SECURITIES AND EXCHANGE COMMISSION

Washington, DC  20549

 

 

FORM 10-Q

 

 

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 126-2 of the Securities Exchange Act of 1934).

Yes ý         No o

 

The number of shares outstanding of each of the registrant’s classes of common stock as of  September 30, 2003:

 

 

 

CAUTIONARY STATEMENT FOR PURPOSES OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

 

First Essex Bancorp, Inc. (the Company) desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.  This Report contains certain “forward-looking statements” including statements concerning plans, objectives, future events or performance, assumptions, and other statements which are other than statements of historical fact.  The Company wishes to caution readers that the following important factors, among others, may have affected, and could in the future affect, the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company herein: (i) the effect of changes in laws and regulations, including federal and state banking laws and regulations, with which the Company and its wholly owned banking subsidiary, First Essex Bank, must comply, and the associated costs of compliance with such laws and regulations, either currently or in the future as applicable; (ii)  the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as by the Financial Accounting Standards Board, or of changes in the Company’s organization, compensation and benefit plans; (iii) the effect on the Company’s competitive position within its market area of the increasing consolidation within the banking and financial services industries, including increased competition from larger regional and out-of-state banking organizations as well as nonbank providers of various financial services; (iv) the effect of unforeseen changes in interest rates; and (v) the effect of changes in the business cycle and downturns in the local, regional and national economies.  The Company disclaims any intent or obligation to update forward-looking statements whether in response to new information, further events or otherwise.

 

2

 

FIRST ESSEX BANCORP, INC.
INDEX

 

PART I - FINANCIAL INFORMATION
ITEM 1.		Financial Statements
		Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002
		Consolidated Statements of Operations for the three months ended September 30, 2003 and 2002
		Consolidated Statements of Operations for the nine months ended September 30, 2003 and 2002
		Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2003 and 2002
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002
		Notes to the Consolidated Financial Statements
ITEM 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
ITEM 3.		Quantitative and Qualitative Disclosure About Market Risk
ITEM 4.		Controls and Procedures
PART II - OTHER INFORMATION
ITEM 6.	Exhibits and Reports on Form 8-K
	Signatures

 

3

 

ITEM 1.  FINANCIAL STATEMENTS

 

FIRST ESSEX BANCORP, INC.
Consolidated Balance Sheets
(Unaudited)

 

		September 30, 2003			December 31, 2002
		(Dollars in thousands)
ASSETS
Cash and cash equivalents		$	52,039		$	217,158
Investment securities available-for-sale		385,028			332,421
Stock in Savings Bank Life Insurance Company		1,194			1,194
Stock in Federal Home Loan Bank of Boston		12,771			12,771
Mortgage loans held-for-sale		6,554			7,684
Loans receivable, less allowance for loan losses of $15,334 and $14,452		1,196,888			1,114,258
Foreclosed property		817			1,198
Bank premises and equipment		8,295			8,670
Accrued interest receivable		6,526			7,193
Goodwill		11,633			11,633
Core deposit intangible		2,672			3,661
Other assets		61,668			58,089
		$	1,746,085		$	1,775,930
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits		$	1,318,228		$	1,380,637
Borrowed funds		234,628			207,408
Company-obligated mandatorily redeemable trust preferred securities of subsidiary trust holding solely junior subordinated debentures of the Company		24,506			24,409
Mortgagors’ escrow accounts		1,581			860
Other liabilities		14,789			18,690
Total liabilities		1,593,732			1,632,004
STOCKHOLDERS’ EQUITY:
Serial preferred stock:  $.10 par value per share; 5,000,000 shares authorized, no shares issued or outstanding
Common stock, $.10 par value per share; 25,000,000 shares authorized, 10,229,361 and 10,090,176 shares issued		1,023			1,009
Additional paid-in capital		84,768			82,698
Retained earnings		86,928			77,365
Treasury stock, at cost, 2,432,851, and 2,429,300 shares		(23,715		)	(23,535		)
Accumulated other comprehensive income		3,349			6,389
Total stockholders’ equity		152,353			143,926
		$	1,746,085		$	1,775,930

 

4

 

FIRST ESSEX BANCORP, INC.
Consolidated Statements of Operations
(Unaudited)

 

		Three Months Ended September 30,
		2003			2002
		(Dollars in thousands, except per share amounts)
Interest and dividend income:
Loans		$	19,697		$	20,677
Investment securities available-for-sale		3,994			5,330
Short-term investments		88			526
Other earning assets		268			267
Total interest and dividend income		24,047			26,800
Interest expense:
Deposits		5,167			7,785
Borrowed funds		2,230			2,413
Trust preferred securities		487			512
Total interest expense		7,884			10,710
Net interest income		16,163			16,090
Provision for loan losses		1,938			1,812
Net interest income after provision for loan losses		14,225			14,278
Non-interest income:
Net gain on sales of loans		539			379
Loan fees		283			244
Other income		2,032			1,926
Total non-interest income		2,854			2,549
Non-interest expense:
Salaries and employee benefits		4,631			4,736
Buildings and equipment		1,297			1,154
Professional services		349			345
Information processing		726			747
Foreclosed (income) expenses, net		208			(270		)
Amortization of core deposit intangible		311			339
Legal and investment banking fees associated with merger		183			—
Other		1,119			1,104
Total non-interest expenses		8,824			8,155
Income before provision for income taxes		8,255			8,672
Provision for income taxes		3,033			3,155
Net income		$	5,222		$	5,517
Earnings per share - Basic		$	0.67		$	0.72
Earnings per share - Diluted		$	0.64		$	0.69
Dividends declared per share		$	0.24		$	0.22
Weighted average number of shares - basic		7,773,620			7,652,171
Weighted average number of shares - diluted		8,216,201			7,996,706

 

5

 

FIRST ESSEX BANCORP, INC.
Consolidated Statements of Operations
(Unaudited)

 

		Nine Months Ended September 30,
		2003			2002
		(Dollars in thousands, except per share amounts)
Interest and dividend income:
Loans		$	59,596		$	61,179
Investment securities available-for-sale		12,928			17,049
Short-term investments		538			1,023
Other earning assets		803			800
Total interest and dividend income		73,865			80,051
Interest expense:
Deposits		17,138			24,221
Borrowed funds		6,786			7,166
Trust preferred securities		1,471			1,539
Total interest expense		25,395			32,926
Net interest income		48,470			47,125
Provision for loan losses		5,814			6,236
Net interest income after provision for loan losses		42,656			40,889
Non-interest income:
Net gain on sales of loans		1,445			1,113
Loan fees		824			734
Other income		6,081			6,242
Total non-interest income		8,350			8,089
Non-interest expense:
Salaries and employee benefits		13,834			13,610
Buildings and equipment		3,835			3,651
Professional services		952			999
Information processing		2,225			2,277
Foreclosed (income) expenses, net		505			(73		)
Amortization of core deposit intangible		989			1,062
Legal and investment banking fees associated with merger		1,058			—
Other		3,459			3,610
Total non-interest expenses		26,857			25,136
Income before provision for income taxes		24,149			23,842
Provision for income taxes		9,006			8,425
Net income		$	15,143		$	15,417
Earnings per share - basic		$	1.96		$	2.02
Earnings per share - diluted		$	1.87		$	1.94
Dividends declared per share		$	0.72		$	0.66
Weighted average number of shares - basic		7,733,147			7,616,020
Weighted average number of shares - diluted		8,106,222			7,950,414

 

6

 

FIRST ESSEX BANCORP, INC.
Consolidated Statements of Stockholders’ Equity
For the Nine Months Ended September 30, 2003 and 2002
(Unaudited)

 

					Components of Stockholders’ Equity
		Comprehensive Income			Common Stock			Additional Paid in Capital			Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income				Total
		(Dollars in thousands)
Balance at December 31, 2002					$	1,009		$	82,698		$	77,365		$	(23,535	)	$	6,389		$		143,926
Comprehensive income:
Net income		$	15,143								15,143									15,143
Other comprehensive income:
• Unrealized securities gains, net of of tax expense, arising during the period		(3,040		)
• Reclassification adjustment for security gains/(losses) included in net income, net of tax		—
Total other comprehensive income		(3,040		)													(3,040		)	(3,040			)
Total Comprehensive income		$	12,103
Cash dividends declared											(5,580		)							(5,580			)
Treasury stock repurchased														(180		)				(180			)
Stock options exercised					14			2,070												2,084
Balance at September 30, 2003					$	1,023		$	84,768		$	86,928		$	(23,715	)	$	3,349		$		152,353
Balance at December 31, 2001					$	996		$	81,035		$	63,782		$	(23,535	)	$	2,916		$		125,194
Comprehensive income:
Net income		$	15,417								15,417									15,417
Other comprehensive income:
• Unrealized securities gains, net of of tax expense, arising during the period		2,746
• Reclassification adjustment for security gains/(losses) included in net income, net of tax		—
Total other comprehensive income		2,746															2,746			2,746
Total Comprehensive income		$	18,163
Cash dividends declared											(5,040		)							(5,040			)
Stock options exercised					12			1,386												1,398
Balance at September 30, 2002					$	1,008		$	82,421		$	74,159		$	(23,535	)	$	5,662		$		139,715

 

7

 

FIRST ESSEX BANCORP, INC.
Consolidated Statements of Cash Flows
(Unaudited)

 

		Nine Months Ended September 30,
		2003			2002
		(Dollars in thousands)
Cash flows from operating activities:
Net income		$	15,143		$	15,417
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		5,814			6,236
Depreciation and amortization		1,425			1,565
Loss on sales of foreclosed property		45			56
Write-down of foreclosed property		176			—
Amortization of investment securities discounts and premiums, net		1,333			661
Amortization of core deposit intangible		989			1,062
Proceeds from sales of mortgage loans		98,026			68,143
Mortgage loans originated for sale		(95,451		)	(67,839		)
Realized gains on the sale of mortgage loans		(1,445		)	(1,113		)
Decrease in accrued interest receivable		667			815
Increase in other assets		(3,579		)	(11,121		)
(Decrease) increase in other liabilities		(2,148		)	681
Net cash provided by operating activities		20,995			14,563
Cash flows from investing activities:
Proceeds from maturities and principal payments of available-for-sale securities		103,512			76,819
Purchases of available-for-sale securities		(162,278		)	(9,748		)
Loans originated and purchased, net of principal collected		(92,051		)	(79,001		)
Proceeds from sales of foreclosed property		3,767			2,467
Purchases of bank premises and equipment		(953		)	(782		)
Net cash used in investing activities		(148,003		)	(10,245		)
Cash flows from financing activities:
Net increase in demand deposits, NOW accounts and savings accounts		24,460			143,411
Net (decrease) increase of term deposits		(86,869		)	8,730
Net increase in borrowed funds with maturities of three months or less		34,278			3,785
Repayments of borrowed funds with maturities in excess of three months		(7,058		)	(54		)
Increase in mortgagors’ escrow accounts		721			772
Dividends paid		(5,547		)	(5,013		)
Stock options exercised		1,904			1,398
Net cash (used in) provided by financing activities		(38,111		)	153,029
Net (decrease) increase in cash and cash equivalents		(165,119		)	157,347
Cash and cash equivalents at beginning of period		217,158			54,237
Cash and cash equivalents at end of period		$	52,039		$	211,584
Supplemental disclosure of cash flow information:
Interest paid during the year		$	25,668		$	31,391
Income taxes paid during the year		9,248			9,336
Supplemental schedule of noncash financing and investing activities:
Assets acquired through, or deeds in lieu of, foreclosure		3,607			3,176

 

8

 

FIRST ESSEX BANCORP, INC.
Notes to Consolidated Financial Statements
September 30, 2003

 

1.              Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying consolidated financial statements are unaudited and include the accounts of the Company and its subsidiaries, First Essex Bank, First Essex Capital Trust I and First Essex Capital Statutory Trust II. These financial statements reflect, in management’s opinion, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the Company’s financial position and the results of its operations and cash flows for the periods presented. All significant intercompany balances have been eliminated in consolidation.  These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s 2002 Form 10-K.  The interim results reported herein are not necessarily indicative of the results for the entire year.

 

On June 13, 2003, First Essex Bancorp, Inc. and Sovereign Bancorp, Inc. jointly announced the execution of a definitive agreement for Sovereign to acquire First Essex.  Under terms of the agreement, each share of First Essex common stock will be exchanged for $48.00 in cash or 2.9250 shares of Sovereign common stock, subject to an election and allocation process, intended to ensure that, in the aggregate, 50% of the First Essex shares will be exchanged for Sovereign common stock and 50% will be exchanged for cash, except in certain circumstances.  The merger is subject to approval by various regulatory agencies and First Essex shareholders and is expected to close in the first quarter of 2004.

 

Earnings Per Share

 

Included in diluted EPS are 442,581 and 344,535 dilutive potential shares for the three months ended September 30, 2003 and 2002, respectively, and 373,075 and 334,394 dilutive potential shares for the nine months ended September 30, 2003 and 2002, respectively. Excluded from diluted earnings per share were options to purchase 123,800 shares at September 30, 2002.  These shares were excluded as the exercise price was greater than the average market price of the common shares during the period.

 

9

 

Stock Based Compensation

 

In December 2002, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“SFAS 148”) an amendment of FASB  Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), which provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  The transition provisions of the statement are effective for financial statements for fiscal years ending after December 15, 2002 while the disclosure requirements are effective for interim periods beginning after December 15, 2002.

 

The Company accounts for stock options at intrinsic value with disclosure of the effects of fair value accounting on net income and earnings per share on a pro forma basis.  Had compensation costs for the stock option plans been determined using the fair value method based upon the Modified Black-Scholes American option model, the Company’s net income and earnings per share from operations for the three and nine months ended September 30, 2003 and 2002 would have been reduced to the following pro forma amounts:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
		(Dollars in thousands, except per share amounts)
Net income, as reported		$	5,222		$	5,517		$	15,143		$	15,417
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(112		)	(94		)	(336		)	(237		)
Pro forma net income		$	5,110		$	5,423		$	14,807		$	15,180
Basic EPS:
As reported		$	0.67		$	0.72		$	1.96		$	2.02
Pro forma		0.66			0.71			1.92			1.99
Diluted EPS:
As reported		$	0.64		$	0.69		$	1.87		$	1.94
Pro forma		0.63			0.68			1.84			1.91

 

Pro forma compensation cost may not be representative of that in future years.

 

10

 

Goodwill and Intangible Assets

 

In the fourth quarter of 2002, the Company adopted and retroactively applied to January 1, 2002, SFAS No. 147, “Acquisitions of Certain Financial Institutions”. Upon adoption, the previously defined balance of unidentified intangibles was reclassified to goodwill effective January 1, 2002. All 2002 goodwill amortization expense recorded through September 30, 2002 was reversed and all future amortization was halted.  As a result of this change, for the three and nine months ended September 30, 2002, diluted earnings per share restated is $0.69 and $1.94, and restated net income was $5,517 million and $15,417 million, respectively.  The Company’s goodwill will be periodically reviewed for impairment, as required by the new standard.

 

2.              Loans

 

The following table sets forth information concerning the Company’s loan portfolio at the dates indicated.  The balances are net of unadvanced funds and unearned discounts and fees:

 

		September 30, 2003					December 31, 2002
		(Dollars in thousands)
Real Estate:
Residential		$	58,336		4.8	%	$	67,238		5.9	%
Commercial		212,409			17.4		195,468			17.2
Construction		66,553			5.4		63,272			5.6
Total Real Estate Loans		337,298			27.6		325,978			28.7
Owner occupied Commercial Real Estate		83,740			6.9		75,886			6.7
Commercial loans		92,727			7.6		117,549			10.3
Aircraft loans		250,821			20.6		217,167			19.1
Consumer loans
Home Equity, Home Improvement & Second Mortgage		41,996			3.4		42,674			3.8
Automobile		409,191			33.6		353,778			31.1
Other		3,003			0.3		3,362			0.3
Total consumer loans		454,190			37.3		399,814			35.2
Total loans		$	1,218,776		100.0	%	$	1,136,394		100.0	%

 

11

 

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

 

FIRST ESSEX BANCORP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
September 30, 2003

 

General

 

First Essex Bancorp, Inc. is a Delaware corporation whose primary activity is to act as the parent holding company for First Essex Bank (the “Bank”).

 

The Company’s net earnings depend to a large extent upon its net interest income, which is the difference between interest and dividend income earned on its loans and investments and interest expense paid on its deposits and borrowed funds. The Company’s net earnings also depend upon its provision for loan loss, noninterest income, noninterest expense and income tax expense.  Interest and dividend income and interest expense are significantly affected by general economic conditions.  These economic conditions, together with conditions in the local real estate markets, affect the levels of non-performing assets and provisions for loan losses.

 

On June 13, 2003, First Essex Bancorp, Inc. and Sovereign Bancorp, Inc. jointly announced the execution of a definitive agreement for Sovereign to acquire First Essex.  Under terms of the agreement, each share of First Essex common stock will be exchanged for $48.00 in cash or 2.9250 shares of Sovereign common stock, subject to an election and allocation process intended to ensure that, in the aggregate, 50% of the First Essex shares will be exchanged for Sovereign common stock and 50% will be exchanged for cash, except in certain circumstances.  The merger is subject to approval by various regulatory agencies and First Essex shareholders and is expected to close in the first quarter 2004.

 

Results of Operations

 

Net income for the three months ended September 30, 2003 was $5.2 million compared to $5.5 million for same period in 2002, or a 5% decrease.  Net interest income totaled $16.2 million for the quarter compared to $16.1 million for the same period in 2002.  The increase in net interest income of $0.1 million, combined with an increase in noninterest income of $305 thousand, offset by increases in noninterest expenses of $669 thousand, and the provision for loan losses of $126 thousand accounts for the $417 thousand decrease in pretax income.

 

Net income for the nine months ended September 30, 2003 was $15.1 million compared to $15.4 million for same period in 2002, or a 2% decrease.  Net interest income totaled $48.5 million for the period compared to $47.1 million for the same period in 2002.  The increase in net interest income of $1.3 million, combined with an increase in noninterest income of $261 thousand and a decrease in the provision for loan losses of $422 thousand, offset by an increase in noninterest expenses of $1.7 million, accounts for the $307 thousand increase in pretax income.

 

12

 

Analysis of Average Yields Earned and Rates Paid

 

The following tables presents an analysis of average yields earned and rates paid for the periods indicated:

 

		For the Three Months Ended September 30,
		2003									2002
		Average Balance			Interest Earned/ Paid			Average Yield/ Rate			Average Balance			Interest Earned/ Paid			Average Yield/ Rate
		(Dollars in thousands)
Assets
Earning assets
Short-term investments		$	37,054		$	88		0.94	%		$	133,914		$	526		1.56	%
Investment securities		388,936			3,994			4.07			369,630			5,330			5.72
Total loans (1)		1,213,917			19,697			6.44			1,117,015			20,677			7.34
Other earning assets		17,917			268			5.93			17,787			267			5.96
Total earning assets		1,657,824			24,047			5.75			1,638,346			26,800			6.49
Allowance for loan losses		(15,849		)							(14,014		)
Total earning assets less allowance for loan losses		1,641,975									1,624,332
Other assets		115,588									101,222
Total assets		$	1,757,563								$	1,725,554
Liabilities and Stockholders’ Equity
Deposits
NOW accounts		$	95,813		$	146		0.60	%		$	91,375		$	203		0.88	%
Money market accounts		242,998			826			1.35			172,705			926			2.13
Savings accounts		321,325			696			0.86			335,968			1,355			1.60
Time deposits		513,424			3,499			2.70			594,443			5,301			3.54
Total interest bearing deposits		1,173,560			5,167			1.75			1,194,491			7,785			2.59
Borrowed funds		255,907			2,717			4.21			233,923			2,925			4.96
Total interest bearing deposits and borrowed funds		1,429,467			7,884			2.19			1,428,414			10,710			2.88
Demand deposits		159,577									139,867
Other liabilities		14,872									19,161
Total liabilities		1,603,916									1,587,442
Stockholders’ equity		153,647									138,112
Total liabilities, trust preferred securities and stockholders’ equity		$	1,757,563								$	1,725,554
Net interest income					$	16,163								$	16,090
Weighted average interest rate spread								3.57	%								3.52	%
Net yield on average earning assets (2)								3.90	%								3.93	%
Return on average assets								1.19	%								1.27	%
Return on average equity								13.59	%								15.87	%

 

(1) Loans on a non-accrual status are included in the average balance.

 

(2) Net interest income before provision for loan losses divided by average earning assets.

 

13

 

		For the Nine Months Ended September 30,
		2003								2002
		Average Balance			Interest Earned/ Paid			Average Yield/ Rate		Average Balance			Interest Earned/ Paid			Average Yield/ Rate
		(Dollars in thousands)
Assets
Earning assets
Short-term investments		$	64,613		$	538		1.11	%	$	89,301		$	1,023		1.53	%
Investment securities		384,033			12,928			4.50		388,623			17,049			5.87
Total loans (1)		1,186,256			59,596			6.72		1,088,081			61,179			7.52
Other earning assets		17,884			803			6.00		17,758			800			6.02
Total earning assets		1,652,786			73,865			5.98		1,583,763			80,051			6.76
Allowance for loan losses		(15,385		)						(13,666		)
Total earning assets less allowance for loan losses		1,637,401								1,570,097
Other assets		118,071								97,330
Total assets		$	1,755,472							$	1,667,427
Liabilities and Stockholders’ Equity
Deposits
NOW accounts		$	93,249		$	425		0.61	%	$	83,352		$	583		0.94	%
Money market accounts		232,006			2,396			1.38		138,620			2,180			2.10
Savings accounts		321,821			2,189			0.91		341,052			4,541			1.78
Time deposits		545,780			12,128			2.97		589,645			16,917			3.84
Total interest bearing deposits		1,192,856			17,138			1.92		1,152,669			24,221			2.81
Borrowed funds		240,506			8,257			4.59		230,187			8,705			5.06
Total interest bearing deposits and borrowed funds		1,433,362			25,395			2.37		1,382,856			32,926			3.09
Demand deposits		152,089								133,424
Other liabilities		20,261								18,382
Total liabilities		1,605,712								1,534,662
Stockholders’ equity		149,760								132,765
Total liabilities, trust preferred securities and stockholders’ equity		$	1,755,472							$	1,667,427
Net interest income					$	48,470							$	47,125
Weighted average interest rate spread								3.61	%							3.57	%
Net yield on average earning assets (2)								3.91	%							3.97	%
Return on average assets								1.15	%							1.22	%
Return on average equity								13.48	%							15.37	%

 

(1) Loans on a non-accrual status are included in the average balance.

 

(2) Net interest income before provision for loan losses divided by average earning assets.

 

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Net Interest Income

 

Net interest income increased by $73 thousand or .5% to $16.2 million for the three months ended September 30, 2003 and by $1.3 million or 2.9% to $48.5 million for the nine months ended September 30, 2003 as compared to the same periods of 2002.

 

Interest and Dividend Income

 

Interest and dividend income decreased by $2.8 million or 10.3% to $24.0 million for the three month period ended September 30, 2003, from $26.8 million in the same period in 2002.  Interest and dividend income also decreased by $6.2 million or 7.7% to $73.9 million for the nine months ended September 30, 2003 from $67.7 million in the same period of 2002.  The average balance of earning assets increased $19.5 million and $69.0 million for the three and nine months ended September 30, 2003, respectively, compared to the same periods of 2002.  The yield on average earning assets decreased to 5.75% and 5.98% for the three and nine months ended September 30, 2003, respectively, as compared to 6.49% and 6.76% for the same periods of 2002.  The declines in yields are primarily due to declining interest rates on loans and investment securities which have resulted from lower interest rates in the economy, in general.

 

Interest Expense

 

Interest expense decreased by $2.8 million or 26.4% to $7.9 million and $7.5 million or 22.9% to $25.4 million for the three and nine months ended September 30, 2003, respectively, when compared to the same periods in 2002.  The average balance of interest-bearing deposits and borrowed funds increased by $1.1 million and $50.5 million for the three and nine months ended September 30, 2003, respectively when compared to the same periods in 2002.  The average cost of funds decreased to 2.19% and 2.37% for the three and nine months ended September 30, 2003, respectively, as compared to 2.88% and 3.09% for the same periods in 2002.  The decreases in the cost of funds have also resulted from lower interest rates in the economy, in general.

 

Provision for Loan Losses

 

Losses on loans are provided for under the accrual method of accounting.  Assessing the adequacy of the allowance for loan losses involves substantial uncertainties and is based upon management’s evaluation of the amount required to meet estimated losses inherent in the loan portfolio after weighing various factors.  Among the factors management may consider are the quality of specific loans, risk characteristics of the loan portfolio generally, the level of non-accruing loans, economic conditions and their effect on borrowers, trends in delinquencies and charge-offs and collateral values of the underlying security.  Ultimate losses may vary significantly from the current estimates.  Losses on loans, including impaired loans, are charged against the allowance when management believes the collectability of principal is doubtful.

 

The provisions for loan losses totaled $1.9 million and $5.8 million for the three and nine month periods ended September 30, 2003, respectively, as compared to $1.8 million and $6.2 million for the same periods of 2002.  Provisions result from management’s continuing internal review of the loan portfolio as well as its judgment as to the adequacy of the reserves in light of the condition of the regional real estate and other markets, and the economy in general.  As a result of increased loans, there is an expectation that the Bank will continue to find it necessary to make provisions for loan losses in the future.

 

Noninterest Income

 

Noninterest income consists of net gains from the sales of loans, fee and other noninterest income.

 

Noninterest income increased by $305 thousand or 12.0% and $261 thousand or 3.2% to $2.9 million and $8.4 million for the three and nine months ended September 30, 2003, respectively, as compared to $2.5 million and $8.1 million for the same periods in 2002.  This increase is primarily attributable to gains recognized on sales of mortgage loans and loan and deposit fee increases during the three and nine month periods of 2003.  Additionally, approximately $600 thousand of income was recorded during the second quarter of 2002 relating to the settlement of an outstanding state income tax issue reducing the overall increase shown for 2003.

 

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Noninterest Expense

 

Noninterest expense increased $669 thousand or 8.2% and $1.7 million or 6.9% to $8.8 million and $26.9 million for the three and nine months ended September 30, 2003, respectively, as compared to $8.2 million and $25.1 million for the same periods in 2002.  This increase is primarily attributable to approximately $183 thousand and $1.1 million in legal and investment banking fees associated with the pending acquisition of First Essex Bancorp, Inc. recognized during the three and nine months ended September 30, 2003.  Also, a gain on the sale of OREO of $440 thousand was recorded during the third quarter of 2002, which further reduced that year’s expenses.

 

Income Taxes

 

The effective income tax rate increased to 36.7% and 37.3% for the three and nine month periods ended September 30, 2003 compared to 36.4% and 35.3% for the same periods of 2002.  These increases are primarily attributable to $183 thousand and $1.1 million of non-deductible acquisition expenses incurred in the three and nine months ending September 30, 2003, respectively, and a $240 thousand gain resulting from the settlement of an outstanding state income tax issue during the second quarter of 2002.

 

Financial Condition

 

Total assets amounted to $1,746 million at September 30, 2003, a decrease of $29.8 million or 1.7% from $1,776 million at December 31, 2002.  Cash and cash equivalents were $165.1 million lower at September 30, 2003 compared to year-end 2002, offset by increases in loans receivable of $82.6 million and investment securities available for sale of $52.6 million.

 

Loans

 

At September 30, 2003, the loan portfolio, including mortgage loans held for sale, and before consideration of the allowance for loan losses, was $1.2 billion, representing 69.8% of total assets, compared to $1.1 billion or 64.0% of total assets at December 31, 2002.   Refer to Note 2 for additional detail regarding the composition of the loan portfolio.

 

Allowance for Loan Losses

 

The allowance for loan losses is maintained at a level determined by management to be adequate to provide for probable losses inherent in the loan portfolio.  The allowance for loan losses is maintained through the provision for loan losses, which is a charge to operations.  The potential for loss in the portfolio reflects the risks and uncertainties inherent in the extension of credit.

 

The determination of the adequacy of the allowance for loan losses is based upon management’s assessment of risk elements in the portfolio, factors affecting loan quality and assumptions about the economic environment in which the Company operates.  The process includes identification and analysis of loss potential in various portfolio segments utilizing a credit risk grading process and specific reviews and evaluations of significant individual problem credits.  In addition, management reviews overall portfolio quality through an analysis of current levels and trends in charge-off, delinquency and nonaccruing loan data, collateral values, economic conditions and their effect on borrowers, and the overall-banking environment.  These reviews are of necessity dependent upon estimates, appraisals and judgments, which may change quickly because of changing economic conditions and the Company’s perception as to how these factors may affect the financial condition of debtors.

 

The methodology for assessing the appropriateness of the allowance consists of a review of the following key elements:

 

•                  a formula allowance for the various loan portfolio classifications,

•                  a valuation allowance for loans identified as impaired, and

•                  a nonspecific allowance.

 

The formula allowance is a percentage-based reflection of historical loss experience and assigns required allowance allocations by loan classification based on an estimated percentage of all outstanding loan balances.  The formula allowance employs a risk-rating model that grades loans based on general characteristics of credit quality and relative risk.  As credit quality becomes more suspect, so-called “watch list” loans, the risk rating and allocation percentage increase.  The sum of these allocations comprise the Company’s “formula” or “general” allowance.

 

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The Company also has “valuation” allowances for impaired loans.  Loans are evaluated for impairment by measuring the net present value of the expected future cash flows using the loan’s original effective interest rate, or looking at the fair value of the collateral if the loan is collateral dependent.  When the difference between the net present value of a loan (or fair value of the collateral if the loan is collateral dependent) is lower than the recorded investment of the loan, the difference is reflected with a resulting “valuation” allowance.

 

In addition to the formula and valuation components, there is a nonspecific allowance component that takes into consideration the imprecise nature of the loan loss estimation process and various other factors as discussed below.  This component’s adequacy is also based upon management’s evaluation of various factors, the effects of which are not directly measured in determining the formula and valuation allowances.  The evaluation of the inherent loss resulting from these factors involves a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.  The factors evaluated in connection with the nonspecific allowance include the following:

 

•                  then-existing general economic and business conditions affecting the Company’s key lending areas,

•                  credit quality trends, including trends in nonperforming loans expected to result from existing conditions,

•                  collateral values,

•                  loan volumes and concentrations,

•                  seasoning of the loan portfolio,

•                  specific industry conditions within portfolio segments,

•                  recent loss experience in particular segments of the portfolio,

•                  duration of the current business cycle,

 

When an evaluation of these conditions signifies a change in the level of risk, the Company adjusts the formula allowance.  Periodic credit reviews enable further adjustment to the allowance through the risk rating of loans and identification of loans requiring a valuation allowance.  In addition, the formula model is designed to be self-correcting by taking into account recent loss experience.

 

The following table summarizes the activity in the allowance for loan losses (including amounts established for impaired loans) for the three and nine months ended September 30, 2003 and 2002:

 

		Three Months Ended						Nine Months Ended
		September 30, 2003			September 30, 2002			September 30, 2003			September 30, 2002
		(Dollars in Thousands)
Balance at beginning of period		$	15,192		$	13,715		$	14,452		$	12,758
Provision for loan losses		1,938			1,812			5,814			6,236
Charge-offs		(1,917		)	(1,234		)	(5,591		)	(5,154		)
Recoveries		121			181			659			634
Net charge-offs		(1,796		)	(1,053		)	(4,932		)	(4,520		)
Balance at end of period		$	15,334		$	14,474		$	15,334		$	14,474
Total loans at end of period*		$	1,218,776		$	1,125,219		$	1,218,776		$	1,125,219
Average loans for the period*		1,213,917			1,117,015			1,186,256			1,088,081
Allowance to loans ratio		1.26		%	1.29		%	1.26		%	1.29		%
Net charge-offs to average loans ratio (annualized)		0.59		%	0.38		%	0.55		%	0.55		%

 

*Includes loans held for sale.

 

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Nonperforming Assets

 

Nonperforming assets consist of nonaccruing loans (including loans impaired under SFAS No. 114), and foreclosed property.  Nonperforming assets totaled $5.9 million at September 30, 2003 and $4.3 million at December 31, 2002.

 

The Bank’s policy is to discontinue the accrual of interest on all loans (including loans impaired under SFAS No. 114), for which payment of interest or principal is 90 days or more past due or for such other loans as considered necessary by management if collection of interest and principal is doubtful.  When a loan is placed on nonaccrual status, all previously accrued but uncollected interest is reversed against the current period interest income.

 

The following table indicates the recorded investment of nonperforming assets and the related valuation allowance for impaired loans:

 

		September 30, 2003						December 31, 2002
		Recorded Investment			Impaired Loan Valuation Allowance			Recorded Investment			Impaired Loan Valuation Allowance
		(Dollars in Thousands)
Non-accruing Loans
Impaired Loans
Requiring a valuation allowance		$	523		$	284		$	105		$	105
Not requiring a valuation allowance		2,225			—			935			—
		2,748			284			1,040			105
Restructured Loans		214			40			—			—
Total impaired		2,962			$	324		1,040			$	105
Residential Mortgage		54						—
Other		2,032						2,065
Total non-accruing		5,048						3,105
Foreclosed property, net		817						1,198
Total non-performing assets		$	5,865					$	4,303
Percentage of non-performing assets to total assets		0.34		%				0.24		%
Percentage of allowance for loan losses to non-accruing loans		303.8		%				465.4		%

 

The valuation allowance for impaired loans is included in the allowance for loan losses on the balance sheet.

 

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Investments

 

At September 30, 2003, the investment portfolio, consisting of short-term investments, investment securities, mortgage-backed securities, Federal Home Loan Bank (“FHLB”) stock and stock in the Savings Bank Life Insurance Company of Massachusetts, totaled $409.4 million or 23.4% of total assets, compared to $472.0 million or 26.6% of total assets at December 31, 2002.  Interest and dividend income on the investment portfolio generated 17.0% and 18.2% of total interest and dividend income for the three and nine months ended September 30, 2003 compared to 21.9% and 22.6% for the same periods in 2002.  The decreases are due to lower interest rates in the economy, in general, and lower average balances during 2003 as compared to 2002.

 

To identify and control market risks associated with the investment portfolio, the Company has established policies and procedures, which include stop loss limits and stress testing on a periodic basis.

 

Deposits

 

Deposits are the primary source of funds for lending and investment activities.  Deposit flows vary significantly and are influenced by prevailing interest rates, market conditions, economic conditions and competition.  At September 30, 2003 the Bank had total deposits of $1,318.2 million representing a net decrease of $62.4 million or 4.5% compared to total deposits of $1,380.6 million at December 31, 2002.

 

While deposit flows are by nature unpredictable, the Bank attempts to manage its deposits through selective pricing.  Due to the uncertainty of market conditions, it is not possible for the Bank to predict how aggressively it will compete for deposits in future quarters or the likely effect of any such decision on deposit levels, interest expense and net interest income. Strategies are currently in place to aggressively market more stable deposit sources in products such as savings accounts.

 

Borrowed Funds

 

The Bank is a member of the FHLB and is entitled to borrow from the FHLB by pledging certain assets. The Bank also utilizes short term repurchase agreements with maturities less than three months, as an additional source of funds. Repurchase agreements are secured by U.S. government and agency securities. Borrowed funds are an alternative source of funds compared to deposits and totaled $234.6 million at September 30, 2003 versus $207.4 million at December 31, 2002.

 

Regulatory Capital Requirements

 

The Bank is subject to regulatory capital requirements administered by the Federal Deposit Insurance Corporation (“FDIC”).  Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, regulatory actions that, if undertaken, could have a direct material effect on the Bank’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.  The Bank’s capital amounts and classification are also subject to qualitative judgments by the FDIC about components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  Management believes, as of September 30, 2003, that the Bank meets all capital adequacy requirements to which it is subject.

 

The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the following table.  Actual capital amounts and ratios are also presented.

 

The Bank may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause stockholders’ equity to be reduced below applicable capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements.

 

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The following table displays the Bank’s capital calculations as defined under prompt corrective action for the periods indicated:

 

							For Capital						To Be Well Capitalized Under Prompt
		First Essex Bank
		Actual			Actual		Adequacy Purposes						Corrective Action Provision:
		Amount			Ratio		Amount			Ratio			Amount			Ratio
		(Dollars in Thousands)
September 30, 2003 (unaudited)
Tier 1 (Core) Capital (to Adjusted Assets)		$	154,413		8.91	%	69,300			>	4.00	%	$	86,625		>	5.00	%
Tier 1 (Core) (to Risk Weighted Assets)		154,413			11.18		55,227			4.00			82,840			6.00
Total Risk Based Capital (to Risk Weighted Assets)		169,747			12.29		110,454			8.00			138,067			10.00
December 31, 2002
Tier 1 (Core) Capital (to Adjusted Assets)		$	137,275		7.81	%	$	70,312		>	4.00	%	$	87,890		>	5.00	%
Tier 1 Capital (to Risk Weighted Assets)		137,275			9.79		56,094			4.00			84,141			6.00
Total Risk Based Capital (to Risk Weighted Assets)		151,727			10.82		112,188			8.00			140,235			10.00

 

Recent Accounting Developments

 

In May 2003, the FASB issued  Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  This statement requires issuers to classify as liabilities (or assets in some circumstances) three classes of freestanding financial instruments that embody obligations of the issuer.  Generally, the statement is effective for financial instruments entered into or modified after, May 31, 2003 and is otherwise effective on July 1, 2003.  On October 29, 2003, the FASB delayed certain aspects of the statement.  During the first quarter of 2003, the trust preferred securities, or junior subordinated debentures, were reclassified to liabilities on the consolidated balance sheet.  In addition, the interest cost on the trust preferred securities has been reclassified as interest on borrowings.  There will be no impact to the results of operations.

 

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

Market Risk

 

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices.  The Company’s primary market risk exposure is interest rate risk.  The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability management process which is governed by policies established by the Board of Directors that are reviewed and approved annually.  The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Asset/Liability Committee (ALCO).  In this capacity, ALCO develops guidelines and strategies impacting the Company’s asset/liability related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels/trends.

 

Interest Rate Risk

 

Interest rate risk represents the sensitivity of earnings to changes in market interest rates.  As interest rates change the interest income and expense streams associated with the Company’s financial instruments also change thereby impacting net interest income (NII), the primary component of the Company’s earnings.  ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of NII to sustained interest rate changes.  While ALCO routinely monitors simulated NII sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.  There have been no material changes in the interest rate risk reported at the conclusion of the Company’s December 31, 2002 year end.

 

Liquidity and Capital Resources

 

The Bank’s principal sources of liquidity are customer deposits, borrowings from the FHLB, scheduled amortization and prepayments of loan principal, cash flow from operations, maturities of various investments and loan sales.

 

Management believes it is prudent to maintain an investment portfolio that not only provides a source of income, but also provides a potential source of liquidity to meet lending demand and deposit flows.  The Bank adjusts the level of its liquid assets and the mix of its loans and investments based upon management’s judgment as to the quality of specific investment opportunities and the relative attractiveness of their maturities and yields.

 

Management believes the Company has adequate sources of liquidity to fund current and future operations.

 

Impact of Inflation

 

The financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles which require measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

 

An important concept in understanding the effect of inflation on financial institutions is the distinction between monetary and non-monetary items.  In a stable environment, monetary items are those assets and liabilities that are or will be converted into a fixed amount of dollars regardless of changes in prices.  Examples of monetary items include cash, investment securities, loans, deposits and borrowings.  Non-monetary items are those assets and liabilities that gain or lose general purchasing power as a result of the relationships between specific prices for the items and price change levels.  Examples of non-monetary items include equipment and real estate.  Additionally, interest rates do not necessarily move in the same direction, or in the same magnitude, as the prices of goods and services as measured by the consumer price index.

 

21

 

Item 4. Controls and Procedures

 

(a)           Evaluation of disclosure controls and procedures.  Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

 

(b)          Changes in internal control over financial reporting.  There were no significant changes in our internal control over financial reporting during our last fiscal quarter that have materially affected, or are reasonable likely to materially affect, our internal control over financial reporting.

 

 

PART II – OTHER INFORMATION

 

Item 6. Exhibits and Reports on Form 8-K

 

(3)            Articles of Incorporation and By-laws:

3.1.                     The Restated Certificate of Incorporation of the Company is incorporated herein by reference to Exhibit 3.1 to Amendment No. 1 to the Company’s Registration Statement on Form S-1, Registration No. 33-10966, filed with the Securities and Exchange Commission on April 17, 1987 (“Amendment No. 1 to the Form S-1”).

3.2.                     The Amended and Restated By-laws of the Company are incorporated herein by reference to Exhibit 4.1 of the Company’s current report on Form 8-K filed on December 28, 1992.

 

(11)                          Computation of Earnings Per Share:

Statement regarding computation of per share earnings is included in Note 1 to the consolidated financial  statements.

 

(31.1)                Certification of chief executive officer  under Section 302 of the Sarbanes-Oxley Act of 2002 is attached hereto as Exhibit 31.1.

 

(31.2)                Certification of chief financial officer  under Section 302 of the Sarbanes-Oxley Act of 2002 is attached hereto as Exhibit 31.2.

 

(32)                          Certification under Section 906 of the Sarbanes-Oxley Act of 2002 is attached hereto as Exhibit 32.

 

(b)             Reports on Form 8-K.

 

The Registrant filed a current report on Form 8-K on July 17, 2003 related to a press release dated July 16, 2003 announcing second quarter 2003 results.

 

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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 ESSEX BANCORP, INC.
			(Registrant)
	Date:  November 5, 2003			By	/s/William F. Burke
						William F. Burke
						Executive Vice President and Chief Financial Officer

 

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