value.

 
  11  
Table of Contents
 
The Company cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill that totaled $37.6 million at September 30, 2004. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on the Company’s customer base, or a material negative change in its relationships with significant customers.

Changes in Financial Condition

The Company’s total assets were $1.6 billion at September 30, 2004 and $1.5 billion at December 31, 2003. During the first three quarters of 2004, significant uses of funds by the Company consisted of a $54.1 million net increase in loans, $169.7 million net increase in investment securities, $6.9 million purchase of treasury stock, $3.0 million in payment of cash dividends, and $2.4 million in net purchases of premises and equipment. Funding sources for the first three quarters of 2004 came from a $33.4 million net increase in deposits, $149.5 million increase in securities sold under agreement to repurchase, $15.0 million in proceeds from a trust preferred securities offering, $3.5 million increase in net cash provided by operating activities, $2.1 million net incre ase in notes payable, and $1.2 million in proceeds from the exercise of stock options.

Asset Quality

At September 30, 2004, the Company’s non-performing assets were $8.7 million, a decrease of $7.1 million from December 31, 2003, primarily due to a decrease of $4.6 million in other real estate owned and $2.5 million in non-accrual loans. The decrease in other real estate owned was mainly due to the sale of one large parcel of real property with a carrying value of $5.2 million, which closed during the second quarter of 2004 at a price resulting in a gain to the Company of approximately $300 thousand. Total non-performing assets as a percentage of total assets were 0.53% at September 30, 2004 and 1.09% at December 31, 2003. As a percentage of total loans outstanding, the level of non-performing loans was 0.84% at September 30, 2004 compared to 1.18% at December 31, 2003. This percentage decrease was due to the de crease in non-performing loans and the increase in average loans outstanding.

When, in the opinion of management, serious doubt exists as to the collectibility of a loan, the loan is placed on non-accrual status. In all cases, however, when a loan reaches 90 days delinquent on the payment of principal or interest the loan is placed on non-accrual status. At the time a loan is classified as non-accrual, interest credited to income in the current year is reversed and interest income accrued in the prior year is charged to the allowance for loan losses. The following table summarizes non-performing assets on the dates indicated (dollars in thousands).

   
Sep. 30
2004
  
Jun. 30
2004
  
Mar. 31
2004
  
Dec. 31
2003
  
Sep. 30
2003
  
Non-accrual loans
  
$
7,830
  
$
8,729
  
$
9,429
  
$
10,332
  
$
10,993
  
Accruing loans past due 90 days or more
    
-
    
-
    
-
    
-
    
-
  
Restructured loans
    
-
    
-
    
-
    
-
    
-
  
Total non-performing and restructured loans
    
7,830
    
8,729
    
9,429
    
10,332
    
10,993
  
Other real estate owned
    
852
    
988
    
5,742
    
5,483
    
5,381
  
Total non-performing assets
  
$
8,682
  
$
9,717
  
$
15,171
  
$
15,815
  
$
16,374
  
Ratios:
                                
Non-performing loans to total loans
    
0.84
%
  
0.97
%
  
1.05
%
  
1.18
%
  
1.40
%
Allowance to total loans
    
1.32
    
1.32
    
1.24
    
1.22
    
1.32
  
Allowance to non-performing loans
    
156.81
    
135.22
    
118.53
    
103.62
    
94.29
  
Non-performing assets to total assets
    
0.53
    
0.61
    
1.01
    
1.09
    
1.24
  

Allowance for Loan Losses and Net Charge-offs

Management maintains the allowance for loan losses (the "Allowance") at a level considered adequate to provide for probable loan losses. The Allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. At September 30, 2004, the Allowance was $12.3 million, an increase of $1.6 million from the balance at December 31, 2003. The Allowance was increased primarily due to the increased number of commercial loans, which are generally higher risk, particularly during a weak economic period. As of September 30, 2004 and December 31, 2003 commercial and commercial real estate loans made up 77% of the total loan portfolio. As the commercial loan portfolio has grown in size, the complexity of the commercial relationship has also increased .

 
  12  
Table of Contents
 
As a percentage of total loans outstanding, the Allowance was 1.32% at September 30, 2004 compared to 1.22% at December 31, 2003. The determination of Allowance adequacy is based upon on-going evaluations of the Company’s loan portfolio conducted by the Internal Loan Review function of its banking subsidiary, State Financial Bank, N.A. (the “Bank”), and reviewed by management. These evaluations consider a variety of factors, including, but not limited to, general economic conditions, loan portfolio size, type, and composition, previous loss experience, the borrowers’ financial condition, collateral adequacy, and the level of non-performing loans. Based upon its analyses, management considered the Allowance adequate to recognize the risk inherent in the loan portfolio at September 30, 2004.

The following table sets forth an analysis of the Allowance for loan losses for the periods indicated (dollars in thousands):

   
Nine months
ended
Sept. 30, 2004 
  
 Year ended
Dec. 31, 2003 
  
Balance at beginning of period
  
$
10,706
  
$
8,805
  
Charge-offs:
              
Commercial
    
166
    
727
  
Commercial Real Estate
    
116
    
403
  
Real estate mortgage
    
114
    
309
  
Installment
    
242
    
390
  
Other
    
13
    
31
  
Total charge-offs
    
651
    
1,860
  
Recoveries:
              
Commercial
    
170
    
121
  
Commercial Real Estate
    
128
    
1
  
Real estate mortgage
    
20
    
17
  
Installment
    
45
    
75
  
Other
    
4
    
3
  
Total recoveries
  
367
    
217
  
Net charge-offs
    
284
    
1,643
  
Balance of acquired allowance at date of acquisitions
    
0
    
919
  
Additions charged to operations
    
1,856
    
2,625
  
Balance at end of period
  
$
12,278
  
$
10,706
  
Ratios:
              
Net charge-offs to average loans outstanding1
    
0.04
%
  
0.21
%
Net charge-offs to total allowance1
    
3.09
    
15.35
  
Allowance to period end loans outstanding
    
1.32
    
1.22
  
 
1. Annualized. 

Results of Operations-Comparison of the Three-Month Periods Ended September 30, 2004 and September 30, 2003.

General

For the quarter ended September 30, 2004, the Company reported net income of $3.7 million and net income per share on a fully diluted basis of $0.55, compared to net income of $3.1 million and net income per share on a fully diluted basis of $0.46 reported for the quarter ended September 30, 2003.

 
  13  
Table of Contents
 
Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the three-month periods ended September 30, 2004 and September 30, 2003 (dollars in thousands):

   
Three months ended
September 30, 2004
  
Three months ended
September 30, 2003
  
   
Average Balance
  
 
Interest
  
Yield/
Rate4
  
Average Balance
  
 
Interest
  
Yield/
Rate4
 
Assets
                          
Interest-earning assets:
                          
Loans123
 
$
915,680
  
$
13,587
    
5.90
%
$
780,713
  
$
11,438
    
5.81
%
Taxable investment securities
    
390,546
    
3,896
    
3.97
%
  
361,133
    
3,277
    
3.60
%
Tax-exempt investment securities3
   
57,714
    
853
    
5.88
%
  
58,444
    
852
    
5.78
%
Interest-earnings deposits
    
3,514
    
17
    
1.94
%
  
6,463
    
17
    
1.06
%
Federal funds sold
    
7,749
    
25
    
1.27
%
  
17,673
    
39
    
0.87
%
Total interest-earning assets
    
1,375,203
    
18,378
    
5.32
%
  
1,224,426
    
15,623
    
5.06
%
Non-interest-earnings assets:
                                      
Cash and due from banks
    
49,540
                
47,845
              
Premises and equipment, net
    
33,192
                
27,255
              
Other assets
    
74,660
                
62,758
              
Less: Allowance for loan losses
    
(12,024
)
              
(10,126
)
            
Total
  
$
1,520,571
              
$
1,352,158
              
Liabilities And Stockholders’ Equity
                              
Interest-bearing liabilities:
                                      
Now accounts
  
$
128,057
  
$
87
    
0.27
%
$
103,685
  
$
51
    
0.20
%
Money market accounts
    
259,164
    
783
    
1.20
%
  
216,469
    
504
    
0.92
%
Savings deposits
    
131,086
    
131
    
0.40
%
  
130,124
    
131
    
0.40
%
Time deposits
    
358,067
    
2,290
    
2.54
%
  
309,263
    
2,140
    
2.75
%
Notes payable
    
62,367
    
651
    
4.15
%
  
33,587
    
303
    
3.58
%
FHLB borrowings
    
67,403
    
789
    
4.66
%
  
77,400
    
785
    
4.02
%
Federal funds purchased
    
3,180
    
19
    
2.38
%
  
1,402
    
5
    
1.41
%
Securities sold under agreement to repurchase
    
212,596
    
731
    
1.37
%
  
202,983
    
708
    
1.38
%
Total interest-bearing liabilities
    
1,221,920
    
5,481
    
1.79
%
  
1,074,913
    
4,626
    
1.71
%
Non-interest-bearings liabilities:
                                      
Demand deposits
    
181,191
                
160,441
              
Other
    
5,597
                
7,717
              
Total liabilities
    
1,408,708
                
1,243,071
              
Stockholders’ equity
    
111,863
                
109,087
              
Total
  
$
1,520,571
              
$
1,352,158
              
Net interest earning and interest rate spread
        
$
12,897
    
3.53
%
      
$
10,997
    
3.35
%
Net yield on interest-earning assets
                
3.73
%
              
3.56
%
 
1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
 
2. Interest earned on loans includes loan fees, which are not material in amount.
 
3. Tax equivalent adjusted
 
4. Annualized.

The foregoing table includes certain non-GAAP performance measures and ratios that are used by management to evaluate and measure the Company's performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the Company's financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities for comparative purposes. Other financial holding companies use these or similar measures and ratios, but may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the three months ended Sep tember 30, 2004 and September 30, 2003.

Management reviews yields on certain asset categories and the net interest margin of the Company, and its banking subsidiaries, on a fully taxable-equivalent basis ("FTE"). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measures comparability of net interest income arising from both taxable and tax-exempt sources (dollars in thousands).

 
  14  
Table of Contents
 
   
Three months ended
September 30,
  
   
2004
  
2003
  
(A) Interest income (GAAP)
  
$
18,072
  
$
15,314
  
Taxable equivalent adjustment-loans
    
7
    
10
  
Taxable equivalent adjustment-Tax-exempt securities
    
299
    
299
  
Interest income-FTE
    
18,378
    
15,623
  
(B) Interest expense (GAAP)
    
5,481
    
4,626
  
(C) Net interest income (GAAP) (A minus B)
    
12,591
    
10,688
  
Net interest income-FTE
    
12,897
    
10,997
  
(D) Net interest margin (GAAP)(annualized)
    
3.64
%
  
3.46
%
Net interest margin-FTE (annualized)
    
3.73
%
  
3.56
%

Taxable-equivalent adjustments to interest income involve the conversion of tax-exempt sources of interest income to the equivalent amounts of interest income that would be necessary to derive the same net return if the investments had been subject to income taxes. A 35% incremental income tax rate is used in the conversion of tax-exempt interest income to a taxable-equivalent basis.

For the quarter ended September 30, 2004, the Company reported taxable-equivalent net interest income of $12.9 million, an increase of $1.9 million, or 17.3%, from the $11.0 million reported for the quarter ended September 30, 2003. This increase reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) increased to 3.73% in the third quarter of 2004 from 3.56% in the third quarter of 2003.

The Company’s taxable-equivalent total interest income increased $2.8 million for the quarter ended September 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, and by an increased rate environment. Average loans outstanding increased by $135.0 million, or 17.3%, in the third quarter of 2004 over the third quarter of 2003. For the quarter ended September 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.32% compared to 5.06% for the quarter ended September 30, 2003. The third quarter 2004 loan yield was 5.90% compared to 5.81% in the third quarter of 2003. The Company experienced increased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at higher r ates. For the quarter ended September 30, 2004, the yield earned on taxable investment securities increased to 3.97% from 3.60% for the quarter ended September 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the quarter ended September 30, 2004 from 5.78% for the quarter ended September 30, 2003. The increase in these yields for the third quarter of 2004 compared to the third quarter of 2003 is the result of matured or repaid securities replaced by higher yielding securities in a higher interest rate environment.

The Company’s funding costs were also impacted by the increased interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities increased to 1.79% for the third quarter of 2004 from 1.71% for the third quarter of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (“FHLB”), to balance the timing differences between its various business funding sources and to support loan origination. In the third quarter of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 28.3% of the Company’s interest-bearing liabilities compared to 29.3% in the third quarter 2003.

Provision for Loan Losses

The provision for loan losses was $656 thousand in the third quarter of 2004 and $600 thousand in the third quarter of 2003. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.

 
  15  
Table of Contents

Other Income

Total other income decreased $1.1 million in the third quarter of 2004 over the third quarter of 2003. The decrease was mainly the result of a $1.1 million decrease in gains on the sale of mortgage loans due to decreased refinancing activity.

Other Expenses

Other expenses increased $163 thousand in the third quarter of 2004 over the third quarter of 2003. The increase was due to increases in net occupancy and equipment expense, data processing, advertising and other expense. These increases were offset by decreases in personnel costs, legal and professional fees, and automated teller machine (“ATM”) and merchant services. Personnel costs decreased $404 thousand partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower staffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expense increased $170 thousand and data processing increased $101 thousand. Both increases are mainly due to the thr ee additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $155 thousand. ATM and merchant services decreased $149 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $498 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.

Income Taxes

The Company's consolidated income tax rate varies from statutory rates principally due to tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the three months ended September 30, 2004 was 26.9% compared to 31.1% for the three months ended September 30, 2003. Provisions for income tax were $1.4 million for the third quarter of 2004 compared to $1.4 million for the third quarter of 2003.

 
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Results of Operations-Comparison of the Nine-Month Periods Ended September 30, 2004 and September 30, 2003.

General

For the nine months ended September 30, 2004, the Company reported net income of $10.4 million and net income per share on a fully diluted basis of $1.52, compared to net income of $9.0 million and net income per share on a fully diluted basis of $1.33 reported for the nine months ended September 30, 2003.

Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the nine-month periods ended September 30, 2004 and September 30, 2003 (dollars in thousands):

   
Nine months ended
September 30, 2004
  
Nine months ended
September 30, 2003
  
   
Average Balance
  
 
Interest
  
Yield/
Rate4
  
Average Balance
  
 
Interest
  
Yield/
Rate4
 
Assets
                          
Interest-earning assets:
                          
Loans123
 
$
898,788
  
$
39,385
    
5.85
%
$
768,380
  
$
35,131
    
6.11
%
Taxable investment securities
    
378,078
    
11,180
    
3.95
%
  
354,916
    
10,291
    
3.88
%
Tax-exempt investment securities3
   
57,610
    
2,535
    
5.88
%
  
61,332
    
2,676
    
5.83
%
Interest-earnings deposits
    
6,384
    
62
    
1.29
%
  
2,401
    
37
    
2.04
%
Federal funds sold
    
13,791
    
102
    
0.98
%
  
13,629
    
101
    
0.99
%
Total interest-earning assets
    
1,354,651
    
53,264
    
5.25
%
  
1,200,658
    
48,236
    
5.37
%
Non-interest-earnings assets:
                                      
Cash and due from banks
    
51,937
                
39,303
              
Premises and equipment, net
    
33,124
                
27,524
              
Other assets
    
77,674
                
61,594
              
Less: Allowance for loan losses
    
(11,444
)
              
(9,554
)
            
Total
  
$
1,505,942
              
$
1,319,525
              
Liabilities And Stockholders’ Equity
                              
Interest-bearing liabilities:
                                      
Now accounts
  
$
124,008
  
$
250
    
0.27
%
$
111,466
  
$
276
    
0.33
%
Money market accounts
    
247,924
    
2,099
    
1.13
%
  
214,285
    
1,744
    
1.09
%
Savings deposits
    
134,137
    
399
    
0.40
%
  
128,645
    
492
    
0.51
%
Time deposits
    
367,658
    
7,049
    
2.56
%
  
317,270
    
6,903
    
2.91
%
Notes payable
    
60,986
    
1,761
    
3.86
%
  
30,403
    
850
    
3.74
%
FHLB borrowings
    
67,667
    
2,366
    
4.67
%
  
77,583
    
2,354
    
4.06
%
Federal funds purchased
    
2,706
    
39
    
1.93
%
  
1,491
    
18
    
1.61
%
Securities sold under agreement to repurchase
    
205,279
    
2,118
    
1.38
%
  
163,246
    
2,070
    
1.70
%
Total interest-bearing liabilities
    
1,210,365
    
16,081
    
1.77
%
  
1,044,389
    
14,707
    
1.88
%
Non-interest-bearings liabilities:
                                      
Demand deposits
    
175,944
                
157,944
              
Other
    
7,281
                
9,029
              
Total liabilities
    
1,393,590
                
1,211,362
              
Stockholders’ equity
    
112,352
                
108,163
              
Total
  
$
1,505,942
              
$
1,319,525
              
Net interest earning and interest rate spread
        
$
37,183
    
3.48
%
      
$
33,529
    
3.49
%
Net yield on interest-earning assets
                
3.67
%
              
3.73
%

1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
 
2. Interest earned on loans includes loan fees, which are not material in amount.
 
3. Tax equivalent adjusted
 
4. Annualized.

The foregoing table includes certain non-GAAP performance measures and ratios that are used by management to evaluate and measure the Company's performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the Company's financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities for comparative purposes. Other financial holding companies use these or similar measures and ratios, but may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the nine months ended Sept ember 30, 2004 and September 30, 2003.

 
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Management reviews yields on certain asset categories and the net interest margin of the Company, and its banking subsidiaries, on a fully taxable-equivalent basis ("FTE"). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measures comparability of net interest income arising from both taxable and tax-exempt sources (dollars in thousands).


   
Nine months ended
September 30,
  
   
2004
  
2003
  
(A) Interest income (GAAP)
  
$
52,352
  
$
47,260
  
Taxable equivalent adjustment-loans
    
25
    
39
  
Taxable equivalent adjustment-Tax-exempt securities
    
887
    
937
  
Interest income-FTE
    
53,264
    
48,236
  
(B) Interest expense (GAAP)
    
16,081
    
14,707
  
(C) Net interest income (GAAP) (A minus B)
    
36,271
    
32,553
  
Net interest income-FTE
    
37,183
    
33,529
  
(D) Net interest margin (GAAP)(annualized)
    
3.58
%
  
3.62
%
Net interest margin-FTE (annualized)
    
3.67
%
  
3.73
%


Taxable-equivalent adjustments to interest income involve the conversion of tax-exempt sources of interest income to the equivalent amounts of interest income that would be necessary to derive the same net return if the investments had been subject to income taxes. A 35% incremental income tax rate is used in the conversion of tax-exempt interest income to a taxable-equivalent basis.

For the nine months ended September 30, 2004, the Company reported taxable-equivalent net interest income of $37.2 million, an increase of $3.7 million, or 10.9%, from the $33.5 million reported for the nine months ended September 30, 2003. This increase reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.67% in the first three quarters of 2004 from 3.73% in the first three quarters of 2003, reflecting repricing of assets in a low rate environment.

The Company’s taxable-equivalent total interest income increased $5.0 million for the nine months ended September 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding. Average loans outstanding increased by $130.4 million, or 17.0%, in the first three quarters of 2004 over the first three quarters of 2003. For the nine months ended September 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.25% compared to 5.37% for the nine months ended September 30, 2003. The first three quarters of 2004 loan yield was 5.85% compared to 6.11% in the first three quarters of 2003. The Company experienced increased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at hig her rates. For the nine months ended September 30, 2004, the yield earned on taxable investment securities increased to 3.95% from 3.88% for the nine months ended September 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the nine months ended September 30, 2004 from 5.83% for the nine month ended September 30, 2003.

The Company’s funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.77% for the first three quarters of 2004 from 1.88% for the first three quarters of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (“FHLB”), to balance the timing differences between its various business funding sources and to support loan origination. In the first three quarters of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 27.8% of the Company’s interest-bearing liabilities compared to 26.1% in the first three quarters of.


 
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Provision for Loan Losses

The provision for loan losses was $1.9 million in the first three quarters of 2004 and $2.0 million in the first three quarters of 2003. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.

Other Income

Total other income decreased $4.3 million for the first three quarters of 2004 over the first three quarters of 2003. The decrease was the result of a $1.3 million gain in the second quarter 2003 on the sale of the merchant credit card processing business, a decrease of $2.8 million in gains on sale of mortgage loans due to decreased refinancing activity, and a decrease of $1.1 million in ATM and merchant services due to the sale of the merchant processing business. The decreases were offset by increases in service charges on deposit accounts of $326 thousand, security commissions and management fees of $169 thousand, investment securities gains of $362 thousand, and other income of $82 thousand.

Other Expenses

Other expenses decreased $2.6 million in the first three quarters of 2004 over the first three quarters of 2003. The decrease was due to expenses in the second quarter 2003 of $450 thousand related to the sale of the merchant credit card processing business, efficiency consulting expense of $570 thousand, and severance charges of $180 thousand. The decrease was also the result of decreases in personnel costs, legal and professional fees, and ATM and merchant services. These decreases were offset by increases in net occupancy and equipment expense, data processing, advertising, and other expense. Personnel costs decreased $1.7 million partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower s taffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expense increased $424 thousand and data processing increased $374 thousand. Both increases are mainly due to the three additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $282 thousand. ATM and merchant services decreased $971 thousand mainly due to the sale of the merchant credit card processing business during 2003. Other expense increased $562 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.

Income Taxes

The Company's consolidated income tax rate varies from statutory rates principally due to tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the nine months ended September 30, 2004 was 30.3% compared to 29.0% for the nine months ended September 30, 2003. Provisions for income tax were $4.5 million for the first three quarters of 2004 compared to $3.7 million for the first three quarters of 2003.

Liquidity

The primary functions of asset/liability management are to assure adequate liquidity and to maintain an appropriate balance between interest-earning assets and interest-bearing liabilities. Liquidity management involves the ability to meet the cash flow requirements of depositors and borrowers. Liquid assets (including cash deposits with banks, short-term investments, interest-earning deposits, and federal funds sold) are maintained primarily to meet customers’ current needs. The Company had liquid assets of $46.5 million and $78.4 million at September 30, 2004 and December 31, 2003, respectively.

 
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Capital Resources

There are certain regulatory requirements that affect the Company's level of capital. The following table sets forth these requirements and the Company's capital levels and ratios at September 30, 2004 (dollars in thousands):

   
 
 
Actual
  
Regulatory
Minimum
Requirement
  
Regulatory
Well-capitalized
Requirement
  
   
Amount

 
Percent

 
Amount

 
Percent

 
Amount

 
Percent
  
Tier 1 leverage
 
$
97,910
    
6.6
%
$
59,102
    
4.0
%
$
73,878
  
5.0
%
Tier 1 risk-based capital
 
$
97,910
    
8.6
%
$
43,322
    
4.0
%
$
67,982
    
6.0
%
Risk-based capital
 
$
124,188
    
11.0
%
$
90,643
  
8.0
%
$
113,304
    
10.0
%

The Company is pursuing a policy of continued asset growth, which requires the maintenance of appropriate ratios of capital to assets. The existing capital levels allow for additional asset growth without further capital infusion. It is the Company's plan to maintain its capital position at or in excess of the "well-capitalized" definition. The Company seeks to obtain additional capital growth through earnings retention and a consistent dividend policy.

Derivative Financial Instruments and Hedging Activities

Interest rate risk, the exposure of the Company’s net interest income and net fair value of its assets and liabilities, to adverse movements in interest rates, is a significant market risk exposure that can have a material effect on the Company’s financial position, results of operations and cash flows. The Company has policies to ensure that neither earnings nor fair value at risk exceed established guidelines and assesses these risks by continually identifying and monitoring changes in interest rates that may adversely impact expected future earnings and fair values.

The Company has designed strategies to confine these risks within the established limits and identify appropriate risk/reward trade-offs in the financial structure of its balance sheet. These strategies include the use of interest rate swap agreements to manage fluctuations in cash flows or fair values resulting from interest rate risk.

The Company designated the current interest swap outstanding as a fair value hedge of an existing loan that qualifies for “short-cut” treatment.    Accordingly, the Company does not anticipate ineffectiveness arising from differences between the fair value of the loan and the fair value of the swap.

The following table summarizes the Company’s fair value hedges at September 30, 2004 (dollars in thousands):

 
 
Hedged Item
  
 
 
Hedging Instrument
  
 
Notional Amount
  
 
Fair Value
  
Remaining Term (Years)
  
Fixed Rate Loan

 

 Receive Variable Swap

 
$ 3,878

 
$ (35)

 

 
8.25
  

Item 3.   Quantitative and Qualitative Disclosures About Market Risk.

Refer to the Company’s annual report on Form 10-K for the year ended December 31, 2003 for a complete discussion of the Company’s market risk. There have been no material changes to the market risk information included in the Company’s 2003 Annual Report on Form 10-K.

Item 4.   Controls and Procedures.

Disclosure Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

 
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Internal Controls Over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Forward Looking Statements

Certain matters discussed in this Report are “forward-looking statements” that are intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified as such because the statements generally will include words such as “believes,” “anticipates,” “expects,” or words of similar meaning. Similarly, statements that describe future plans, objectives, outlooks, targets or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Report. Factors that could cause such a varian ce include, but are not limited to, changes in interest rates, local market competition, customer loan and deposit preferences, governmental regulations, and other general economic conditions. Shareholders, potential investors, and other readers are urged to consider these factors in evaluating the forward-looking statements and cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in this Report are only made as of the date of this Report, and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

Assumptions regarding interest rate sensitivity of some deposits also require significant judgment based on historical patterns relative to the industry and the Company’s own experience. Actual sensitivity may vary from the assumptions made, and have an impact on the Company’s net interest margin.

Part II.  Other Information

Item 1.   Legal Proceedings.

From time to time, the Company and the Bank, are party to legal proceedings arising out of their general lending activities and other operations. Currently there are no material proceedings.

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds.

Period
  
Total Number of Shares Purchased
  
Average Price Paid per Share
  
Total Number of Shares Purchased as Part of Publicly Announced Program
  
Maximum Number of Shares that May Yet Be Purchased Under the Program
  
July 1, 2004 - July 31, 2004
    
45,000
  
 
$ 29.05
    
45,000
    
139,500
  
August 1, 2004 - August 31, 2004
    
50,000
  
 
$ 29.09
    
50,000
    
89,500
  
September 1, 2004 - September 30, 2004
    
0
  
 
$        0
    
0
    
89,500
  
Total
    
95,000
  
 
$ 29.07
    
95,000
    
89,500
  

 
On April 28, 2003, the Company’s Board of Directors authorized the repurchase of up to 5%, or approximately 348,000 shares, of the Company’s Common Stock in open market or privately negotiated transactions. Through September 30, 2004, 238,500 shares had been repurchased at an average price of $29.02 per share, and the Company had authority to repurchase approximately 89,500 additional shares under this authorization. There is no specific expiration date for the Company’s share repurchase authorization.

 
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Item 3.   Default Upon Senior Securities.

None.

Item 4.   Submission of Matters to Vote of Security Holders.

None.

Item 5.   Other Information.

None.

Item 6.    Exhibits

10.1 ISO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan.

10.2 NQO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan.

  31.1 Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

  31.2 Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

  32 Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.

 
  22  
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SIGNATURES

 
Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
STATE FINANCIAL SERVICES CORPORATION
 
(Registrant)
   
   
Date:   November 9, 2004
By /s/ Michael J. Falbo
 
Michael J. Falbo
President and Chief Executive Officer
   
   
Date :  November 9,2004
By /s/ Daniel L. Westrope
 
Daniel L. Westrope
Senior Vice President and
Chief Financial Officer
   

 
  23  
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STATE FINANCIAL SERVICES CORPORATION
EXHIBIT INDEX TO FORM 10-Q
For The Quarter Ended September 30, 2004


Exhibit Number
    
     
10.1
  
     
10.2
  
     
31.1
 
     
31.2
 
     
32
  


 
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