SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

 

110 Thomas Johnson Drive

Frederick, Maryland 21702

(Address of principal executive offices) (Zip Code)

 

(888) 694-4170

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

NONE

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock ($5 par value)

(Title of class)

 

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 ý  No o

 

Common Stock of 10,785,723 shares outstanding as of July 18, 2003.

 

 

Form 10-Q

TABLE OF CONTENTS

 

PART I	Financial Information
Item 1.	Financial Statements
	Consolidated Statements of Income (Unaudited)
	Consolidated Balance Sheets (Unaudited)
	Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income (Unaudited)
	Consolidated Statements of Cash Flows (Unaudited)
	Notes to Financial Statements (Unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
	Summary Financial Data
	Overview
	Earnings Performance
	Net Interest Income
	Provision for Credit Losses
	Noninterest Income
	Noninterest Expense
	Balance Sheet Analysis
	Securities Available for Sale
	Loan Portfolio
	Nonaccrual Loans and Other Assets
	Nonaccrual Loans and Other Real Estate Owned
	Allowance for Credit Losses
	Deposits
	Capital Adequacy/Ratios
	Contractual Obligations and Other Commitments
	Asset/Liability and Market Risk Management
	Capital Management
Item 3.	Quantitative and Qualitative Disclosure about Market Risk
Item 4.	Controls and Procedures
	Factors that May Affect Future Results
PART II	Other Information
Item 4.	Submission of Matters to a Vote of Security Holders
Item 6.	Exhibits and Reports on Form 8-K
Signature

 

The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q.  The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with F&M Bancorp’s 2003 Annual Report on Form 10-K.

 

2

 

PART I – FINANCIAL INFORMATION

F&M BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 

		Quarter ended June 30,						Six months ended June 30,
(in thousands, except shares)		2003			2002			2003			2002
INTEREST INCOME
Loans		$	20,080		$	20,447		$	40,571		$	41,439
Loans held for sale		368			203			664			495
Securities available for sale		5,994			7,011			12,350			13,554
Other interest income		101			158			194			294
Total interest income		26,543			27,819			53,779			55,782
INTEREST EXPENSE
Deposits		6,301			8,071			12,751			16,920
Short-term borrowings		333			329			700			641
Long-term borrowings		931			828			1,876			1,607
Total interest expense		7,565			9,228			15,327			19,168
NET INTEREST INCOME		18,978			18,591			38,452			36,614
Provision for credit losses		700			150			1,225			975
Net interest income after provision for credit losses		18,278			18,441			37,227			35,639
NONINTEREST INCOME
Service charges on deposit accounts		2,285			2,282			4,398			4,478
Insurance income		3,201			2,540			6,141			5,190
Mortgage banking fees		1,247			814			1,925			1,651
Trust and investment fees		760			910			1,476			1,831
Gains on sales of securities		50			—			516			—
Gains on sales of property		189			36			225			122
Other operating income		1,514			1,357			2,896			2,672
Total noninterest income		9,246			7,939			17,577			15,944
NONINTEREST EXPENSE
Salaries		7,731			7,549			15,063			14,663
Incentive compensation		968			573			1,814			1,202
Employee benefits		1,721			1,459			3,158			3,373
Occupancy and equipment expense		2,537			2,625			4,768			5,099
Core deposit intangible		237			224			483			439
Other operating expense		3,579			4,765			8,184			9,188
Total noninterest expenses		16,773			17,195			33,470			33,964
INCOME BEFORE INCOME TAX EXPENSE		10,751			9,185			21,334			17,619
Income tax expense		3,230			3,069			6,614			5,726
NET INCOME		$	7,521		$	6,116		$	14,720		$	11,893
EARNINGS PER COMMON SHARE
Earnings per common share		$	0.70		$	0.57		$	1.37		$	1.10
Diluted earnings per common share		$	0.68		$	0.56		$	1.35		$	1.09
DIVIDENDS PAID PER COMMON SHARE		$	0.29		$	0.28		$	0.58		$	0.56
Average common shares outstanding		10,772,543			10,814,183			10,755,483			10,833,329
Diluted average common shares outstanding		11,017,292			10,877,815			10,942,118			10,895,311

 

3

 

F&M BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (Unaudited)

 

(in thousands, except shares)		June 30, 2003			December 31, 2002			June 30, 2002
ASSETS
Cash and due from banks		$	81,916		$	81,444		$	58,732
Federal funds sold		143			232			8,327
Total cash and cash equivalents		82,059			81,676			67,059
Loans held for sale		24,110			28,722			10,655
Securities available for sale		651,710			618,452			606,826
Nonmarketable equity securities		7,274			6,780			6,866
Loans		1,331,509			1,305,348			1,171,946
Less: Allowance for credit losses		(12,980		)	(13,668		)	(13,999		)
Net loans		1,318,529			1,291,680			1,157,947
Bank premises and equipment, net		36,109			36,024			34,751
Other real estate owned, net		422			414			354
Interest receivable		8,572			9,513			8,982
Core deposit intangible		1,403			1,886			2,378
Mortgage servicing rights		274			580			898
Cash value of life insurance		12,408			12,109			11,256
Other assets		5,936			7,150			8,132
Total assets		$	2,148,806		$	2,094,986		$	1,916,104
LIABILITIES & SHAREHOLDERS’ EQUITY
Liabilities:
Deposits:
Noninterest-bearing		$	307,694		$	264,965		$	260,082
Interest-bearing		1,386,763			1,330,174			1,289,159
Total deposits		1,694,457			1,595,139			1,549,241
Short-term borrowings		166,012			219,060			96,437
Long-term borrowings		77,692			78,023			78,342
Accrued taxes and other liabilities		15,421			18,508			14,622
Total liabilities		1,953,582			1,910,730			1,738,642
Shareholders’ equity:
Common stock, $5 par value; authorized 50,000,000 shares; issued 10,784,383 shares, 10,862,257 shares, and 10,884,140 shares, respectively		53,922			53,646			53,882
Surplus		71,720			70,598			72,121
Retained earnings		58,352			50,179			43,657
Accumulated other comprehensive income		11,230			9,833			7,802
Total shareholders’ equity		195,224			184,256			177,462
Total liabilities and shareholders’ equity		$	2,148,806		$	2,094,986		$	1,916,104

 

4

 

F&M BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’

EQUITY AND COMPREHENSIVE INCOME (Unaudited)

 

(in thousands, except per share data)		Number of shares		Common stock			Surplus			Retained earnings			Accumulated other comprehensive (loss) income			Total
Balance at December 31, 2001		10,862,257		$	54,311		$	75,147		$	34,782		$	3,185		$	167,425
Comprehensive income:
Net income		—		—			—			11,893			—			11,893
Other comprehensive income net of tax:
Net unrealized gains on securities		—		—			—			—			4,617			4,617
Total comprehensive income																16,510
Dividend reinvestment plan		—		—			—			(24		)	—			(24		)
Cash dividends declared ($.56 per share)		—		—			—			(2,985		)	—			(2,985		)
Stock consideration for options exercised		(596	)	(3		)	(674		)	(9		)	—			(686		)
Stock options exercised		30,484		152			469			—			—			621
Stock repurchase and retirement		(115,830	)	(578		)	(2,821		)	—			—			(3,399		)
Net change		(85,942	)	(429		)	(3,026		)	8,875			4,617			10,037
Balance at June 30, 2002		10,776,315		$	53,882		$	72,121		$	43,657		$	7,802		$	177,462
Balance at December 31, 2002		10,729,304		53,646			70,598			50,179			9,833			184,256
Comprehensive income:
Net income		—		—			—			14,720			—			14,720
Other comprehensive income net of tax:
Net unrealized gains on securities available for sale, net of reclassification of $317 of net gains included in net income		—		—			—			—			1,397			1,397
Total comprehensive income																16,117
Dividend reinvestment plan		—		—			—			—			—			—
Cash dividends declared ($.58 per share)		—		—			—			(6,236		)	—			(6,236		)
Stock consideration for options exercised		(9,572	)	(47		)	(62		)	(311		)	—			(420		)
Stock options exercised		64,651		323			1,184			—			—			1,507
Stock repurchase and retirement		—		—			—			—			—			—
Net change		55,079		276			1,122			8,173			1,397			10,968
Balance at June 30, 2003		10,784,383		$	53,922		$	71,720		$	58,352		$	11,230		$	195,224

 

5

 

F&M BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited)

 

		Six months ended June 30,
(in thousands)		2003			2002
Cash Flows from Operating Activities
Net Income		$	14,720		$	11,893
Adjustments to reconcile net income to net cash provided by operating activities
Provision for credit losses		1,225			975
Depreciation and amortization		1,480			1,939
Amortization of intangibles		789			591
Net premium amortization on investment securities		1,254			1,349
Decrease in interest receivable		941			435
Decrease in interest payable		(18		)	(407		)
Gain on sales of property		(225		)	(122		)
Gain on sales of securities		(516		)	—
Decrease in loans held for sale		4,612			18,124
(Increase) decrease in other assets		(247		)	372
Decrease in other liabilities		(3,068		)	(1,923		)
Gain on sales of loans		(1,925		)	(1,721		)
Net cash provided by operating activities		19,022			31,505
Cash Flows from Investing Activities
Purchases of investment securities available for sale		(253,846		)	(159,741		)
Proceeds from sales/maturities of securities available for sale		221,915			105,340
Net Increase in loans		(26,327		)	(8,998		)
Purchases of premises and equipment		(1,745		)	(1,126		)
Proceeds from sales of property		575			481
Net cash used in investing activities		(59,428		)	(64,044		)
Cash Flows from Financing Activities
Net increase in noninterest-bearing deposits, interest-bearing checking, savings and money market accounts		92,705			74,231
Net increase (decrease) in certificates of deposit		6,614			(41,058		)
Net decrease in short-term borrowings		(53,050		)	(21,108		)
Gross debt issued in long-term borrowings		—			15,000
Gross debt maturitiess in long-term borrowings		(331		)	(102		)
Cash dividends paid		(6,236		)	(2,984		)
Dividend reinvestment plan		—			(24		)
Proceeds from issuance of common stock		1,087			(65		)
Common stock purchased and retired		—			(3,400		)
Net cash provided by financing activities		40,789			20,490
Net increase (decrease) in cash and cash equivalents		383			(12,049		)
Cash and cash equivalents at beginning of year		81,676			79,108
Cash and cash equivalents at end of period		$	82,059		$	67,059
Supplemental Disclosures of Cash Flow Information
Cash payments for interest		$	15,346		$	19,574
Cash payments for income tax		$	7,581		$	5,711
Non-Cash Investing and Financing Activities
Fair value adjustment for securities available for sale, net of income taxes		$	1,397		$	4,617

 

6

 

F&M BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1. Summary of Significant Accounting Policies

 

F&M Bancorp and Subsidiaries (consolidated) (the Bancorp) is a diversified financial services company providing banking, insurance, investments, mortgage banking and consumer finance through banking branches, the internet and other distribution channels to consumers and businesses located primarily within the State of Maryland.  F&M Bancorp (the Parent) is a bank holding company.

 

The accounting and reporting policies and practices of the Bancorp conform with accounting principles generally accepted in the United States of America (“GAAP”) and prevailing practice within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements and income and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in the financial statements for prior years have been reclassified to conform with the current financial statement presentation.

 

Descriptions of the significant accounting policies of F&M Bancorp and Subsidiaries (the Bancorp) are included in Note 1 (Summary of Significant Accounting Policies) to the audited consolidated financial statements included in the Bancorp’s 2002 Annual Report on Form 10-K. There have been no significant changes to these policies.

 

The table below reflects the fair value-based accounting of stock options under the provisions of FASB Statement No. 148, Accounting for Stock-Based Compensation.

 

		Quarter ended June 30,						Six months ended June 30,
(in thousand, except per share amounts)		2003			2002			2003			2002
Net income, as reported		$	7,521		$	6,116		$	14,720		$	11,893
Add: Stock-based employee compensation expense included in reported net income, net of related tax effect		—			—			—			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect		(151		)	(47		)	(291		)	(81		)
Pro forma net income		$	7,370		$	6,069		$	14,429		$	11,812
Earnings per common share
As reported		0.70			0.57			1.37			1.10
Pro forma		0.68			0.56			1.34			1.09
Diluted earnings per common share
As reported		0.68			0.56			1.35			1.09
Pro forma		0.67			0.56			1.32			1.08

 

2. Business Combinations

 

On July 8, 2003, the Board of Governors of the Federal Reserve System approved the application by Mercantile Bankshares Corporation to merge with F&M Bancorp. The Federal Reserve Board also approved the application by F&M Bancorp’s bank subsidiary, Farmers & Mechanics Bank, to merge with Fredericktown Bank and Trust, a Mercantile Bankshares subsidiary. The merger between Mercantile Bankshares and F&M Bancorp is subject

 

7

 

to approval by state regulators and the shareholders of F&M Bancorp. The shareholders meeting to approve the F&M Bancorp transaction will occur on August 6, 2003. Provided that state bank regulators and shareholders approve the transaction, it is expected that the merger closing for the holding company will occur on August 12, 2003.

 

3. Earnings Per Share

 

The table below shows dual presentation of earnings per common share and diluted earnings per common share and a reconciliation of the numerator and denominator of both earnings per common share calculations.

 

		Quarter ended June 30,						Six months ended June 30,
(in thousands except per share data)		2003			2002			2003			2002
Net income		$	7,521		$	6,116		$	14,720		$	11,893
Basic EPS
Average Shares		10,772,543			10,814,183			10,755,483			10,833,329
EPS		$	0.70		$	0.57		$	1.37		$	1.10
Dilutive shares
Stock options		244,749			63,632			186,635			61,982
EPS		$	0.02		$	0.01		$	0.02		$	0.01
Diluted EPS
Average Shares including options		11,017,292			10,877,815			10,942,118			10,895,311
EPS		$	0.68		$	0.56		$	1.35		$	1.09

 

4. Operating Segments

 

Operating segments as defined by SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information are components of an enterprise with separate financial information.  The component engages in business activities, from which it derives revenues and incurs expenses and whose operating result’s management relies on for decision making and performance assessment. The Bancorp, as defined by this standard, does not have any segment whose revenues, reported profit and loss, or assets are 10% or more of the combined revenues of all reporting segments.

 

5. Intangible Assets

 

The gross carrying amount of intangible assets and the associated accumulated amortization at June 30 is presented in the following table.

 

		June 30, 2003
(in thousands)		Gross Carrying amount			Accumulated amortization			Valuation allowance			Net intangible assets
Amortized intangible assets:
Core deposit intangible		$	8,565		$	7,162		$	—		$	1,403
Mortgage servicing rights		1,757			1,120			363			274
Total		$	10,322		$	8,282		$	363		$	1,677

 

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		June 30, 2002
(in thousands)		Gross carrying amount			Accumulated amortization			Valuation allowance			Net intangible assets
Amortized intangible assets:
Core deposit intangible		$	8,565		$	6,187		$	—		$	2,378
Mortgage servicing rights		1,757			859			—			898
Total		$	10,322		$	7,046		$	—		$	3,276

 

The projections of amortization expense shown below for mortgage servicing rights are based on asset balances and the interest rate environment as of June 30, 2003. Future amortization expense may be significantly different depending upon changes in the mortgage servicing portfolio, mortgage interest rates and market conditions.

 

The following table shows the current period and estimated future amortization expense for amortized intangible assets. Core deposit intangibles are amortized on useful lives of up to 15 years. The Bancorp reviews other intangible assets for impairment quarterly (except mortgage servicing rights, which are reviewed monthly), or whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. For those intangible assets subject to amortization, impairment is indicated if the sum of undiscounted estimated future net cash flow is less than the carrying amount of the asset. Impairment is recognized by accelerating the write off of the asset to the extent that the carrying value exceeds the estimated fair value.

 

(in thousands)		Core deposit intangibles			Mortgage servicing rights			Total
Six months ended June 30, 2003 (actual)		$	419		$	130		$	549
Six months ended December 31, 2003 (estimated)		470			130			600
Estimate for year ended December 31,
2004		790			144			934
2005		143			—			143
2006		—			—			—
2007		—			—			—
2008		—			—			—

 

6. Commitments

 

Various commitments to extend credit (lines of credit) are made in the normal course of the banking business. Total unused lines of credit approximated $297.2 million, $154.1 million and $255.3 million at June 30, 2003, December 31, 2002 and June 30, 2002, respectively. In addition, letters of credit are issued for the benefit of customers. Outstanding letters of credit were $29.1 million at June 30, 2003, $23.8 million at December 31,

 

9

 

2002 and $23.9 million at June 30, 2002 in accordance with FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. A liability of $90 thousand for performance under standby letters of credit was recorded as of June 30, 2003. All standby letters of credit are supported by collateral or recourse provisions that are expected to cover the majority of these obligations. The fees received for issuing letters of credit are deferred and amortized over the life of the commitment.

 

7. Derivative Instruments and Hedging Activities

 

FASB Statement No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, and FASB Statement No. 138 (SFAS No. 138), Accounting for Certain Derivative Instruments and Certain Hedging Activities – an amendment to FASB Statement No. 133, collectively (SFAS No. 133) establishes accounting and reporting standards for derivative instruments and for hedging activities. The Bancorp enters into interest rate locks with mortgage loan customers and forward commitments to sell loans to mortgage investors. These are considered derivative instruments under SFAS No. 133.

 

All derivative instruments are recognized on the balance sheet at fair value. On the date the Bancorp enters into a derivative contract, the Bancorp designates the derivative instrument as (1) a hedge of the fair value of a recognized asset or liability or of a unrecognized firm commitment (“fair value hedge”), or (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”). For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability or of an unrecognized firm commitment attributable to the hedged risk are recorded in current period net income in the same financial statement category of the hedged item. For a cash flow hedge, changes in the fair value of the derivative instrument to the extent that it is effective are recorded in other comprehensive income within stockholders’ equity and subsequently reclassified to net income in the same period(s) that the hedged transaction impacts net income in the same financial statement category as the hedged item.

 

The fair value of derivative instruments was $437 thousand in loans held for sale, $337 thousand in other assets, and $774 thousand in accrued expenses and other liabilities at June 30, 2003.

 

8.  Recent Accounting Standards

 

In April 2003, the FASB issued SFAS No. 149 (SFAS No. 149), Amendment of Statement No.133 on Derivative Instruments and Hedging Activities.  SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133.  In particular, SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. This Statement is generally effective for contracts entered into or modified after June 30, 2003 and is not expected to have a material impact on the Bancorp’s financial statements.

 

In May 2003, the FASB issued SFAS No. 150 (SFAS No. 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity.  This Statement is not expected to have a material impact on the Bancorp’s financial statements.

 

On January 17, 2003, FASB issued FASB Interpretation No. 46 Consolidation of Variable Interest Entities – an interpretation of ARB No. 51 (FIN 46).  FIN 46 is applicable immediately to all entities with variable interests in variable interest entities created after January 31, 2003.  For the Bancorp, FIN 46 is applicable beginning June 15, 2003 to any variable interest entity acquired before February 1, 2003.  The Bancorp is currently in the process of evaluating the impact of FIN 46.

 

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

SUMMARY FINANCIAL DATA

 

		Quarter ended						% Change June 30, 2003 from
(in thousands, except per share amounts)		Jun 30, 2003		Mar 31, 2003		Jun 30, 2002		Mar 31, 2003		Jun 30, 2002
For the Period
Net income		7,521		7,199		6,116		4	%	23	%
Diluted earnings per common share		0.68		0.66		0.56		3		21
Profitability ratios (annualized)
Net income to average total assets (ROA)		1.44	%	1.42	%	1.30	%	2		11
Net income applicable to common stock to average common stockholders equity (ROE)		15.59	%	15.59	%	14.14	%	—		10
Efficiency ratio (1)		58.15	%	58.64	%	63.19	%	(1	)	(8	)
Dividends paid per common share		0.29		0.29		0.28		—		4
Average common shares outstanding		10,772,543		10,738,234		10,814,183		—		—
Diluted average common shares outstanding		11,017,292		10,843,032		10,877,815		2		1
Total revenue		28,224		27,804		26,530		2		6
Average loans		1,316,390		1,306,446		1,166,373		1		13
Average assets		2,093,050		2,056,449		1,882,011		2		11
Average deposits		1,647,090		1,595,580		1,528,191		3		8
Net interest margin		3.95	%	4.19	%	4.36	%	(6	)	(9	)
At Period End
Securities available for sale		651,710		627,633		606,826		4		7
Loans		1,331,509		1,317,789		1,171,946		1		14
Allowance for credit losses		(12,980	)	(13,673	)	(13,999	)	(5	)	(7	)
Assets		2,148,806		2,098,469		1,916,104		2		12
Deposits		1,694,457		1,649,633		1,549,241		3		9
Shareholders’ equity		195,224		189,717		177,462		3		10
Tier 1 capital (2)		182,564		177,491		167,161		3		9
Total capital (2)		196,507		191,952		181,160		2		8
Capital ratios
Shareholders’ equity to assets		9.09	%	9.04	%	9.26	%	—		(2	)
Risk-based capital (2)
Tier 1 capital		12.19	%	11.85	%	12.20	%	3		—
Total capital		13.12	%	12.82	%	13.24	%	2		(1	)
Leverage (2)		8.73	%	8.64	%	8.81	%	1		(1	)
Book value per common share		18.12		17.67		16.47		3		10
Staff (active, full-time equivalent)		718		728		715		(1	)	—
Common Stock Price
High		50.85		44.94		35.66		13		43
Low		43.87		28.45		26.21		54		67
Period end		49.23		44.01		35.28		12		40
Credit Quality
Nonperforming assets/total assets		0.10	%	0.12	%	0.13	%	(17	)	(23	)
Net chargeoffs/total loans		0.40		0.16		0.08		153		400
Allowance for credit losses/total loans		0.97		1.05		1.20		(8	)	(19	)

 

(1)          The efficiency ratio is defined as noninterest expense divided by the total revenue (net interest income and noninterest income).

(2)          See the Capital Adequacy/Ratios section for additional information.

 

11

 

Statements made in this document, other than statements of historical information, are forward-looking statements that are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may sometimes be identified by words such as “expect”, “may”, “looking forward”, “we plan”, “we believe”, “are planned”, “could be” and “currently anticipate”. Although we believe these statements, as well as other oral and written forward-looking statements made by us from time to time, to be true and reasonable, we can give no assurance that these plans, intentions or expectations will be achieved. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in our other filings with the SEC, and in this document under the heading “Risk Factors”, beginning in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. We caution that the risks and factors discussed below and in such filings are not exclusive. We do not undertake to update any forward-looking statement that may be made from time to time by or on behalf of the Bancorp.

 

OVERVIEW

 

F&M Bancorp is the registered bank holding company for Farmers & Mechanics Bank (the “Bank”), headquartered in Frederick, Maryland. The Bancorp is a $2.1 billion diversified financial services company providing banking, insurance, wealth management, and mortgage banking through banking branches, the internet and other distribution channels to consumers and commercial businesses. The Bank operates 48 community offices in Frederick, Howard, Baltimore, Montgomery, Washington, Carroll and Alleghany Counties in Maryland, together with two insurance agencies.

 

Certain amounts in the financial review for prior quarters have been reclassified to conform with the current financial statement presentation.

 

Net income for the second quarter of 2003 reached a record $7.5 million, an increase of 23% compared with earnings of $6.1 million for the second quarter of 2002. Earnings per diluted share for the second quarter of 2003 reached a record $0.68 per share, a 21% increase over the prior year’s $0.56 per share results. Return on average assets (ROA) was 1.44% and return on average equity (ROE) was 15.59% for the second quarter of 2003, compared with 1.30% and 14.14%, respectively, for the same period of 2002.

 

Net income for the first six months of 2003 reached $14.7 million, or $1.35 per diluted share, compared with $11.9 million, or $1.09 per diluted share, for the first six months of 2002. ROA was 1.43% in the first six months of 2003, compared with 1.28% for the first six months of 2002. ROE was 15.59% in the first six months of 2003, compared with 13.93% for the same period of 2002.

 

Net interest income on a taxable-equivalent basis was $19.6 million for the second quarter of 2003 and $39.7 million for the first six months of 2003 compared with $19.3 million and $38.2 million for the same periods of 2002. The Bancorp’s net interest margin was 3.95% for the second quarter and 4.07% for the first six months of 2003, compared with 4.36% and 4.35% for the same periods of 2002.

 

Noninterest income totaled $9.2 million and $17.6 million for the second quarter and the first six months of 2003, respectively, compared with $7.9 million and $15.9 million for the same periods of 2002.

 

Noninterest expense totaled $16.8 million and $33.5 million for the second quarter and the first six months of 2003, respectively, compared with $17.2 million and $34.0 million for the same periods of 2002.

 

12

 

The provision for credit losses was $700 thousand and $1.2 million in the second quarter and the first six months of 2003, respectively, compared with $150 thousand and $975 thousand in the same periods in 2002. During the second quarter of 2003, net charge-offs were $1.4 million, or .42% of average loans outstanding (annualized), compared with $283 thousand, or .08%, in the second quarter of 2002. The provision for credit losses during the quarter represented approximately 50 percent of net charge-offs. The allowance for credit losses was $13.0 million, or .97% of total loans, at June 30, 2003, compared with $13.7 million, or 1.08%, at December 31, 2002 and $14.0 million, or 1.19% at June 30, 2002.

 

At June 30, 2003, total nonperforming assets were $2.2 million, or .10% of total assets, compared with $2.5 million, or .12%, at December 31, 2002 and $2.5 million, or .13%, at June 30, 2002.  In this foreclosed assets amounted to $422 thousand at June 30, 2003, $414 thousand at December 31, 2002 and $354 thousand at June 30, 2002.

 

At June 30, 2003, the ratio of shareholders’ equity to total assets was 9.09%, compared with 9.26% at June 30, 2002. The Bancorp’s total risk-based capital (RBC) ratio at June 30, 2003 was 13.12% and its Tier 1 RBC ratio was 12.19%, exceeding the minimum regulatory guidelines of 8% and 4%, respectively for bank holding companies. The Bancorp’s ratios at June 30, 2002 were 13.24% and 12.20%, respectively. The Bancorp’s leverage ratio was 8.73% at June 30, 2003 and 8.81% at June 30, 2002, exceeding the minimum regulatory guideline of 3% for bank holding companies.

 

CRITICAL ACCOUNTING POLICIES

 

Reserve for Credit Losses

 

The Bancorp has an established process to determine the adequacy of the allowance for credit losses which assesses the risk inherent in its portfolio. This process provides an allowance consisting of two components, allocated and unallocated. To arrive at the allocated component of the allowance, the Bancorp combines estimates of the allowance needed for loans analyzed individually (including impaired loans subject to Statement of Financial Accounting Standards No. 114 (SFAS No. 114), Accounting by Creditors for Impairment of a Loan) and loans analyzed on a pool basis.

 

The determination of the allocated allowance for portfolios of larger commercial and commercial real estate loans involves a review of individual higher-risk transactions, focusing on the accuracy of loan grading, assessments of specific loss indicators, and in some cases, strategies for resolving problem credits. These considerations are supplemented by the application of loss factors delineated by individual loan grade to the existing distribution of risk exposures, which provides an assessment of inherent losses across the entire wholesale lending portfolio segment which respond to shifts in portfolio risk indicators. The loss factors used for this analysis have been derived from tracking historical loss experience by asset loan grade over a 5-year period. The loan loss allocations arrived at through this factor methodology are adjusted by management’s judgement concerning the effect of recent economic events on portfolio performance.

 

In the case of most homogeneous portfolios, such as consumer loans, residential mortgage loans, and some segments of small business lending, the determination of the allocated allowance is performed in the aggregate, or pooled, level. For such portfolios, the risk assessment process captures the net charge-offs experienced over the past year. The historic loss factors are then considered for either positive or negative adjustment by management to reflect the current risk inherent in the portfolios as of the date presented. These adjustments in the loss factors are tied to management’s evaluation of a number of factors including: 1) changes in the trend of the volume and severity of past due, classified and non-accrual assets; 2) changes in the nature and volume of the portfolio; 3) changes in lending policies, underwriting standards, or collection practices; and 4) changes in the experience, ability, depth of lending management and staff.

 

13

 

While coverage of one year’s losses is often adequate (particularly for homogeneous pools of loans), the time period covered by the allowance may vary by portfolio, based on the Bancorp’s best estimate of the inherent losses in the entire portfolio as of the evaluation date. To mitigate the imprecision inherent in most estimates of expected credit losses, the allocated component of the allowance is supplemented by an unallocated component. The unallocated component includes management’s judgmental determination of the amounts necessary for concentrations, economic uncertainties and other subjective factors; correspondingly, the relationship of the unallocated component to the total allowance for credit losses may fluctuate from period to period.  Although management has allocated a portion of the allowance to specific loan categories, the adequacy of the allowance must be considered in its entirety.

 

The Bancorp’s determination of the level of the allowance and, correspondingly, the provision for credit losses rests upon various judgements and assumptions, including general economic conditions, loan portfolio composition, prior loan loss experience and the Bancorp’s ongoing examination process and that of its regulators. The Bancorp has an internal risk analysis and review staff that continuously reviews loan quality and reports the results of its examinations to the President and Chief Executive Officer, the Board of Directors and its Audit Committee. Such reviews also assist executive management in establishing the level of the allowance.

 

The Bancorp is examined annually by the Federal Reserve Board and the State of Maryland, including specific segments of the loan portfolio.

 

The Bancorp considers the allowance for credit losses of $13.0 million adequate to cover probable losses inherent in loans, loan commitments and standby and other letters of credit at June 30, 2003.

 

Valuation of Mortgage Servicing Rights

 

The Bancorp recognizes as assets the right to service mortgage loans for others that were retained upon sales of loan originations. For purposes of evaluating and measuring impairment of mortgage servicing rights, the Bancorp stratifies its portfolio on the basis of certain risk characteristics including loan type and note rate. Based upon current fair values, mortgage servicing rights are periodically assessed for impairment. Any such indicated impairment is recognized in income, during the period in which it occurs, in a mortgage servicing valuation account which is adjusted each subsequent period to reflect any increase or decrease in the indicated impairment. Mortgage servicing rights are amortized over the period of estimated net servicing income and take into account appropriate prepayment assumptions.

 

Key economic assumptions used in measuring any potential impairment of the servicing rights include the prepayment speed of the underlying mortgage loans, the weighted-average life of the loan and the discount rate. The primary risk of material changes to the value of the mortgage servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speed. The Bancorp monitors this risk and adjusts its valuation allowance as necessary to adequately reserve for any probable impairment in the portfolio. By adjusting the allowance, as necessary each quarter, the Bancorp mitigates its risk to material adverse changes in the value of the portfolio. See further discussion in Note 1 and Note 16 to Financial Statements of F&M Bancorp’s 2002 Annual Report on Form 10-K.

 

Valuation of Identifiable Intangible Assets

 

Identifiable intangible assets primarily consist of core deposit intangibles acquired in branch office acquisitions. Core deposit intangible assets represent the excess of the fair value of liabilities assumed over the fair value of tangible assets acquired in branch office acquisitions. These intangible assets are amortized on an accelerated basis over an original life of 10 to 15 years. The Bancorp reviews its intangible assets periodically for other-than-temporary impairment. If such impairment is indicated, impairment is recognized by accelerating the amortization of the asset to the extent that the carrying value exceeds the estimated fair value.

 

14

 

EARNINGS PERFORMANCE

 

NET INTEREST INCOME

 

Net interest income on a taxable-equivalent basis was $19.6 million in second quarter 2003, up 1 percent from second quarter of last year. Net interest income is affected by both changes in interest rates and the composition of interest-earning assets and interest-bearing liabilities. Net interest income benefited from continued growth in earning asset levels, up 12% over the second quarter of 2002. Average investment securities increased 9% to $634 million compared to $580 million in the prior year, and increased 4% since last quarter. Average total loans increased 13% to $1.316 billion compared to the prior year and 1% (3% annualized) from the first quarter of 2003. The residential real estate portfolio and commercial real estate portfolio reflect strong growth, up 33% and 27%, respectively from last year. The growth in these portfolios was slightly offset by a 14% reduction in the consumer loan portfolio, which reflects higher prepayments on the indirect automobile portfolio. Total average interest-bearing deposits increased 6% to $1.362 billion in the second quarter 2003 from $1.281 billion a year ago. For the same period, total average noninterest-bearing deposits increased by 15% to $285 million from $247 million.

 

Offsetting this growth was the current low interest rate environment, which caused a decline in net interest margin from 4.36 percent a year ago to 3.95 percent in second quarter 2003. Bancorp is asset sensitive, with assets repricing more quickly than liabilities in response to changes in interest rates. As a result, Bancorp’s net interest margin tends to compress and growth in net interest income tends to slow in a falling interest rate environment, which has been occurring since the first quarter of 2001. Average funding costs declined 66 basis points in second quarter 2003, while average net asset yields declined 96 basis points.

 

For the six months ended 2003 taxable-equivalent net interest income was $39.7 million, an increase of 4% over the same period of 2002.  The net interest margin for the first half of 2003 decline 28 basis to 4.07 percent from 4.35 percent in the first half of 2002.

 

Individual components of net interest income and the net interest margin are presented in the rate/yield table on the following pages.

 

15

 

AVERAGE BALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENT BASIS) (1)

 

		Quarter ended Jun 30,
		2003								2002
(in thousands)		Average balance			Interest income/ expense			Yields/ rates		Average balance			Interest income/ expense			Yields/ rates
ASSETS
Interest earning assets:
Short-term funds		$	5,821		$	17		1.17	%	$	13,183		$	57		1.73	%
Loans held for sale		25,666			368			5.75		11,797			203			6.90
Securities available for sale (2)(4);
U.S. Treasury and federal agencies		74,194			595			3.22		52,694			577			4.39
U.S. States and political subdivisions		100,259			1,595			6.38		115,430			1,954			6.79
Mortgage-backed securities		409,320			3,949			3.87		387,253			4,898			5.07
Other securities		49,986			413			3.31		25,114			265			4.23
Total investment securities		633,759			6,552			4.15		580,491			7,694			5.32
FHLB / Federal Reserve stock		7,274			84			4.63		6,866			101			5.90
Portfolio Loans (3)(4):
Commercial		172,180			2,548			5.94		159,370			2,648			6.67
Residential real estate		358,573			5,002			5.60		269,459			4,522			6.73
Commercial real estate		422,474			6,754			6.41		333,822			6,142			7.38
Real estate construction		107,774			1,439			5.36		107,083			1,532			5.74
Consumer installment		255,389			4,399			6.91		296,639			5,677			7.68
Total loans		1,316,390			20,142			6.14		1,166,373			20,521			7.06
Total interest-earning assets		1,988,910			27,163			5.48		1,778,710			28,576			6.44
Total noninterest-earning assets		104,140								103,301
Total assets		$	2,093,050							$	1,882,011
LIABILITIES
Interest bearing liabilities:
Interest bearing deposits
Savings		$	239,515		$	472		0.79		$	211,440		$	627		1.19
Checking		213,546			156			0.29		204,478			281			0.55
Money market accounts		287,557			731			1.02		272,194			1,120			1.65
Certificates of deposit		621,559			4,941			3.19		592,966			6,043			4.09
Total interest bearing deposits		1,362,177			6,300			1.86		1,281,078			8,071			2.53
Short-term borrowings		159,126			333			0.84		94,116			329			1.40
Long-term borrowings		77,883			931			4.79		71,983			828			4.61
Total interest bearing liabilities		1,599,186			7,564			1.90	%	1,447,177			9,228			2.56	%
Non-interest bearing liabilities:
Demand deposits		284,913								247,113
Other liabilities		15,508								14,276
Total non-interest bearing liabilities		300,421								261,389
Shareholders’ equity		193,443								173,445
Total liabilities and shareholders’ equity		$	2,093,050							$	1,882,011
Net interest income and net interest margin on a taxable-equivalent basis (4)					$	19,599		3.95	%				$	19,348		4.36	%

 

(1)          The average prime rate of the Bancorp was 4.24% and 4.75% for the quarters ended June 30, 2003 and 2002, respectively. The average three-month London Interbank Offered Rate (LIBOR) was 1.23% and 1.92% for the quarters ended June 30, 2003 and 2002, respectively.

(2)          Yields are based on amortized cost balances computed on a settlement day basis.

(3)          Loan fee income is included in the interest income calculation, and nonaccrual loans are included in the average loan base upon which the interest rate earned on loans is calculated.

(4)          Interest and yield on obligations of state and political subdivisions and tax-exempt loans are computed on a taxable equivalent basis using U.S. statutory tax rate of 35 percent.

 

16

 

AVERAGE BALANCES, YIELDS AND RATES PAID (TAXABLE-EQUIVALENT BASIS) (1)

 

		Six months ended June 30,
		2003								2002
(in thousands)		Average balance			Interest income/ expense			Yields/ rates		Average balance			Interest income/ expense			Yields/ rates
ASSETS
Interest earning assets:
Short-term funds		$	4,492		$	26		1.17	%	$	12,824		$	101		1.59	%
Loans held for sale		22,550			664			5.94		15,374			495			6.49
Securities available for sale (2)(4);
U.S. Treasury and federal agencies		79,450			1,362			3.46		47,305			1,039			4.43
U.S. States and political subdivisions		103,277			3,306			6.46		116,906			3,978			6.86
Mortgage-backed securities		393,606			8,106			4.15		387,231			9,694			5.05
Other securities		46,555			733			3.18		15,570			235			3.04
Total investment securities		622,888			13,507			4.37		567,012			14,946			5.32
FHLB / Federal Reserve stock		7,048			168			4.81		6,899			194			5.67
Portfolio Loans (3)(4):
Commercial		172,393			5,050			5.91		159,645			5,470			6.91
Residential real estate		357,502			10,200			5.75		267,017			9,302			7.03
Commercial real estate		414,517			13,464			6.55		334,587			12,352			7.44
Real estate construction		105,814			2,843			5.42		105,758			2,980			5.68
Consumer installment		261,220			9,142			7.06		298,691			11,480			7.75
Total loans		1,311,446			40,699			6.26		1,165,698			41,584			7.19
Total interest-earning assets		1,968,424			55,064			5.64		1,767,807			57,321			6.54
Total noninterest-earning assets		106,427								103,793
Total assets		$	2,074,851							$	1,871,600
LIABILITIES
Interest bearing liabilities:
Interest bearing deposits
Savings		$	233,121		$	970		0.84		$	202,657		$	1,208		1.20
Checking		212,777			318			0.30		201,139			541			0.54
Money market accounts		282,895			1,480			1.05		269,295			2,232			1.67
Certificates of deposit		620,438			9,983			3.24		609,148			12,939			4.28
Total interest bearing deposits		1,349,231			12,751			1.91		1,282,239			16,920			2.66
Short-term borrowings		168,131			700			0.84		98,460			641			1.31
Long-term borrowings		77,918			1,876			4.86		67,730			1,607			4.78
Total interest bearing liabilities		1,595,280			15,327			1.94		1,448,429			19,168			2.67
Non-interest bearing liabilities:
Demand deposits		272,247								236,029
Other liabilities		16,951								14,939
Total non-interest bearing liabilities		289,198								250,968
Shareholders’ equity		190,373								172,203
Total liabilities and shareholders’ equity		$	2,074,851							$	1,871,600
Net interest income and net interest margin on a taxable-equivalent basis (4)					$	39,737		4.07	%				$	38,153		4.35	%

 

(1)          The average prime rate of the Bancorp was 4.25% and 4.75% for the six months ended June 30, 2003 and 2002, respectively. The average six-month London Interbank Offered Rate (LIBOR) was 1.28% and 1.91% for the six months ended June 30, 2003 and 2002, respectively.

(2)          Yields are based on amortized cost balances computed on a settlement day basis.

(3)          Loan fee income is included in the interest income calculation, and nonaccrual loans are included in the average loan base upon which the interest rate earned on loans is calculated.

(4)          Interest and yield on obligations of state and political subdivisions and tax-exempt loans are computed on a taxable equivalent basis using U.S. statutory tax rate of 35 percent.

 

17

 

PROVISION FOR CREDIT LOSSES

 

The provision for credit losses was $700 thousand and $1.2 million in the second quarter and the first six months of 2003, respectively, compared with $150 thousand and $975 thousand in the same periods in 2002. Losses incurred in the second quarter primarily resulted from the charge-off of a single commercial credit and normal levels of consumer portfolio losses. The loan portfolio is well diversified, split nearly equally between consumer and commercial borrowers

 

NONINTEREST INCOME

 

(in thousands)								% Change		Six months ended Jun. 30						% Change
		Quarter ended Jun. 30
		2003			2002					2003			2002
Service charges on deposit accounts		$	2,285		$	2,282		—	%	$	4,398		$	4,478		(2	)%
Trust and investment fees:
Asset management and custody fees		484			607			(20	)	957			1,218			(21	)
Mutual fund and annuity sales fees		276			303			(9	)	519			613			(15	)
Total trust and invesment fees		760			910			(16	)	1,476			1,831			(19	)
Other fees:
Cash network fees		899			832			8		1,681			1,543			9
Charges and fees on loans		71			122			(42	)	166			191			(13	)
Bank-owned life insurance		177			128			38		352			251			40
All other fees		367			275			34		697			687			2
Total other fees		1,514			1,357			12		2,896			2,672			8
Mortgage banking fees:
Origination and other closing fees		410			274			50		734			494			49
Net gains on mortgage loan sales		782			488			60		1,337			1,055			27
Servicing fees, net of amortization		55			52			6		(146		)	102			(243	)
Total mortgage banking		1,247			814			53		1,925			1,651			17
Insurance		3,201			2,540			26		6,141			5,190			18
Net gains (losses) on securities sold		50			—			100		516			—			100
Net gains (losses) on sale of property		189			36			425		225			122			84
Total		$	9,246		$	7,939		16	%	$	17,577		$	15,944		10	%

 

Noninterest income was $9.2 million in the second quarter 2003, up 16 percent from $7.9 million in the second quarter of last year. Fee income growth generated in the second quarter from strong insurance sales were offset by declines in trust and investment fees. Mortgage banking fees remained strong increasing 53 percent to $1.2 million in the second quarter of 2003, up from $814 thousand in the second quarter of 2002. Noninterest income during the second quarter of 2003 also included $189 thousand in gains on sales of properties due primarily to the sale of bank owned real estate, and $50 thousand in realized gains on the sale of investment securities.

 

For the first half of 2003 noninterest income was $17.6 million, up 10 percent from $15.9 million for the same period last year. Mortgage banking fees of $1.9 million in the first six months of 2003 were impacted by a $176 thousand charge recorded for the impairment of mortgage servicing rights. Noninterest income during the first quarter of 2003 also included $516 thousand in gains on sales of securities due to a repositioning of the investment portfolio as part of the ongoing asset/liability management strategy of the Bancorp.

 

18

 

NONINTEREST EXPENSE

 

(in thousands)		Quarter ended Jun. 30						% Change		Six months ended Jun. 30						% Change
		2003			2002					2003			2002
Salaries		$	7,731		$	7,549		2	%	$	15,063		$	14,663		3	%
Incentive compensation		968			573			69		1,814			1,202			51
Employee benefits		1,721			1,459			18		3,158			3,373			(6	)
Occupancy and equipment		2,537			2,625			(3	)	4,768			5,099			(6	)
Professional services		334			465			(28	)	900			954			(6	)
Telecommunications		317			331			(4	)	642			633			1
Advertising and promotions		40			896			(96	)	407			1,399			(71	)
Computer software and maintenance		406			364			12		757			706			7
Stationary and office supplies		286			354			(19	)	652			739			(12	)
Core deposit intangible amortization		237			224			6		483			439			10
Postage		199			226			(12	)	437			486			(10	)
Other real estate owned		—			8			(100	)	1			18			(94	)
All other		1,997			2,121			(6	)	4,388			4,253			3
Total		$	16,773		$	17,195		(2	)%	$	33,470		$	33,964		(1	)%

 

Management views the efficiency ratio (the ratio of noninterest expense to the sum of tax equivalent net interest income and noninterest income) as an important measure of overall operating expense performance and cost management. Bancorp’s efficiency ratio decreased to 58.15% for the quarter compared to 63.19% for the comparable period in 2002. For the six months ended June 30, 2003 and 2002 respectively, the Bancorp’s efficiency ratio was 58.40% and 62.78%.

 

Salary expenses of $7.7 million for the second quarter 2003 were 2% higher then the prior year’s quarter and on a year-to-date basis salary expense increased to $15.1 million or 3% higher than year-to-date 2002 due to normal merit increases. Incentive compensation increased by 69% and 51% from the prior year’s quarter and prior year year-to-date respectively. These increases are directly tied to the Bancorp’s revenue and overall profitability performance as measured by our team-based compensation and sale programs. While employee benefit costs for the second quarter of 2003 were 18% greater that the comparable quarter of 2002, they were 6% lower for the six months ended June 2003 compared to the same period in 2002. A major component of benefits expense is medical insurance which was impacted by lower medical claims incurred during the six month period.

 

Occupancy expenses for the quarter of $2.5 million decreased $88 thousand or 3% compared to the second quarter of 2002, and on a year-to-date basis decreased $331 thousand or 6% from year-to-date 2002 due to branch consolidation efforts initiated in the previous year.

 

Most other categories of expenses for 2003 were reduced from the prior years quarter, and year-to-date in 2002. Significant reductions in professional services and advertising related expenditures were reduced in anticipation of the pending merger.

 

INCOME TAXES

 

Tax expense varies from one period to the next with changes in the level of income before taxes, changes in the amount of tax-exempt income, and the relationship of these changes to each other. The effective income tax expense rate differs from the amount computed at statutory rates primarily due to tax-exempt interest from certain loans and investment securities.

 

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For the second quarter of 2003, provision for income taxes increased by 5% to $3.2 million from the previous year quarter due to lower levels of tax deferred assets in relation to total assets.  For the six months ended June 30, 2003, the provision for income taxes increased 15.5% to $6.6 million from the comparable 2002 period.  The first half of 2003 effective tax rate was 31.15% compared to 32.5% in the first half of 2002, as most of the components of the increased revenues are fully taxable.

 

BALANCE SHEET ANALYSIS

 

SECURITIES AVAILABLE FOR SALE

 

The following table provides the cost and fair value for the major components of securities available for sale carried at fair value. There were no securities classified as held to maturity or trading at the end of the periods presented.

 

		June 30, 2003						December 31, 2002						June 30, 2002
(in thousands)		Cost			Estimated fair value			Cost			Estimated fair value			Cost			Estimated fair value
Securities of U. S. Treasury and federal agencies		$	69,466		$	72,253		$	77,809		$	79,830		$	65,419		$	66,735
Securities of U. S. states and political subdivisions		92,985			99,170			104,792			108,487			112,372			115,527
Mortgage-backed securities		430,771			436,487			384,530			391,988			382,183			388,276
Other		38,143			38,911			33,041			33,556			30,979			31,185
Total debt securities		631,365			646,821			600,172			613,861			590,953			601,723
Marketable equity securities		2,751			4,889			2,751			4,591			3,806			5,103
Total		$	634,116		$	651,710		$	602,923		$	618,452		$	594,759		$	606,826

 

The following table provides the components of the estimated unrealized net gains on securities available for sale for the end of each period presented. The estimated unrealized net gain or loss on securities available for sale is reported on an after-tax basis as a component of cumulative other comprehensive income.

 

(in thousands)		June 30, 2003			December 31, 2002		June 30, 2002
Estimated unrealized gross gains		$	19,061		16,433		$	12,507
Estimated unrealized gross losses		1,467			904		440
Estimated unrealized net gain		$	17,594		15,529		$	12,067

 

The weighted average expected remaining maturity of the debt securities portion of the securities available for sale portfolio was 2.2 years at June 30, 2003. For adjustable rate securities, the weighted average time to the next repricing date was used in place of weighted average maturity in making this calculation.  Expected remaining maturities will differ from contractual maturities because obligations may be prepaid.

 

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LOAN PORTFOLIO

 

											% Change Jun. 30, 2003 from
(in thousands)		Jun. 30 2003			Dec. 31 2002			Jun. 30 2002			Dec. 31 2002		Jun. 30 2002
Commercial (1)		$	175,628		$	174,975		$	158,958		0	%	10	%
Residential real estate (2)		372,288			348,289			281,049			7		32
Commercial mortgage		422,017			403,870			332,460			4		27
Real estate construction		112,206			105,047			106,102			7		6
Consumer installment		249,370			273,167			293,377			(9	)	(15	)
Total loans (net of unearned income, including net deferred loan fees, of $926, $785 and $351		$	1,331,509		$	1,305,348		$	1,171,946		2	%	14	%

 

(1)          Includes agricultural loans (loans to finance agricultural production) of $177 thousand, $308 thousand and $318 thousand at June 30, 2003, December 31, 2002 and June 30, 2002, respectively.

(2)          Includes agricultural loans that are secured by real estate of $6,363 thousand, $6,516 thousand and $5,489 thousand at June 30, 2003, December 31, 2002 and June 30, 2002, respectively.

 

NONACCRUAL LOANS AND OTHER ASSETS

 

The table below presents comparative data for nonaccrual loans and other assets. Management’s classification of a loan as nonaccrual does not necessarily indicate that the principal of the loan is uncollectible in whole or in part. The Bancorp anticipates changes in the amount of nonaccrual loans that result from increases in loans outstanding, changes in borrower’s circumstances or from resolutions of loans in the nonaccrual portfolio. The performance of any individual loan can be affected by external factors, such as the interest rate environment or factors particular to a borrower such as actions taken by a borrower’s management.

 

NONACCRUAL LOANS AND OTHER REAL ESTATE OWNED

 

(in thousands)		Jun. 30, 2003			Dec. 31, 2002			Jun. 30, 2002
Nonaccrual loans:
Commercial		$	1,092		$	1,186		$	1,190
Residential real estate		—			126			147
Commercial mortgage		434			461			535
Real estate construction		71			71			71
Consumer installment		213			233			189
Total nonaccrual loans		$	1,810		$	2,077		$	2,132
As a percentage of total loans		0.14		%	0.16		%	0.18		%
Other real estate owned		422			414			354
Total nonaccrual loans and other real estate owned		$	2,232		$	2,491		$	2,486
As a percentage of total assets		0.10		%	0.12		%	0.13		%
Loans past due 90 days as to interest & principal		$	1,198		$	1,191		$	890

 

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Loans are placed on nonaccrual status when, in the opinion of management, reasonable doubt exists as to the full, timely collection of interest or principal, or a specific loan meets the criteria for nonaccrual status established by regulatory authorities. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. No interest is taken into income on nonaccrual loans until such time the borrower demonstrates sustained performance over a period of time in accordance with contractual terms and is removed from nonaccrual status.

 

Other real estate owned includes real estate acquired by foreclosure (in partial or complete satisfaction of debt), or otherwise surrendered by the borrower to Bancorp’s possession. Other real estate owned is recorded at the lower of cost or fair value on the date of acquisition or transfer from loans. Write-downs to fair value at the date of acquisition are charged to the allowance for credit losses. Subsequent to transfer, these assets are adjusted through a valuation allowance to the lower of the net carrying value or the fair value (net of estimated selling expenses) based on periodic appraisals

 

Loans contractually past due 90 days or more as to interest or principal, but not included in nonaccrual loans are both well-secured and in the process of collection.

 

ALLOWANCE FOR CREDIT LOSSES

 

		Quarter ended						Six months ended
(in thousands)		June 30, 2003			June 30, 2002			June 30, 2003			June 30, 2002
Balance, beginning of period		$	13,673		$	14,132		$	13,668		$	13,947
Provision for credit losses		700			150			1,225			975
Loan charge-offs:
Commercial		853			37			915			110
Residential mortgage		35			46			168			54
Commercial mortgage		—			9			—			9
Real estate construction		—			—			—			—
Consumer		913			860			1,858			2,121
Total loans charged-off		1,801			952			2,941			2,294
Loan recoveries:
Commercial		2			165			127			191
Residential mortgage		—			3			2			3
Commercial mortgage		—			1			1			2
Real estate construction		—			—			—			—
Consumer		406			500			898			1,175
Total loan recoveries		408			669			1,028			1,371
Net charge-offs		1,393			283			1,913			923
Balance, end of period		$	12,980		$	13,999		$	12,980		$	13,999
Total net loan charge-offs as a percent of average total loans (annualized)		0.40		%	0.10		%	0.40		%	0.10		%
Allowance as a percentage of total loans		0.97		%	1.20		%	0.97		%	1.20		%

 

The Bancorp considers the allowance for loan losses of $13.0 million adequate to cover losses inherent in loans, loan commitments and standby and other letters of credit at June 30, 2003. During the quarter a comprehensive review of the allowance is performed considering such factors as the levels of loans outstanding, loss experience, delinquency levels, certain individual loan reviews, and an evaluation of the regional and national

 

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economic environment. The credit quality of the loan portfolio remains exceptionally strong with very low levels of impaired loans and declining historical loss ratios, which are the primary drivers of the necessary allowance for credit losses.

 

DEPOSITS

 

The following table shows comparative detail of deposits.

 

(in thousands)		June 30, 2003			December 31, 2002			June 30, 2002
Noninterest-bearing demand deposits		$	307,694		$	264,965		$	260,082
Interest-bearing deposits:
Checking		221,480			220,509			216,284
Savings		243,048			217,342			213,520
Money market		294,708			271,409			269,664
Certificates of deposit		627,527			620,914			589,691
Total deposits		$	1,694,457		$	1,595,139		$	1,549,241

 

CAPITAL ADEQUACY/RATIOS

 

The Bancorp and its subsidiary bank are subject to various regulatory capital adequacy requirements administered by the Federal Reserve Board. Risk-based capital (RBC) guidelines establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures.

 

		Actual					For capital adequacy purposes					To be well capitalized under the FDICIA prompt corrective action provisions
(in thousands)		Amount			Ratio		Amount			Ratio		Amount			Ratio
As of June 30, 2003:
Total capital (to risk-weighted assets)
F&M Bancorp		$	197		13.12	%	$	120		8.00	%	$	150		10.00	%
Farmers & Mechanics Bank		$	188		12.51		$	120		8.00		$	150		10.00
Tier 1 capital (to risk-weighted assets)
F&M Bancorp		$	183		12.19	%	$	60		4.00	%	$	90		6.00	%
Farmers & Mechanics Bank		$	175		11.65		$	60		4.00		$	90		6.00
Tier 1 capital (to average assets)
(Leverage ratio)
F&M Bancorp		$	183		8.73	%	$	84		4.00	%(1)	$	105		5.00	%
Farmers & Mechanics Bank		$	175		8.44		$	83		4.00	(1)	$	104		5.00

 

(1)          The leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding goodwill and certain other items. The minimum leverage ratio guideline is 3% for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality, high liquidity, good earnings, effective management and monitoring of market risk and, in general, are considered top-rated, strong banking organizations.

 

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CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS

 

Through the normal course of operations, the Bancorp has entered into certain contractual obligations and commitments. Such obligations generally relate to the funding of operations as well as leases for premises and equipment. As a financial services provider, the Bancorp routinely enters into commitments to extend credit, including loan commitments, standby letters of credit and financial guarantees. While contractual obligations represent future cash requirements of the Bancorp, a portion of commitments to extend credit are likely to expire without being drawn upon. Such commitments are subject to the same credit policies and approval processes accorded to loans made in the regular course of business.

 

ASSET/LIABILITY AND MARKET RISK MANAGEMENT

 

Asset/liability management comprises the evaluation, monitoring, and management of the Bancorp’s interest rate risk, market risk and liquidity and funding. The Asset/Liability Management Committee (ALCO) maintains oversight of these risks. The Committee is comprised of senior financial and senior business executives.

 

INTEREST RATE RISK

 

Interest rate risk, one of the more prominent risks in terms of potential earnings impact, is an inevitable part of being a financial intermediary. For more information, see “Market Risk and Asset/Liability Management” in the Bancorp’s 2002 Annual Report on Form 10-K.

 

Management believes that medium term (12-month horizon) interest rate risk is best measured by simulation modeling.  This analysis calculates expected net interest income based upon historical trends, spreads to market rates, historical market relationships, prepayment behavior and current and expected product offerings. As of June 30, 2003, the simulation analysis indicated that the Bancorp’s net interest income would tend to increase if rates were to rise over the next 12 months. For example, if rates were to rise 1.00% or 2.00% over the next 12 months, net interest income would increase by 0.1% and fall by 1.7%, respectively. Conversely, if rates were to decline over the next 12 months, net interest income would decline by 1.6% and 8.4%, respectively. The principal source of net interest income risk in a falling rate scenario is that certain short-term market rates and a majority of the Bank’s deposit rates are equal to or below 1.0%. Therefore, these rates cannot decline below a floor rate of 0%.

 

Computations of prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of market interest rates, loan prepayments and changes in deposit levels.  They are not intended to be a forecast and should not be relied upon as indicative of actual results.  Further, the computations do not contemplate certain actions that management could take in response to changes in interest rates.

 

LIQUIDITY AND FUNDING

 

The objective of effective liquidity management is to ensure that the Bancorp can meet customer loan requests, customer deposit maturities/withdrawals and other cash commitments efficiently under both normal operating conditions as well as under unforeseen and unpredictable circumstances of industry or market stress. To achieve this objective, ALCO establishes and monitors liquidity guidelines requiring sufficient asset based liquidity to cover potential funding requirements and to avoid over-dependence on volatile, less reliable funding sources. The Bancorp manages liquidity at both the parent and subsidiary levels through active management of the balance sheet.

 

In addition to the immediately liquid resources of cash and due from banks and federal funds sold, asset liquidity is provided by the debt securities in the securities available for sale portfolio. Asset liquidity is further enhanced by the Bancorp’s ability to sell loans in secondary markets through whole-loan sales.

 

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Core customer deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds.

 

Long-term debt, and short-term borrowings (federal funds purchased and securities sold under repurchase agreements and other short-term borrowings) mostly provide the remaining funding of assets. The Bank also has extensive access to funds from its membership in the Federal Home Loan Bank of Atlanta.

 

CAPITAL MANAGEMENT

 

The Bancorp has an active program for managing shareholders’ equity. The objective of effective capital management is to produce long-term returns by opportunistically utilizing capital when returns are perceived to be high and issuing/accumulating capital when the costs of doing so is perceived to be low.

 

Uses of capital include investments for organic growth, acquisitions of banks and other financial services companies, dividends and share repurchases. During the first six months of 2003, the Bancorp’s consolidated assets increased by $53.8 million, or 3%. During 2002, the Board of Directors authorized the repurchase of up to 500,000 shares of the Bancorp’s outstanding common stock. With the announcement of the merger agreement between Bancorp and Mercantile Bankshares this share repurchase program was discontinued.

 

Sources of capital include retained earnings and common stock issuance. In the first six months of 2003, total net income was $14.7 million and the change in retained earnings was $8.2 million after payment of $6.2 million in common stock dividends.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Information required by this item as of June 30, 2003 is set forth in “Asset Liability and Market Risk Management” on pages 32-34 of the registrant’s 2002 Annual Report on Form 10-K for the year ended December 31, 2002. There was no material change in such information as of June 30, 2003.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Within the ninety days prior to the filing of this report, the Bancorp’s management, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Bancorp’s disclosure controls and procedures. Based on the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Bancorp’s disclosure controls and procedures were effective. There were no significant changes in the Bancorp’s internal controls or in other factors subsequent to the date of the evaluation that could significantly affect those controls.

 

FACTORS THAT MAY AFFECT FUTURE RESULTS

 

We make forward-looking statements in this report and from time to time in other reports and proxy statements we file with the SEC. Also, our senior management might make forward-looking statements orally to analysts, investors and others. Broadly speaking, forward-looking statements include:

•                  descriptions of plans or objectives of our management for future operations, products or services;

•                  descriptions of assumptions underlying or relating to critical accounting estimates and projections.

 

In this report, for example, we make forward-looking statements about:

•                  future credit losses and non-performing assets;

•                  future cash requirements relating to commitments to extend credit;

•                  future amortization expense;

•                  the impact of new accounting standards;

•                  and the impact of interest rate changes on our net interest income.

 

Forward-looking statements discuss matters that are not historical facts. These forward-looking statements may sometimes be identified by words such as “expect”, “may”. “looking forward”, “we plan”, “we believe”, “are planned”, “could be”, and “currently anticipate”. Although we believe these statements, as well as other oral and

 

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written forward-looking statements made by us from time to time, to be true and reasonable, we can give no assurance that these plans, intentions or expectations will be achieved. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements.

 

There are several factors—many beyond our control—that could cause results to differ significantly from our expectations. Some of these factors are described below. Other factors, such as credit, market, operational, liquidity, interest rate and other risks, are described elsewhere in this report (see, for example, “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Balance Sheet Analysis” and – Asset/Liability and Market Risk Management”). Factors relating to regulation and supervision of the Bancorp are described in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

Industry Factors

 

As a financial services company, our earnings are significantly affected by business and economic conditions.

 

Our earnings are impacted by business and economic conditions in the United States and the Maryland economic region. These conditions include short-term and long-term interest rates, inflation, monetary supply, and the strength of the U.S. economy and Maryland economies in which we operate. Business and economic conditions that negatively impact household or business incomes could decrease demand for the Bancorp’s products and increase the number of customers who fail to pay their loans.

 

Our earnings are significantly affected by the fiscal and monetary polices of the federal government and its agencies.

 

The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its policies significantly impact our cost of funds for lending and investing and the return we earn on those loans and investments, both of which impact our net interest margin, and can materially affect the value of financial instruments we hold. Its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans. Changes in Federal Reserve Board policies are beyond our control and hard to predict or anticipate.

 

The financial services industry is highly competitive.

 

We operate in a highly competitive industry which could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation of banks. Banks, securities firms and insurance companies can now merge by creating a new type of financial services company called a “financial holding company”, which can offer virtually any type of financial service. Many of our competitors have fewer regulatory constraints and some have lower cost structures.

 

We are heavily regulated by federal and state agencies.

 

The holding company and its subsidiaries are heavily regulated at the federal and state levels. This regulation is to protect customers, federal deposit insurance funds and the banking system as a whole, not security holders. Changes to statutes, regulations and regulatory policies, could affect us in substantial and unpredictable ways including limiting the types of financial services and products we may offer and increasing the ability of non-banks to offer competing financial services and products. Also, our failure to comply with laws, regulations and policies could result in sanctions by regulatory agencies and damage our reputation. For more information, refer to the “Regulation and Supervision” section in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

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Company Factors

 

Maintaining or increasing our market share depends on market acceptance and regulatory approval of new products and services.

 

Our success depends, in part, on our ability to adapt our products and services to evolving industry standards and the changing need of our customers. There is increasing pressure on financial service companies to provide products and services at lower prices. This can reduce our net interest margin and revenues from our fee-based products and services. Also, the wide-spread adoption of new technologies, including internet-based services, could require us to make substantial investments to modify or adapt our existing products and services.

 

The holding company relies on dividends from its subsidiaries for most of its revenues.

 

The holding company is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on the holding company’s common stock. Various federal and state laws and regulations limit the amount of dividends that our bank and certain non-bank subsidiaries may pay to the holding company. For more information, refer to “Dividend Restrictions” in our Annual Report on Form 10-K as of December 31, 2002.

 

We have businesses other than banking.

 

We are a diversified financial services company. In addition to banking, we provide insurance, wealth management, and mortgages. Although we believe our diversity helps mitigate the impact to the Bancorp when downturns affect any one-business line, it also means that our earnings could be subject to different risks and uncertainties. We discuss some examples below.

 

Mortgage Banking. The impact of interest rates on our mortgage banking business can be large and complex. Changes in interest rates can impact loan origination fees and gains on mortgage loans sold. A decline in mortgage rates might be expected to increase the demand for mortgages as borrowers refinance. Conversely, in a constant or increasing rate environment, we would expect fewer loans to be refinanced and a decline in our fee income.

 

Wealth Management. The impact of changes in the U.S. stock market on our wealth management business can be large. As much of our fee income is derived based on assets under management, the loss in value of those assets due to stock market declines can significantly reduce our fee income. Also, if market conditions are volatile many of our investors limit their mutual fund investments and in some cases withdraw their funds to invest in safer investment alternatives.

 

Legislative Risk

 

Our business model relies heavily on our ability to share information between the team of companies owned by F&M Bancorp to better satisfy our customers’ needs. Future laws that restrict our ability to share information about customers could negatively impact our revenue and profit.

 

Our stock price can be volatile.

 

Our stock price can fluctuate widely in response to a variety of factors including:

•                  actual or anticipated variations in our quarterly operating results;

•                  recommendations by security analysts;

•                  operating and stock price performance of other companies that investors deem comparable to us:

•                  significant acquisitions or business combinations by or involving us or our competitors;

•                  news reports relating to trends, concerns and other issues in the financial services industry; and

•                  changes in government regulations.

 

General market fluctuations, industry factors and general economic trends, interest rate changes, or credit loss trends, also could cause our stock price to decrease regardless of our operating results.

 

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PART II - Other Information

 

Item 6.           Exhibits and Reports on Form 8-K

 

(a)                                  Exhibits

 

32.1 CEO Certification of corporate responsibility for financial reports. Filed as an exhibit hereto and incorporated herein by reference

 

32.2 CFO Certification of corporate responsibility for financial reports. Filed as an exhibit hereto and incorporated herein by reference

 

(b)                                 Reports on Form 8-K

 

1.                                       Item 5. Other Event and Regulation FD Disclosure, was filed April 21, 2003. Announced first quarter earnings.

 

2.                                       Item 5. Other Event and Regulation FD Disclosure, was filed April 28, 2003. Announced bank name and management teams for Mercantile’s Frederick & Western Maryland affiliates.

 

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.

 

				F&M BANCORP
				(Registrant)
August 06, 2003				/s/ Faye E. Cannon
Date				FAYE E. CANNON
				PRESIDENT AND CEO
August 06, 2003				/s/ Kaye A. Simmons
Date				KAYE A. SIMMONS
				CFO AND TREASURER

 

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