UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003.
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________.
Commission File Number: 0-22219
FIRST SOUTH BANCORP, INC.
-------------------------
(Exact name of registrant as specified in its charter)
VIRGINIA 56-1999749
------------------------------- -------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
1311 CAROLINA AVENUE, WASHINGTON, NORTH CAROLINA 27889
------------------------------------------------------
(Address of principal executive offices)
(Zip Code)
(252) 946-4178
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Number of shares of common stock outstanding as of July 31, 2003: 4,133,430
CONTENTS
PART I. FINANCIAL INFORMATION PAGE
---------------------
Item 1. Financial Statements
Consolidated Statements of Financial Condition as of
June 30, 2003 (unaudited) and December 31, 2002 1
Consolidated Statements of Operations for the Three and
Six Months Ended June 30, 2003 and 2002 (unaudited) 2
Consolidated Statements of Stockholders' Equity for the
Six Months Ended June 30, 2003 (unaudited) 3
Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 2003 and 2002 (unaudited) 4
Notes to Consolidated Financial Statements (unaudited) 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 13
Item 4. Controls and Procedures 14
PART II. OTHER INFORMATION
-----------------
Item 1. Legal Proceedings 15
Item 2. Changes in Securities and Use of Proceeds 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 15
Signatures 16
Exhibits 17
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30 DECEMBER 31
2003 2002
---- ----
ASSETS (UNAUDITED)
Cash and due from banks $ 32,148,494 $ 30,540,790
Interest-bearing deposits in financial institutions 1,669,137 3,931,369
Investment securities - available for sale 53,435,332 55,786,842
Mortgage-backed securities - available for sale 22,317,423 23,526,435
Loans and leases receivable, net:
Held for sale 28,625,132 38,664,967
Held for investment 499,557,834 452,248,942
Premises and equipment, net 7,553,166 7,825,003
Deferred income taxes 227,383 --
Real estate owned 309,634 401,632
Federal Home Loan Bank of Atlanta stock, at cost
which approximates market 2,127,200 2,402,500
Accrued interest receivable 3,093,924 3,403,195
Goodwill 4,218,575 4,218,576
Mortgage servicing rights 1,878,762 1,642,172
Prepaid expenses and other assets 4,740,611 2,544,807
Note receivable 1,299,007 1,336,194
-------------- --------------
Total assets $ 663,201,614 $ 628,473,424
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand $ 213,961,428 $ 199,615,945
Savings 19,566,280 18,950,380
Large denomination certificates of deposit 108,318,752 80,021,790
Other time 238,977,056 227,739,049
-------------- --------------
Total deposits 580,823,516 526,327,164
Borrowed money 19,211,164 38,194,727
Other liabilities 12,480,945 13,851,721
-------------- --------------
Total liabilities 612,515,625 578,373,612
Common stock, $.01 par value, 8,000,000 shares authorized,
6,545,848 shares issued 65,458 65,458
Additional paid-in capital 48,368,377 48,466,569
Retained earnings, substantially restricted 39,162,212 35,086,795
Treasury stock at cost, 2,412,318 and 2,341,936 shares (40,273,453) (37,317,469)
Accumulated other comprehensive income, net 3,363,395 3,798,459
-------------- --------------
Total stockholders' equity 50,685,989 50,099,812
-------------- --------------
Total liabilities and stockholders' equity $ 663,201,614 $ 628,473,424
============== ==============
See Notes to Consolidated Financial Statements.
1
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30 JUNE 30
---------------------------- ----------------------------
2003 2002 2003 2002
---------------------------- ----------------------------
Interest income:
Interest and fees on loans $ 8,045,728 $ 7,673,884 $ 15,958,368 $ 15,141,300
Interest and dividends on investments and deposits 1,203,817 1,511,202 2,432,509 3,091,196
------------ ------------ ------------ ------------
Total interest income 9,249,545 9,185,086 18,390,877 18,232,496
------------ ------------ ------------ ------------
Interest expense:
Interest on deposits 2,648,485 3,180,154 5,352,914 6,532,085
Interest on borrowings 35,310 17,667 72,846 26,941
------------ ------------ ------------ ------------
Total interest expense 2,683,795 3,197,821 5,425,760 6,559,026
------------ ------------ ------------ ------------
Net interest income before provision for possible loan losses 6,565,750 5,987,265 12,965,117 11,673,470
Provision for possible loan losses 122,000 333,000 455,918 642,000
------------ ------------ ------------ ------------
Net interest income 6,443,750 5,654,265 12,509,199 11,031,470
------------ ------------ ------------ ------------
Noninterest income:
Loan fees and service charges 1,533,383 1,082,447 2,876,527 2,101,159
Loan servicing fees 156,470 180,009 295,087 358,276
Gain on sale of real estate, net -6,388 -10,199 42,240 74,948
Gain on sale of mortgage loans 783,394 390,477 1,800,091 695,787
Gain on sale of mortgage-backed securities 0 -5,622 168,938 52,666
Other income 219,589 273,495 423,331 431,951
------------ ------------ ------------ ------------
Total noninterest income 2,686,448 1,910,607 5,606,214 3,714,787
------------ ------------ ------------ ------------
Noninterest expenses:
Compensation and fringe benefits 2,632,700 2,444,208 5,277,480 4,633,528
Federal insurance premiums 21,092 20,897 43,130 42,236
Premises and equipment 377,753 303,220 740,311 612,452
Advertising 46,964 54,877 95,492 115,955
Payroll and other taxes 243,259 211,239 482,238 432,797
Data processing 484,888 443,134 948,732 869,637
Amortization of mortgage servicing rights 57,215 36,637 109,409 68,642
Other 641,795 478,696 1,228,277 958,599
------------ ------------ ------------ ------------
Total noninterest expenses 4,505,666 3,992,908 8,925,069 7,733,846
------------ ------------ ------------ ------------
Income before income taxes 4,624,532 3,571,964 9,190,344 7,012,411
Income taxes 1,737,255 1,218,902 3,460,162 2,480,773
------------ ------------ ------------ ------------
NET INCOME $ 2,887,277 $ 2,353,062 $ 5,730,182 $ 4,531,638
============ ============ ============ ============
Per share data:
Basic earnings per share $ 0.70 $ 0.53 $ 1.38 $ 1.02
Diluted earnings per share $ 0.66 $ 0.50 $ 1.30 $ 0.97
Dividends per share $ 0.20 $ 0.17 $ 0.40 $ 0.34
Weighted average shares Basic 4,133,601 4,417,346 4,147,868 4,427,747
Weighted average shares Diluted 4,380,263 4,682,069 4,401,680 4,661,549
See Notes to Consolidated Financial Statements.
2
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
SIX MONTHS ENDED JUNE 30, 2003
(UNAUDITED)
Accumulated
Retained Other
Additional Earnings, Comprehensive
Common Paid-in Substantially Treasury Income (Loss),
Stock Capital Restricted Stock Net Total
------------ ------------ ------------ ------------ ------------ ------------
Balance December 31, 2002 $ 65,458 $ 48,466,569 $ 35,086,795 $(37,317,469) $ 3,798,459 $ 50,099,812
Net income 5,730,182 5,730,182
Other comprehensive income, net
of taxes (435,064) (435,064)
Exercise of stock options (98,192) 504,279 406,087
Acquisition of treasury shares (3,460,263) (3,460,263)
Dividends ($.40 per share) (1,654,765) (1,654,765)
------------ ------------ ------------ ------------ ------------ ------------
Balance June 30, 2003 $ 65,458 $ 48,368,377 $ 39,162,212 $(40,273,453) $ 3,363,395 $ 50,685,989
============ ============ ============ ============ ============ ============
See Notes to Consolidated Financial Statements.
3
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Six Months Ended
June 30
--------------------------------
2003 2002
--------------------------------
Operating activities:
Net Income $ 5,730,182 $ 4,531,638
Adjustments to reconcile net income to net cash provided
in operating activities:
Provision for loan losses 455,918 642,000
Depreciation 339,359 304,068
Amortization of discounts on securities, net (88,889) (93,264)
Gain on disposal of premises and equipment and
real estate owned (41,509) (151,593)
Gain on loans held for sale and mortgage-backed securities (1,969,029) (748,453)
Originations of loans held for sale, net (76,092,963) (32,472,893)
Proceeds from sale of loans held for sale 78,980,794 39,730,724
Other operating activities (3,567,782) (3,538,230)
-------------- --------------
Net cash provided in operating activities 3,746,081 8,203,997
-------------- --------------
Investing activities:
Proceeds from maturities of investments securities available for sale 2,000,000 --
Proceeds from principal repayments and sales of
mortgage-backed securities available for sale 10,068,728 8,633,503
Originations of loans held for investment, net of principal repayments (48,074,719) (35,518,484)
Proceeds from disposal of premises and equipment and
real estate owned 444,148 706,929
Redemption of FHLB stock 275,300 --
Purchases of premises and equipment (68,254) (359,389)
Repayment of note receivable 37,187 13,761
-------------- --------------
Net cash used in investing activities (35,317,610) (26,523,680)
-------------- --------------
Financing activities:
Net increase in deposit accounts 54,496,352 31,240,690
Proceeds from FHLB borrowings 115,400,000 19,500,000
Repayments of FHLB borrowings (134,400,000) (20,500,000)
Purchase of treasury shares (3,460,263) (1,578,777)
Cash paid for fractional shares -- (5,812)
Cash dividends paid (1,541,612) (1,500,579)
Proceeds from exercise of stock options 406,087 77,563
Net change in repurchase agreements 16,437 367,791
-------------- --------------
Net cash provided by financing activities 30,917,001 27,600,876
-------------- --------------
Increase (decrease) in cash and cash equivalents (654,528) 9,281,193
Cash and cash equivalents, beginning of period 34,472,159 21,683,082
-------------- --------------
Cash and cash equivalents, end of period $ 33,817,631 $ 30,964,275
============== ==============
Supplemental disclosures:
Real estate acquired in settlement of loans $ 309,909 $ 218,364
Exchange of loans for mortgage-backed securities $ 8,952,095 $ --
Dividends declared, not paid $ 826,706 $ 747,571
See Notes to Consolidated Financial Statements.
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1. NATURE OF BUSINESS. First South Bancorp, Inc. (the "Company") was formed
for the purpose of issuing common stock and owning 100% of the stock of First
South Bank (the "Bank") and operating through the Bank a commercial banking
business. The Bank has one significant operating segment, the providing of
general commercial banking services to its markets located in the state of North
Carolina. The Company's common stock is traded on The Nasdaq National Market
under the symbol "FSBK".
NOTE 2. BASIS OF PRESENTATION. The accompanying unaudited consolidated financial
statements have been prepared in accordance with generally accepted accounting
principles and with the instructions to Form 10-Q of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments necessary for a fair presentation
of the financial position and results of operations for the periods presented
have been included, none of which were other than normal recurring accruals. The
financial statements of the Company are presented on a consolidated basis with
those of the Bank. The results of operations for the three and six month periods
ended June 30, 2003 are not necessarily indicative of the results of operations
that may be expected for the year ended December 31, 2003.
NOTE 3. STOCK SPLIT. On March 28, 2002 the Company declared a three-for-two
stock split, in the form of a 50% stock dividend, payable April 19, 2002 to
stockholders of record as of April 8, 2002. Stockholders received one additional
share of common stock for every two shares held on the record date. All share
and per share data for the three and six months ended June 30, 2002 were
adjusted to reflect the stock split, and issued shares increased to 6,545,848.
NOTE 4. GOODWILL. The Company applies the provisions of Statement of Financial
Accounting Standards No. 142 (SFAS No. 142), Goodwill and Other Intangible
Assets, and Statement of Financial Accounting Standards No. 147 (SFAS No. 147),
Acquisition of Certain Financial Institutions, effective as of January 1, 2002.
SFAS No. 142 requires the Company to discontinue the amortization of goodwill
associated with acquisitions accounted for under the purchase method of
accounting. SFAS No. 147 requires the Company to cease amortization of
unidentifiable intangible assets associated with certain branch acquisitions. As
a result of applying the provisions of SFAS No.'s 142 and 147, goodwill is not
amortized, but reviewed for potential impairment on an annual basis. The Company
has performed its annual impairment test and has determined there has been no
impairment of goodwill.
NOTE 5. DIVIDENDS DECLARED. On June 19, 2003, the Company declared a cash
dividend of $0.20 per share, payable on July 25, 2003 to stockholders of record
as of July 5, 2003. This dividend payment represents a payout ratio of 28.6% of
the basic earnings for the quarter ended June 30, 2003, and is the Company's
twenty-fifth consecutive quarterly cash dividend.
NOTE 6. EARNINGS PER SHARE. Basic and diluted earnings per share for the three
and six month periods ended June 30, 2003 are based on weighted average shares
of common stock outstanding, excluding treasury shares. Diluted earnings per
share include the potentially dilutive effects of the Company's stock option
plan.
NOTE 7. STOCK OPTIONS. On December 31, 2002, the Financial Accounting Standards
Board (FASB or the "Board") issued FASB Statement No. 148 (FAS 148), Accounting
for Stock-Based
5
Compensation--Transition and Disclosure, which amends FASB Statement No. 123
(FAS 123), Accounting for Stock-Based Compensation. FAS 148 allows three
transition methods for companies that adopt fair value recognition provisions of
FAS 123. The following are two new transition alternatives: Modified Prospective
Approach and Limited Retrospective Approach. Under FAS 148, the prospective
transition method in FAS 123 will not be available for companies that elect to
initially apply the fair value method of accounting for stock-based employee
compensation in fiscal years beginning after December 15, 2003. In addition, FAS
148 requires that the accumulated liability or equity balances accrued under APB
Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, would be
reversed through additional paid-in-capital as of the beginning of the period
that FAS 123 is adopted if those liabilities or contra-equity balances would not
have been recognized under FAS 123. Also, companies must disclose for each
period for which an income statement is presented an accounting policy footnote
that includes the method of accounting for stock options; total stock
compensation cost that is recognized in the income statement and would have been
recognized had FAS 123 been adopted for recognition purposes as of its effective
date; and pro forma net income and earnings per share (where applicable) that
would have been reported had FAS 123 been adopted for recognition purposes as of
its effective date.
These disclosures would be required to be made in annual financial statements
and in quarterly information provided to shareholders without regard to whether
the entity has adopted FAS 123 for recognition purposes. The Company implemented
the disclosure provisions of SFAS No. 148 beginning with the December 31, 2002
consolidated financial statements.
For proforma disclosure purposes for the three and six months ended June 30,
2003, no stock option grants were made in the three and six months ended June
30, 2003. For the three and six months ended June 30, 2003, the table below
summarizes the net income and stock-based compensation expense, as reported,
compared to pro forma amounts had the fair value method been applied:
Three Months Ended June 30, 2003 As Reported Pro Forma
- -------------------------------- ----------- ---------
Net income attributable to common shareholders $ 2,887,277 $ 2,857,096
Stock based compensation $ 0 $ 45,728
Net income per share - basic $ .70 $ .69
Net income per share - diluted $ .66 $ .65
Six Months Ended June 30, 2003 As Reported Pro Forma
- ------------------------------ ----------- ---------
Net income attributable to common shareholders $ 5,730,182 $ 5,669,821
Stock based compensation $ 0 $ 91,456
Net income per share - basic $ 1.38 $ 1.37
Net income per share - diluted $ 1.30 $ 1.29
NOTE 8. RECLASSIFICATIONS. Certain amounts reported in the three and six months
ended June 30, 2002 have been reclassified to conform to the presentation for
the three and six months ended June 30, 2003. These reclassifications had no
effect on net income or shareholders' equity for the periods presented, nor did
they materially impact trends in financial information.
NOTE 9. COMPREHENSIVE INCOME. The Company applies the provisions of Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income".
Comprehensive income includes net income and all other changes to the Company's
equity, with the exception of transactions with shareholders ("other
comprehensive income"). The Company's only component of other comprehensive
income relates to unrealized gains and losses on available for sale securities.
6
Information concerning the Company's other comprehensive income for the three
and six month periods ended June 30, 2003 and 2002 is as follows:
Three Months Ended Six Months Ended
June 30, June 30,
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income $ 2,887,277 $ 2,353,063 $ 5,730,182 $ 4,531,638
Reclassification of (gains) losses
recognized in net income 0 5,622 (168,938) (52,666)
Gains (losses) unrealized,
net of income taxes (126,511) 1,118,948 (266,126) 492,798
------------ ------------ ------------ ------------
Other comprehensive income (loss) (126,511) 1,124,570 (435,064) 440,132
------------ ------------ ------------ ------------
Comprehensive income $ 2,760,766 $ 3,477,633 $ 5,295,118 $ 4,971,770
============ ============ ============ ============
NOTE 10. FORWARD LOOKING STATEMENTS. The Private Securities Litigation Reform
Act of 1995 states that the disclosure of forward looking information is
desirable for investors and encourages such disclosure by providing a safe
harbor for forward looking statements by corporate management. This Form 10-Q,
including Management's Discussion and Analysis of Financial Condition and
Results of Operations, contains forward looking statements that involve risk and
uncertainty. In order to comply with the terms of the safe harbor, the Company
notes that a variety of risks and uncertainties could cause its actual results
and experience to differ materially from the anticipated results or other
expectations expressed in the Company's forward looking statements. There are
risks and uncertainties that may affect the operations, performance,
development, growth projections and results of the Company's business. They
include, but are not limited to, economic growth, interest rate movements,
timely development of technology enhancements for products, services and
operating systems, the impact of competitive products, services and pricing,
customer requirements, regulatory changes and similar matters. Readers of this
report are cautioned not to place undue reliance on forward looking statements
that are subject to influence by these risk factors and unanticipated events.
Accordingly, actual results may differ materially from management's
expectations.
7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The Company has engaged in no activity other than holding the stock of the Bank
and operating through the Bank a commercial banking business. Therefore, the
discussion below focuses primarily on the Bank's results of operations.
COMPARISON OF FINANCIAL CONDITION AT JUNE 30, 2003 AND DECEMBER 31, 2002
Total assets increased to $663.2 million at June 30, 2003 from $628.5 million at
December 31, 2002, reflecting an 11.1% annualized internal growth rate. Earning
assets increased to $607.7 million at June 30, 2003 from $576.6 million at
December 31, 2002, reflecting growth of the commercial and consumer loan
portfolio, as further discussed below. Earning assets were 91.6% of total assets
at June 30, 2003 compared to 91.8% at December 31, 2002.
Interest-bearing overnight deposits in financial institutions were $1.7 million
at June 30, 2003, compared to $3.9 million at December 31, 2002. Overnight funds
are available to fund loan originations, liquidity management activities and
daily operations of the Bank.
The Bank has implemented strategies to sell certain securities and loans during
favorable interest rate windows, to maintain its regulatory liquidity at
required levels, and to securitize certain mortgage loans held for sale into
mortgage-backed securities. The Bank had no mortgage-backed security sales
during the three months ended June 30, 2003 and $3.0 million sold during six
months ended June 30, 2003, compared to $1.5 million of mortgage-backed
securities sold during the three and six months ended June 30, 2002,
respectively. The Bank securitized $5.3 million and $9.0 million of mortgage
loans into mortgage-backed securities during the three and six months ended June
30, 2003, compared to no mortgage loans securitized into mortgage-backed
securities during the three and six months ended June 30, 2002. The
mortgage-backed securities portfolio was $22.3 million at June 30, 2003,
compared to $23.5 million at December 31, 2002.
Loans held for sale declined to $28.6 million at June 30, 2003 from $38.7
million at December 31, 2002. The Bank sold $39.6 million and $79.0 million of
mortgage loans during the three and six months ended June 30, 2003, compared to
$15.4 million and $39.7 million of mortgage loans sold during the three and six
months ended June 30, 2002. Net loans and leases held for investment increased
to $499.6 million at June 30, 2003 from $452.3 million at December 31, 2002,
reflecting a 20.9% annualized growth rate during the period. To support the risk
associated with its loan portfolio, the Bank maintained reserves for potential
loan losses of $7.3 million at June 30, 2003, compared to $7.0 million at
December 31, 2002. The ratio of reserves for loan losses to loans outstanding,
net of loans in process and deferred loan fees, was 1.4%, respectively, at June
30, 2003 and December 31, 2002.
Total deposits and borrowings increased to $600.0 million at June 30, 2003 from
$564.5 million at December 31, 2002. Deposits increased to $580.8 million at
June 30, 2003 from $526.3 million at December 31, 2002. Checking accounts
increased at an annualized growth of 14.4% to $214.0 million at June 30, 2003
from $199.6 million at December 31, 2002, resulting from the Bank's efforts to
attract more lower costing core checking accounts. Time deposits increased at an
annualized growth rate of 25.7% to $347.3 million at June 30, 2003 from $307.8
million at December 31, 2002.
8
FHLB advances used primarily to fund loan originations were $15.0 million at
June 30, 2003, compared to $34.0 million at December 31, 2002. Borrowings in the
form of repurchase agreements were $4.2 million at June 30, 2003 and $4.3
million at December 31, 2002. These borrowings represent funds held in cash
management accounts for commercial banking customers.
Stockholders' equity was $50.7 million at June 30, 2003, compared to $50.1
million at December 31, 2002. See "Consolidated Statements of Stockholders'
Equity" for additional information. At June 30, 2003, the Company's equity to
assets ratio was 7.6%, compared to 8.0% at December 31, 2002. Accumulated other
comprehensive income was $3.4 million at June 30, 2003, compared to $3.8 million
at December 31, 2002, reflecting the impact of current market rates and the
mortgage-backed securities sales as previously discussed.
As a North Carolina chartered commercial bank, the Bank must meet various
capital standards required by federal and state banking regulatory agencies. The
Bank's stand-alone capital was $50.4 million at June 30, 2003, substantially in
excess of all regulatory capital requirements. See "Liquidity and Capital
Resources" below for additional information.
During the quarter ended June 30, 2003, the Company acquired $1.0 million of its
common stock through open market and private purchases pursuant to a stock
repurchase plan previously adopted by the board of directors. Shares acquired
via the stock repurchase plan are held as treasury stock, at cost. At June 30,
2003, treasury shares held were 2,412,318 totaling $40.3 million, compared to
2,341,936 shares totaling $37.3 million at December 31, 2002. The Company
believes the repurchase of its outstanding common stock will increase per share
earnings and return on average equity, and decrease the potential dilutive
effect caused by the exercise of stock options. During the three and six months
ended June 30, 2003, 14,350 and 30,500 shares, respectively, were issued as a
result of the exercise of stock options, compared to no shares issued during the
three months and 6,375 shares issued during the six months ended June 30, 2002.
COMPARISON OF OPERATING RESULTS - THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND
2002
GENERAL. Net income for the three and six months ended June 30, 2003 was $2.9
million and $5.7 million, compared to $2.4 million and $4.5 million for the
three and six months ended June 30, 2002. Basic earnings per share was $0.70 and
$1.38 per share for the three and six months ended June 30, 2003, compared to
$0.53 and $1.02 per share for the three and six months ended June 30, 2002,
adjusted for the stock split. Diluted earnings per share was $0.66 and $1.30 per
share for the three and six months ended June 30, 2002, compared to $0.50 and
$0.97 per share for the three and six months ended June 30, 2002, adjusted for
the stock split.
INTEREST INCOME. Interest income was $9.3 million and $18.4 million for the
three and six months ended June 30, 2003, compared to $9.2 million and $18.2
million for the three and six months ended June 30, 2002. This increase is due
to the increase in the volume of average interest-earning assets between the
respective periods. Average interest-earning assets were $595.8 million and
$586.0 million for the three and six months ended June 30, 2003, compared to
$526.2 million and $518.7 million for the three and six months ended June 30,
2002, reflecting the growth in loans and leases held for sale as discussed
above. The yield on average interest-earning assets was 6.2% and 6.3%,
respectively, for the three and six months ended June 30, 2003, compared to 7.0%
for both the three and six months ended June 30, 2002.
INTEREST EXPENSE. Interest expense on deposits and borrowings was $2.7 million
and $5.4 million for the three and six months ended June 30, 2003, compared to
$3.2 million and $6.6 million for the
9
three and six months ended June 30, 2002, reflecting the general decline in
interest rates and the change in the deposit mix as discussed above. Average
deposits and borrowings were $585.0 million and $576.1 million for the three and
six months ended June 30, 2003, compared to $503.7 million and $494.1 million
for the three and six months ended June 30, 2002. The effective cost of average
deposits and borrowings was 1.8% and 1.9% for the three and six months ended
June 30, 2003, compared to 2.5% and 2.7% for the three and six months ended June
30, 2002.
NET INTEREST INCOME. Net interest income was $6.6 million and $13.0 million for
the three and six months ended June 30, 2003, compared to $6.0 million and $11.7
million for the three and six months ended June 30, 2002. The interest rate
spread (the difference between the effective yield on average earning assets and
the effective cost of average deposits and borrowings) was 4.4% for both the
three and six months ended June 30, 2003, compared to 4.4% for both the three
and six months ended June 30, 2002. The net yield on interest-earning assets
(net interest income divided by average interest assets) was 4.4% for both the
three and six months ended June 30, 2003, compared to 4.6% and 4.5% for the
three and six months ended June 30, 2002.
PROVISION FOR LOAN LOSSES. The Bank recorded $122,000 and $456,000 of provisions
for loan losses during the three and six months ended June 30, 2003, compared to
$333,000 and $642,000 recorded in the three and six months ended June 30, 2002.
These provisions were necessary to support the risk associated with the growth
in the Bank's loan portfolio. Provisions are charged to current operations and
the Bank believes the resulting allowance for loan losses is adequate to absorb
probable losses on loans that may become uncollectible. Additions to the
allowance for loan losses are based on a review and classification of the loan
portfolio and other factors, such as past collection experience, changes in the
nature and volume of the loan portfolio, risk characteristics of individual
loans or groups of similar loans and underlying collateral, overall portfolio
quality and current and prospective economic conditions. The Bank believes the
current level of its reserves for loan losses is adequate to provide for
probable future losses, however, there are no assurances that future losses, if
any, will not exceed estimated amounts.
NONINTEREST INCOME. Noninterest income was $2.7 million and $5.6 million for the
three and six months ended June 30, 2003, compared $1.9 million and $3.7 million
for the three and six months ended June 30, 2002. Noninterest income consists of
fees and service charges earned on loans, service charges on deposit accounts,
gains from sales of loans and mortgage-backed securities and other miscellaneous
income. Fees and service charges were $1.7 million and $3.2 million for the
three and six months ended June 30, 2003, compared to $1.3 million and $2.5
million for the three and six months ended June 30, 2002. The increase in fees
and service charges during the current periods is attributable to a greater
volume of loans and checking deposits discussed above. In addition, the Bank
recorded $783,000 and $2.0 million of gains from sales of loans and
mortgage-backed securities during the three and six months ended June 30, 2003,
compared to $385,000 and $748,000 during the three and six months ended June 30,
2002.
NONINTEREST EXPENSE. Noninterest expenses were $4.5 million and $8.9 million for
the three and six months ended June 30, 2003, compared to $4.0 million and $7.7
million for the three and six months ended June 30, 2002. The largest component
of these expenses, compensation and fringe benefits, was $2.6 million and $5.3
million for the three and six months ended June 30, 2003, compared to $2.4
million and $4.6 million for the three and six months ended June 30, 2002.
Fulltime equivalent employees increased to 236 at June 30, 2003 from 222 at June
30, 2002. This growth is due to additional personnel resulting from opening a
new full-service branch office, a new loan production office and administrative
staff required to support the 14.7% growth in assets between the periods.
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Premises and equipment and data processing expenses have grown proportionately
with the growth in the number of customer accounts and transaction activity,
primarily attributable to both internal growth and the new offices opened. Other
noninterest expenses including premises and equipment, repairs, printing,
advertising, and office supplies have also grown proportionately with the growth
in earning assets, deposits and branch office locations.
INCOME TAXES. Income tax expense was $1.7 million and $3.5 million for the three
and six months ended June 30, 2003, compared to $1.2 million and $2.5 million
for the three and six months ended June 30, 2002. The changes in the amounts of
income tax provisions reflect the changes in pretax income and the estimated
income tax rates in effect during the respective periods.
LIQUIDITY AND CAPITAL RESOURCES. As a state chartered commercial bank, the Bank
must meet certain liquidity requirements established by the State of North
Carolina Office of the Commissioner of Banks (the "Commissioner"). The Bank's
liquidity ratio at June 30, 2003, as calculated under such requirements,
exceeded the requirements. Liquidity generally refers to the Bank's ability to
generate adequate amounts of funds to meet its cash needs. Adequate liquidity
guarantees that sufficient funds are available to meet deposit withdrawals, fund
future loan commitments, maintain adequate reserve requirements, pay operating
expenses, provide funds for debt service, pay dividends to stockholders, and
meet other general commitments. At June 30, 2003, the Bank had cash, deposits in
banks, investment securities, mortgage-backed securities, FHLB stock and loans
held for sale totaling $140.3 million, or 21.2% of total assets, compared to
$154.9 million at December 31, 2002 or 24.6% of total assets.
The Bank believes it can meet future liquidity needs with existing funding
sources. The Bank's primary source of funds are deposits, payments on loans and
mortgage-backed securities, maturities of investment securities, earnings and
funds provided from operations, the ability to borrow from the FHLB of Atlanta
and the availability of loans held for sale. While scheduled repayments of loans
and mortgage-backed securities are relatively predictable sources of funds,
deposit flows and general market interest rates, economic conditions and
competition substantially influence loan prepayments. In addition, the Bank
attempts to manage its deposit pricing in order to maintain a desired deposit
mix.
The FDIC requires the Bank to meet a minimum leverage capital requirement of
Tier I capital (consisting of retained earnings and common stockholder's equity,
less any intangible assets) to assets ratio of 4%. The FDIC also requires the
Bank to meet a ratio of total capital to risk-weighted assets of 8%, of which at
least 4% must be in the form of Tier I capital. The Commissioner requires the
Bank at all times to maintain a capital surplus of not less than 50% of common
capital stock. The Bank was in compliance with all capital requirements of the
FDIC and the Commissioner at June 30, 2003 and December 31, 2002.
IMPACT OF INFLATION AND CHANGING PRICES. The consolidated financial statements
of the Company have been prepared in accordance with generally accepted
accounting principles, which require the measurement of financial position and
operating results in terms of historical dollars without considering the change
in relative purchasing power of money over time and due to inflation. Unlike
most industrial companies, nearly all assets and liabilities of the Company are
monetary. As a result, interest rates have greater impact on the Company's
performance than do the effects of general levels of inflation. Interest rates
do not necessarily move in the same direction or to the same extent as the price
of goods and services. The impact of inflation upon the Company is reflected in
the cost and prices it pays for goods and services.
11
CRITICAL ACCOUNTING POLICIES. The Company has identified the policies below as
critical to its business operations and the understanding of its results of
operations. The impact and any associated risks related to these policies on the
Company's business operations is discussed throughout Management's Discussion
and Analysis of Financial Condition and Results of Operations where such
policies affect reported and expected financial results.
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. Estimates affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.
LOANS IMPAIRMENT AND ALLOWANCE FOR LOAN LOSSES. A loan is considered
impaired, based on current information and events, if it is probable that the
Bank will be unable to collect the scheduled payments of principal or interest
when due according to the contractual terms of the loan agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.
The Bank uses several factors in determining if a loan is impaired. The internal
asset classification procedures include a thorough review of significant loans
and lending relationships and include the accumulation of related data. This
data includes loan payment status, borrowers' financial data and borrowers'
operating factors such as cash flows, operating income or loss, etc.
The allowance for loan losses is increased by charges to income and decreased by
charge-offs (net of recoveries). Management's periodic evaluation of the
adequacy of the allowance is based on the Bank's past loan loss experience,
known and inherent risks in the portfolio, adverse situations that may affect
the borrower's ability to repay, the estimated value of any underlying
collateral, and current economic conditions. While management believes that it
has established the allowance in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of
its regulators and the current economic environment, there can be no assurance
that in the future the Bank's regulators or risks in its portfolio will not
require further increases in the allowance.
INCOME TAXES. Deferred tax asset and liability balances are determined by
application to temporary differences of the tax rate expected to be in effect
when taxes will become payable or receivable. Temporary differences are
differences between the tax basis of assets and liabilities and their reported
amounts in the financial statements that will result in taxable or deductible
amounts in future years. The effect on deferred taxes of a change in tax rates
is recognized in income in the period that includes the enactment date.
OFF-BALANCE SHEET RISK. The Company is a party to financial instruments
with off-balance sheet risk in the normal course of business to meet the
financing needs of its customers and to reduce its own exposure to fluctuations
in interest rates. These financial instruments include commitments to extend
credit and involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the balance sheet.
The Company's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit is
represented by the contractual amount of
12
those instruments. The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments.
NEW ACCOUNTING PRONOUNCEMENTS
In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others". This interpretation elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about its obligations
under certain guarantees it has issued. It also clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the fair
value of the obligation undertaken in issuing the guarantee. The application of
this interpretation is not expected to have a material impact on the Company's
consolidated financial statements.
In April 2003, FASB issued Statement of Financial Accounting Standards No. 149
"Amendment of Statement 133 on Derivative Instruments and Hedging Activities".
FASB Statements No. 133 "Accounting for Derivative Instruments and Hedging
Activities" and No. 138, "Accounting for Certain Derivative Instruments and
Certain Hedging Activities", establish accounting and reporting standards for
derivative instruments including derivatives embedded in other contracts
(collectively referred to as derivatives) and for hedging activities. Statement
149 amends Statement 133 for certain decisions made by the Board as part of the
Derivatives Implementation Group (DIG) process. This Statement contains
amendments relating to FASB Concepts Statement No. 7, "Using Cash Flow
Information and Present Value in Accounting Measurements", and FASB Statements
No. 65, "Accounting for Certain Mortgage Banking Activities", No. 91 "Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases", No. 95, "Statement of Cash Flows", and No.
126, "Exemption from Certain Required Disclosures about Financial Instruments
for Certain Nonpublic Entities". The Company is presently evaluating the effect
of this pronouncement.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the possible chance of loss from unfavorable changes in market
prices and rates. These changes may result in a reduction of current and future
period net interest income, which is the favorable spread earned from the excess
of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.
The Company considers interest rate risk to be its most significant market risk,
which could potentially have the greatest impact on operating earnings. The
structure of the Company's loan and deposit portfolios is such that a
significant decline in interest rates may have a negative impact on net market
values and net interest income. The Company monitors whether material changes in
market risk have occurred since March 31, 2003. The Company does not believe
that any material adverse changes in market risk exposures occurred since March
31, 2003.
The current period earnings growth reflects the Company's success in increasing
its net interest income during an environment of declining interest rates. The
Company has made significant progress in restructuring its loan portfolio, in
attracting lower costing core checking accounts and repricing higher costing
certificates of deposit at lower rates, collectively allowing the Company to
maintain more consistent net interest income.
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ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management of the Company
carried out an evaluation, under the supervision and with the participation of
the Company's principal executive officer and principal financial officer, of
the effectiveness of the Company's disclosure controls and procedures. Based on
this evaluation, the Company's principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures are effective in ensuring that information required to be disclosed
by the Company in reports that it files or submits under the Securities Exchange
Act of 1934, as amended, is recorded, processed, summarized and reported, within
the time periods specified in the Securities and Exchange Commission's rules and
forms. It should be noted that the design of the Company's disclosure controls
and procedures is based in part upon certain reasonable assumptions about the
likelihood of future events, and there can be no reasonable assurance that any
design of disclosure controls and procedures will succeed in achieving its
stated goals under all potential future conditions, regardless of how remote,
but the Company's principal executive and financial officers have concluded that
the Company's disclosure controls and procedures are, in fact, effective at a
reasonable assurance level.
In addition, there have been no changes in the Company's internal control over
financial reporting (to the extent that elements of internal control over
financial reporting are subsumed within disclosure controls and procedures)
identified in connection with the evaluation described in the above paragraph
that occurred during the Company's last fiscal quarter, that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is currently not engaged in any material legal proceedings. From
time to time, the Bank is a party to legal proceedings within the ordinary
course of business wherein it enforces its security interest in loans, and other
matters of similar nature.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's Annual Meeting of Stockholders held on May 15, 2003, the
following matter was submitted to a vote of stockholders with the following
results:
A. The election of three directors:
Name For Withheld
---- --------- --------
Three-year terms:
Edmund T. Buckman, Jr. 3,560,186 20,525
Frederick N. Holscher 3,576,686 4,025
Frederick H. Howdy 3,575,186 5,525
ITEM 5. OTHER INFORMATION
Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibits: The following exhibit is filed herewith:
Exhibit
Number Title
------ -----
31 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002
32 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
B. Reports on Form 8-K. A Form 8-K was filed on April 17, 2003 under Item
7. Financial Statements, Pro Forma Financial Information and Exhibits,
and under Item 9. Regulation FD Disclosure reporting the Company
issued a press release announcing its unaudited financial results for
the three months ended March 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FIRST SOUTH BANCORP, INC.
/s/ William L. Wall
-----------------------------
William L. Wall
Executive Vice President
Chief Financial Officer
(Principal Financial Officer)
/s/ Kristie W. Hawkins
-----------------------------
Kristie W. Hawkins
Controller
Treasurer
(Principal Accounting Officer)
Date: August 12, 2003
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