UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

(Mark One)

 

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2004

 

OR

 

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                    

 

Commission file number   0-14289

 

GREENE COUNTY BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

 

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 12b-2 of the Act.) YES ý   NO o

 

As of November 5, 2004, the number of shares outstanding of the issuer’s common stock was: 7,646,330.

 

 

PART 1 – FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

The unaudited condensed consolidated financial statements of the Registrant and its wholly owned subsidiaries are as follows:

 

Condensed Consolidated Balance Sheets – September 30, 2004 and December 31, 2003.
Condensed Consolidated Statements of Income and Comprehensive Income - For the three and nine months ended September 30, 2004 and 2003.
Condensed Consolidated Statement of Changes in Shareholders’ Equity – For the nine months ended September 30, 2004.
Condensed Consolidated Statements of Cash Flows - For the nine months ended September 30, 2004 and 2003.
Notes to Condensed Consolidated Financial Statements.

 

1

 

GREENE COUNTY BANCSHARES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

September 30, 2004 and December 31, 2003

(Amounts in thousands, except share and per share data)

 

		(Unaudited)
		September 30, 2004			December 31, 2003*
ASSETS
Cash and due from banks		$	30,450		$	36,087
Federal funds sold		722			5,254
Securities available for sale		27,598			33,199
Securities held to maturity (with a market value of $4,641 and $5,846)		4,482			5,632
FHLB, Bankers Bank and other stock, at cost		6,154			5,992
Loans held for sale		1,865			3,546
Loans		981,506			952,225
Less: Allowance for loan losses		(14,850		)	(14,564		)
Net loans		966,656			937,661
Premises and equipment, net		34,867			33,886
Goodwill and other intangible assets		20,508			20,970
Other assets		26,926			26,295
Total assets		$	1,120,228		$	1,108,522
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits		$	878,088		$	907,115
Repurchase agreements		10,470			12,896
FHLB advances and notes payable		100,757			63,030
Subordinated debentures		10,310			10,310
Accrued interest payable and other liabilities		12,589			13,236
Total liabilities		1,012,214			1,006,587
Shareholders’ equity
Common stock: $2 par, 15,000,000 shares authorized, 7,644,650 and 7,659,929 shares outstanding		15,290			15,320
Additional paid in capital		24,119			24,482
Retained earnings		68,533			61,947
Accumulated other comprehensive income		72			186
Total shareholders’ equity		108,014			101,935
Total liabilities and shareholders’ equity		$	1,120,228		$	1,108,522

 

* Derived from audited consolidated financial statements.

 

See accompanying notes.

 

2

 

GREENE COUNTY BANCSHARES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

Three and Nine Months Ended September 30, 2004 and 2003

(Amounts in thousands, except share and per share data)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
		(Unaudited)						(Unaudited)
Interest income
Interest and fees on loans		$	15,796		$	13,603		$	46,843		$	40,942
Investment securities		344			117			1,069			761
Federal funds sold and interest-earning deposits		2			143			29			242
		16,142			13,863			47,941			41,945
Interest expense
Deposits		2,665			2,856			8,857			9,610
Borrowings		1,065			850			2,809			2,320
		3,730			3,706			11,666			11,930
Net interest income		12,412			10,157			36,275			30,015
Provision for loan losses		1,062			1,655			3,747			4,510
Net interest income after provision for loan losses		11,350			8,502			32,528			25,505
Noninterest income
Service charges and fees		2,436			2,388			7,349			6,919
Other		584			572			1,835			1,662
		3,020			2,960			9,184			8,581
Noninterest expense
Salaries and employee benefits		4,800			3,997			13,971			12,086
Occupancy and furniture and equipment expense		1,494			1,184			4,445			3,357
Other		2,917			2,198			8,320			6,860
		9,211			7,379			26,736			22,303
Income before income taxes		5,159			4,083			14,976			11,783
Provision for income taxes		1,946			1,483			5,636			4,264
Net income		$	3,213		$	2,600		$	9,340		$	7,519
Comprehensive income		$	3,418		$	2,550		$	9,226		$	7,546
Per share of common stock:
Basic earnings		$	0.42		$	0.38		$	1.22		$	1.10
Diluted earnings		0.42			0.38			1.21			1.09
Dividends		0.12			0.12			0.36			0.36
Weighted average shares outstanding:
Basic		7,644,544			6,823,315			7,657,078			6,822,040
Diluted		7,710,335			6,894,097			7,724,756			6,893,420

 

See accompanying notes.

 

3

 

GREENE COUNTY BANCSHARES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

For Nine Months Ended September 30, 2004

(Amounts in thousands, except share and per share data)

 

		Common Stock			Additional Paid-in Capital			Retained Earnings			Accumulated Other Compre- hensive Income (loss)			Total Share- holders’ Equity
Balance, January 1, 2004		$	15,320		$	24,482		$	61,947		$	186		$	101,935
Common stock transactions:
Issuance of 10,421 shares under stock option plan		21			120									141
Repurchase of common stock, 25,700 shares		(51		)	(487		)							(538		)
Tax benefit from exercise of nonincentive stock options					4									4
Dividends ($.36 per share)		—						(2,754		)				(2,754		)
Comprehensive income:
Net income		—						9,340						9,340
Change in unrealized gains (losses), net of reclassification and taxes		—									(114		)	(114		)
Total comprehensive income		—			—			—			—			9,226
Balance, September 30, 2004		$	15,290		$	24,119		$	68,533		$	72		$	108,014

 

See accompanying notes.

 

4

 

GREENE COUNTY BANCSHARES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2004 and 2003

(Amounts in thousands, except share and per share data)

 

		September 30, 2004			September 30, 2003
		(Unaudited)
Cash flows from operating activities
Net income		$	9,340		$	7,519
Adjustments to reconcile net income to net cash from operating activities
Provision for loan losses		3,747			4,510
Depreciation and amortization		2,297			1,519
Security amortization and accretion, net		83			113
FHLB stock dividends		(162		)	(139		)
Net gain on sale of mortgage loans		(368		)	(927		)
Originations of mortgage loans held for sale		(36,085		)	(61,460		)
Proceeds from sales of mortgage loans		38,134			65,190
Net losses from sales of fixed assets		47			104
Net loss on OREO and repossessed assets		216			199
Net changes:
Other assets		2,199			245
Accrued interest payable and other liabilities		(643		)	(2,808		)
Net cash from operating activities		18,805			14,065
Cash flows from investing activities
Net change in securities and other interest-earning investments		6,488			10,475
Increase in cash surrender value of life insurance		(2,858		)	(561		)
Net increase in loans		(36,005		)	(67,104		)
Improvements to other real estate and proceeds from sales of other real estate owned, net		3,145			4,564
Proceeds from fixed assets additions and sale of fixed assets, net		(2,866		)	(3,104		)
Net cash from investing activities		(32,096		)	(55,730		)
Cash flows from financing activities
Net decrease in deposits		(29,027		)	(14,825		)
Net (decrease) increase in repurchase agreements		(2,426		)	10,482
Net increase in FHLB advances and notes payable		37,726			6,707
Proceeds from subordinated debentures		—			10,000
Dividends paid		(2,754		)	(2,456		)
Proceeds from issuance of common stock		141			37
Repurchase of common stock		(538		)	—
Net cash from financing activities		3,122			9,945
Net decrease in cash and cash equivalents		(10,169		)	(31,720		)
Cash and cash equivalents, beginning of year		41,341			62,959
Cash and cash equivalents, end of period		$	31,172		$	31,239
Supplemental disclosures – cash and noncash
Interest paid		$	12,585		$	12,578
Income taxes paid		3,527			3,790
Loans transferred to other real estate		3,817			5,195
Unrealized (loss) gain on available for sale securities, net of tax		(114		)	27

 

See accompanying notes.

 

5

 

GREENE COUNTY BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004

Unaudited

(Amounts in thousands, except share and per share data)

 

NOTE 1 – PRINCIPLES OF CONSOLIDATION

 

The accompanying unaudited condensed consolidated financial statements of Greene County Bancshares, Inc. (the “Company”) and its wholly owned subsidiary, Greene County Bank (the “Bank”), have been prepared in accordance with accounting principles generally accepted in the United States of America for interim information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Certain amounts from prior period financial statements have been reclassified to conform to the current year’s presentation.

 

NOTE 2 – STOCK COMPENSATION

 

Employee compensation expense under stock option plans is reported if options are granted below market price at grant date, whereas expense for options granted at market price are reported on a pro forma basis. Pro forma disclosures of net income and earnings per share are shown below using the fair value method of SFAS No. 123 to measure expense for options using the Black-Scholes option pricing model to estimate fair value.

 

The shareholders of the Company approved, at their annual meeting on April 22, 2004, the Greene County Bancshares, Inc. 2004 Long-Term Incentive Plan (the “Plan”), for the purpose of attracting, retaining and motivating employees, officers and directors of the Company and to provide incentives and awards for superior performance. The Plan reserved 500,000 shares of common stock for issuance. No options have yet been granted under the Plan but options have been granted under the Company’s previous stock option plans.

 

The following disclosures show the effect on income and earnings per share had the outstanding options’ fair value been recorded using the Black-Scholes model.

 

		Three Months Ended September 30						Nine Months Ended September 30
		2004			2003			2004			2003
Net income:
As reported		$	3,213		$	2,600		$	9,340		$	7,519
Deduct: Total stock-based compensation expense determined under fair value-based method for all awards, net of tax		(38		)	(29		)	(113		)	(86		)
Pro forma		$	3,175		$	2,571		$	9,227		$	7,433
Earnings per common share:
As reported		$	0.42		$	0.38		$	1.22		$	1.10
Pro forma		$	0.42		$	0.37		$	1.20		$	1.08
Diluted earnings per common share:
As reported		$	0.42		$	0.38		$	1.21		$	1.09
Pro forma		$	0.41		$	0.37		$	1.19		$	1.07

 

6

 

NOTE 3 – ALLOWANCE FOR LOAN LOSSES

 

Transactions in the allowance for loan losses for the nine months ended September 30, 2004 and twelve months ended December 31, 2003 were as follows:

 

		September 30, 2004			December 31, 2003
Balance at beginning of year		$	14,564		$	12,586
Add (deduct):
Reserve acquired in acquisition		—			1,340
Provision		3,747			5,775
Loans charged off		(4,914		)	(6,797		)
Recoveries of loans charged off		1,453			1,660
Ending balance		$	14,850		$	14,564

 

		September 30, 2004			December 31, 2003
Loans past due 90 days still on accrual		$	979		$	224
Nonaccrual loans		7,214			4,305
Total		$	8,193		$	4,529

 

7

 

NOTE 4 – EARNINGS PER SHARE OF COMMON STOCK

 

Basic earnings per share (EPS) of common stock is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share of common stock is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding during the period. Stock options are regarded as potential common shares. Potential common shares are computed using the treasury stock method. For the three and nine months ended September 30, 2004, 72,155 options are excluded from the effect of dilutive securities because they are anti-dilutive; 70,105 options are similarly excluded from the effect of dilutive securities for the three and nine months ended September 30, 2003.

 

The following is a reconciliation of the numerators and denominators used in the basic and diluted earnings per share computations for the three and nine months ended September 30, 2004 and 2003:

 

		Three Months Ended September 30,
		2004					2003
		Income			Shares		Income			Shares
		(Numerator)			(Denominator)		(Numerator)			(Denominator)
Basic EPS
Income available to common shareholders		$	3,213		7,644,544		$	2,600		6,823,315
Effect of dilutive securities
Stock options outstanding		—			65,791		—			70,782
Diluted EPS
Income available to common shareholders plus assumed conversions		$	3,213		7,710,335		$	2,600		6,894,097

 

		Nine Months Ended September 30,
		2004					2003
		Income			Shares		Income			Shares
		(Numerator)			(Denominator)		(Numerator)			(Denominator)
Basic EPS
Income available to common shareholders		$	9,340		7,657,078		$	7,519		6,822,040
Effect of dilutive securities
Stock options outstanding		—			67,678		—			71,380
Diluted EPS
Income available to common shareholders plus assumed conversions		$	9,340		7,724,756		$	7,519		6,893,420

 

8

 

NOTE 5 – SEGMENT INFORMATION

 

The Company’s operating segments include banking, mortgage banking, consumer finance, subprime automobile lending and title insurance. The reportable segments are determined by the products and services offered, and internal reporting. Loans, investments, and deposits provide the revenues in the banking operation, loans and fees provide the revenues in consumer finance, mortgage banking, and subprime lending and insurance commissions provide revenues for the title insurance company. Consumer finance, subprime automobile lending and title insurance do not meet the quantitative threshold on an individual basis, and are therefore shown below in “other”. Mortgage banking operations are included in “Bank”.  All operations are domestic.

 

Segment performance is evaluated using net interest income and noninterest income. Income taxes are allocated based on income before income taxes, and indirect expenses (including management fees) are allocated based on time spent for each segment. Transactions among segments are made at fair value. Information reported internally for performance assessment follows.

 

Three months ended September 30, 2004		Bank			Other			Total
Net interest income		$	11,049		$	1,363		$	12,412
Provision for loan losses		838			224			1,062
Noninterest income		2,828			192			3,020
Noninterest expense		8,127			1,084			9,211
Income tax expense		1,870			76			1,946
Segment profit		$	3,042		$	171		$	3,213
Segment assets at September 30, 2004		$	1,087,230		$	32,998		$	1,120,228

 

Three months ended September 30, 2003		Bank			Other			Total
Net interest income		$	8,518		$	1,639		$	10,157
Provision for loan losses		1,099			556			1,655
Noninterest income		2,590			370			2,960
Noninterest expense		6,133			1,246			7,379
Income tax expense		1,387			96			1,483
Segment profit		$	2,489		$	111		$	2,600
Segment assets at September 30, 2003		$	869,200		$	35,255		$	904,455

 

Nine months ended September 30, 2004		Bank			Other			Total
Net interest income		$	31,947		$	4,328		$	36,275
Provision for loan losses		2,674			1,073			3,747
Noninterest income		8,402			782			9,184
Noninterest expense		23,330			3,406			26,736
Income tax expense		5,447			189			5,636
Segment profit		$	8,898		$	442		$	9,340

 

Nine months ended September 30, 2003		Bank			Other			Total
Net interest income		$	25,141		$	4,874		$	30,015
Provision for loan losses		2,865			1,645			4,510
Noninterest income		7,473			1,108			8,581
Noninterest expense		18,633			3,670			22,303
Income tax expense		4,009			255			4,264
Segment profit		$	7,107		$	412		$	7,519

 

9

 

Asset Quality Ratios

 

As of and for the period ended September 30, 2004		Bank		Other		Total
Nonperforming loans as a percentage of total loans		0.77	%	1.67	%	0.83	%
Nonperforming assets as a percentage of total assets		1.01	%	3.18	%	1.10	%
Allowance for loan losses as a percentage of total loans		1.25	%	6.19	%	1.50	%
Allowance for loan losses as a percentage of nonperforming assets		108.50	%	249.81	%	120.52	%
Annualized net charge-offs to average total loans, net of unearned interest		0.30	%	3.98	%	0.47	%

 

As of and for the period ended September 30, 2003		Bank		Other		Total
Nonperforming loans as a percentage of total loans		0.49	%	1.58	%	0.57	%
Nonperforming assets as a percentage of total assets		0.95	%	2.88	%	1.09	%
Allowance for loan losses as a percentage of total loans		1.19	%	7.22	%	1.56	%
Allowance for loan losses as a percentage of nonperforming assets		110.96	%	249.61	%	129.03	%
Annualized net charge-offs to average total loans, net of unearned interest		0.41	%	5.67	%	0.74	%

 

As of and for the period ended December 31, 2003		Bank		Other		Total
Nonperforming loans as a percentage of total loans		0.40	%	1.64	%	0.47	%
Nonperforming assets as a percentage of total assets		0.68	%	3.38	%	0.79	%
Allowance for loan losses as a percentage of total loans		1.24	%	6.45	%	1.51	%
Allowance for loan losses as a percentage of nonperforming assets		154.91	%	239.41	%	166.35	%
Net charge-offs to average total loans, net of unearned interest		0.33	%	5.53	%	0.64	%

 

10

 

NOTE 6 – GOODWILL AND OTHER INTANGIBLE ASSETS

 

Goodwill

 

Goodwill was no longer amortized starting in 2002; however, it is periodically evaluated for impairment and no impairment was recognized during the first nine months of 2004.

 

The change in the carrying amount of goodwill for the nine months ended September 30, 2004 is as follows:

 

Beginning of year		$	15,885
Goodwill from acquisition during the year		—
End of quarter		$	15,885

 

Core deposit and other intangibles

 

Other intangible assets consist of core deposit intangibles arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on a straight-line method over their estimated useful lives, which is 10 years.

 

Core deposit intangibles had a gross carrying amount of $6,367 for the period ended September 30, 2004 and the year ended December 31, 2003 and accumulated amortization of $1,744 and $1,282 for the same periods, respectively. Aggregate amortization expense for the three and nine months ended September 30, 2004 was $154 and $462, respectively. Annual estimated amortization expense for the next five years is:

 

2004		$	616
2005		616
2006		506
2007		506
2008		506
Total		$	2,750

 

11

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-Looking Statements

 

This Quarterly Report on Form 10-Q, including all documents incorporated herein by reference, contains forward-looking statements. Additional written or oral forward-looking statements may be made by the Company from time to time in filings with the Securities and Exchange Commission (“SEC”) or otherwise. The words “believe”, “expect”, “seek”, and “intend” and similar expressions identify forward-looking statements, which speak only as of the date the statement is made.  The use of “annualized” information, which extrapolates nine months actual financial results to the full year 2004, is also forward-looking.  Such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but are not limited to, projections of income or loss, expenditures, acquisitions, plans for future operations, financing needs or plans relating to services of the Company, as well as assumptions relating to the foregoing. The Company’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors, including, but not limited to (1) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; (2) lack of sustained growth in the economy in the markets that the Bank serves; (3) increased competition with other financial institutions in the markets that the Bank serves; (4) changes in the legislative and regulatory environment; and (5) the loss of key personnel.

 

Presentation of Amounts

 

All dollar amounts set forth below, other than per-share amounts, are in thousands unless otherwise noted.

 

General

 

Greene County Bancshares, Inc. (the “Company”) is the bank holding company for Greene County Bank (the “Bank”), a Tennessee-chartered commercial bank that conducts the principal business of the Company. In addition to its commercial banking operations, the Bank conducts separate businesses through its three wholly-owned subsidiaries: Superior Financial Services, Inc. (“Superior Financial”), a consumer finance company; GCB Acceptance Corporation (“GCB Acceptance”), a subprime automobile lending company; and Fairway Title Co., a title company formed in 1998. The Bank also operates a mortgage banking operation which has its main office in Knox County, Tennessee and this operation also has representatives located throughout the Company’s branch system.

 

On November 21, 2003, the Company entered the Middle Tennessee market by completing its acquisition of Gallatin, Tennessee-based Independent Bankshares Corporation (“IBC”).  IBC was the bank holding company for First Independent Bank, which had four offices in Gallatin and Hendersonville, Tennessee, and Rutherford Bank and Trust, with three offices in Murfreesboro and Smyrna, Tennessee.  First Independent Bank and Rutherford Bank and Trust were subsequently merged with the Bank, with the Bank as the surviving entity.  The Company completed the IBC system conversion process during the latter part of the quarter ended March 31, 2004.

 

On September 20, 2004, the Company announced that it has agreed to purchase three branch offices in Lawrence County, Tennessee, from National Bank of Commerce.  These branches, two located in Lawrenceburg and the third in St. Joseph, have a combined total of approximately $68 million in deposits and $31 million in loans outstanding.  The transaction is expected to be completed by year’s end and is subject to regulatory approvals and other customary conditions.

 

On September 27, 2004, the Company announced that it plans to establish new banking operations in Nashville, Tennessee to serve the surrounding metropolitan area.  This new initiative, named Middle Tennessee Bank & Trust, is expected to complement the Company’s existing presence in the mid-state and help fill in the market between Sumner and Rutherford Counties of Tennessee.  Each banking location will operate as a branch office of the Bank.  The first branch office for Middle Tennessee Bank & Trust is set to open in Donelson, Tennessee in mid-November 2004.

 

12

 

Growth and Business Strategy

 

The Company expects that, over the intermediate term, its growth from mergers and acquisitions, including acquisitions of both entire financial institutions and selected branches of financial institutions, will continue.  With respect to the acquisition of entire financial institutions, the Company is focusing on institutions with assets between $100 million and $400 million.  De novo branching is also expected to be a method of growth, particularly in high-growth and other demographically-desirable markets.

 

The Company’s strategic plan outlines a geographic expansion policy within a 300-mile radius of Greene County, Tennessee. This policy could result in the Company expanding westward and eastward up to and including Nashville, Tennessee and Roanoke, Virginia, respectively, east/southeast up to and including the Piedmont area of North Carolina and western North Carolina, southward to northern Georgia and northward into eastern and central Kentucky. In particular, the Company believes the markets in and around Knoxville and Nashville, Tennessee are highly desirable areas with respect to expansion and growth plans.

 

The Company is continuously investigating and analyzing other lines and areas of business.  These include, but are not limited to, various types of insurance, real estate activities, etc. Conversely, the Company frequently evaluates and analyzes the profitability, risk factors and viability of its various business lines and segments and, depending upon the results of these evaluations and analyses, may conclude to exit certain segments and/or business lines. Further, in conjunction with these ongoing evaluations and analyses, the Company may decide to sell, merge or close certain branch facilities.

 

Overview

 

The Company’s results of operations for the third quarter and year-to-date period ended September 30, 2004, compared to the same periods in 2003, reflected a significant increase in net interest income due, in part, to the November 2003 acquisition of IBC in Middle Tennessee, which added seven branch offices, as well as growth in other key markets, most notably in Blount County and Knoxville, Tennessee.  Because of this growth and the associated increase in loans, along with the short-term interest rate increases by the Federal Reserve Board (“FRB”) beginning in the quarter ended September 30, 2004, the Company experienced an increase in net income and earnings per share for the quarter versus the same period last year.

 

Critical Accounting Policies and Estimates

 

The Company’s consolidated financial statements and accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported periods.

 

Management continually evaluates the Company’s accounting policies and estimates it uses to prepare the consolidated financial statements.  In general, management’s estimates are based on historical experience, information from regulators and third party professionals and various assumptions that are believed to be reasonable under the facts and circumstances.  Actual results could differ from those estimates made by management.

 

The Company believes its critical accounting policies and estimates include the valuation of the allowance for loan losses and the fair value of financial instruments and other accounts.  Based on management’s calculation, an allowance of $14,850, or 1.50%, of total loans was an adequate estimate of losses within the loan portfolio as of September 30, 2004.  This estimate resulted in a provision for loan losses on the income statement of $1,062 and $3,747, respectively, for the three and nine months ended September 30, 2004.  If the mix and amount of future charge-off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could be materially affected.

 

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The consolidated financial statements include certain accounting and disclosures that require management to make estimates about fair values. Estimates of fair value are used in the accounting for securities available for sale, loans held for sale, goodwill, other intangible assets, and acquisition purchase accounting adjustments.  Estimates of fair values are used in disclosures regarding securities held to maturity, stock compensation, commitments, and the fair values of financial instruments. Fair values are estimated using relevant market information and other assumptions such as interest rates, credit risk, prepayments and other factors.  The fair values of financial instruments are subject to change as influenced by market conditions.

 

Liquidity and Capital Resources

 

Liquidity.  Liquidity refers to the ability or the financial flexibility to manage future cash flows to meet the needs of depositors and borrowers and fund operations. Maintaining appropriate levels of liquidity allows the Company to have sufficient funds available for reserve requirements, customer demand for loans, withdrawal of deposit balances and maturities of deposits and other liabilities. The Company’s liquid assets include cash and due from banks, federal funds sold, investment securities and loans held for sale. Including securities pledged to collateralize municipal deposits, these assets represented 7.13% of the total liquidity base at September 30, 2004, as compared to 9.03% at December 31, 2003. The liquidity base is generally defined to include deposits, repurchase agreements, notes payable and subordinated debentures.  In addition, the Company maintains borrowing availability with the Federal Home Loan Bank of Cincinnati (“FHLB”) approximating $21,706 at September 30, 2004. The Company also maintains federal funds lines of credit totaling $106,000 at eight correspondent banks of which $106,000 was available at September 30, 2004. The Company believes it has sufficient liquidity to satisfy its current operating needs.

 

For the nine months ended September 30, 2004, operating activities of the Company provided $18,805 of cash flows. Net income of $9,340 comprised a substantial portion of the cash generated from operations.  Cash flows from operating activities were also positively affected by various non-cash items, including (i) $3,747 in provision for loan losses, (ii) $2,297 of depreciation and amortization and (iii) $2,199 net change in other assets.  In addition, the cash flows provided by the proceeds from sales of mortgage loans exceeded the cash flows used by the originations of mortgage loans held for sale by $2,049.

 

The Company’s net increase in loans originated, net of principal collected, used $36,005 in cash flows and was the primary component of the $32,096 in net cash used in investing activities.  The increase in cash surrender value of life insurance, reflecting both normal increases via earnings and also purchases of additional insurance related to certain benefit plans, used $2,858 in cash flows, and fixed asset additions, net of proceeds from sale of fixed assets, used $2,866 in cash flows.  Offsetting, in part, this use of cash flows were the net changes in securities and other interest-earning investments and in improvements to other real estate and proceeds from sales of other real estate owned, net, in the amounts of $6,488 and $3,145, respectively.

 

The net increase in notes payable provided $37,726 in cash flows and was the primary component in net cash generated from financing activities in the amount of $3,122, as the Company elected to increase its short-term borrowings from the FHLB to offset the $29,027 decrease in deposits resulting from the Company’s decision to reduce higher cost deposits. In addition, dividends paid in the amount of $2,754 further reduced the total net cash provided from financing activities.

 

Capital Resources.  The Company’s capital position is reflected in its shareholders’ equity, subject to certain adjustments for regulatory purposes. Shareholders’ equity, or capital, is a measure of the Company’s net worth, soundness and viability. The Company continues to exhibit a strong capital position while consistently paying dividends to its shareholders. Further, the capital base of the Company allows it to take advantage of business opportunities while maintaining the level of resources deemed appropriate by management of the Company to address business risks inherent in the Company’s daily operations.

 

Shareholders’ equity on September 30, 2004 was $108,014, an increase of $6,079, or 5.96%, from $101,935 on December 31, 2003. The increase in shareholders’ equity primarily reflected net income for the nine months ended September 30, 2004 of $9,340 ($1.21 per share, assuming dilution). This increase was offset by quarterly dividend payments during the nine months ended September 30, 2004 totaling $2,754 ($0.36 per share).

 

On September 18, 2002 the Company announced that its Board of Directors had authorized the repurchase of up to $2,000 of the Company’s outstanding shares of common stock beginning in October 2002, and the

 

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repurchase plan was renewed by the Board of Directors in September 2003. On June 4, 2004 the Company announced that its Board of Directors had approved an increase in the amount authorized to be repurchased from $2,000 to $5,000. The repurchase plan is dependent upon market conditions and there is no guarantee as to the exact number of shares to be repurchased by the Company.  To date, the Company has purchased 25,700 shares at an aggregate cost of approximately $538 under this program which expired on October 1, 2004.  The Company expects that the Board of Directors will renew this repurchase plan in November 2004.

 

The Company’s primary source of liquidity is dividends paid by the Bank.  Applicable Tennessee statutes and regulations impose restrictions on the amount of dividends that may be declared by the Bank. Further, any dividend payments are subject to the continuing ability of the Bank to maintain its compliance with minimum federal regulatory capital requirements and to retain its characterization under federal regulations as a “well-capitalized” institution.

 

Risk-based capital regulations adopted by the Board of Governors of the FRB and the Federal Deposit Insurance Corporation (the “FDIC”) require bank holding companies and banks, respectively, to achieve and maintain specified ratios of capital to risk-weighted assets. The risk-based capital rules are designed to measure Tier 1 Capital and Total Capital in relation to the credit risk of both on- and off-balance sheet items.  Under the guidelines, one of four risk weights is applied to the different on-balance sheet items.  Off-balance sheet items, such as loan commitments, are also subject to risk-weighting after conversion to balance sheet equivalent amounts. All bank holding companies and banks must maintain a minimum total capital to total risk-weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital (consisting of shareholders’ equity, less goodwill and other intangible assets and accumulated other comprehensive income). At September 30, 2004, the Company and the Bank each satisfied their respective minimum regulatory capital requirements, and the Bank was “well-capitalized” within the meaning of federal regulatory requirements.  The capital ratios of the Bank contained within the table below do not differ materially from those of the Company.

 

CAPITAL RATIOS AT SEPTEMBER 30, 2004

 

 

On September 25, 2003, the Company issued $10,310 of subordinated debentures, as part of a privately placed pool of trust preferred securities.  The securities, due in 2033, bear interest at a floating rate of 2.85% above the three-month LIBOR rate, reset quarterly, and are callable in five years without penalty.  The Company used the proceeds of the offering to support its acquisition of IBC, and the capital raised from the offering qualifies as Tier I capital for regulatory purposes.

 

On May 6, 2004, the FRB issued proposed rules which would continue to include trust preferred securities in the Tier 1 capital of bank holding companies, subject to stricter quantitative limits and qualitative standards.  The proposed rules also considered the impact of Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN 46”) and its revision (“FIN 46R”), and the related accounting treatment for trust preferred securities, on the inclusion of trust preferred securities as Tier 1 capital.

 

The Company has reviewed these proposed rules and believes that they will have no negative effect on the capital treatment of the Company’s existing trust preferred securities. In addition, management believes that these proposed rules will not constrain the Company with respect to the potential issuance of additional trust preferred securities in accordance with the Company’s growth plans and attendant regulatory capital needs.

 

The FDIC, however, has indicated to the FRB that it opposes the continuation of trust preferred securities as Tier 1 regulatory capital. Should the FRB modify its proposed rules to agree with the FDIC’s opposition to the continuation of trust preferred securities as Tier 1 regulatory capital, there would be a reduction in the Company’s consolidated capital ratios and the Company may not remain “well capitalized”, with respect to total risk-based capital, under FRB guidelines.  However, the Bank would remain “well capitalized”, with respect to all capital ratios, as a result of the push down accounting transaction associated with the IBC acquisition. In addition, under such a scenario, the Company’s potential issuance of additional trust preferred securities may well be curtailed or

 

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eliminated.  As a result, it may be necessary for the Company to issue additional common stock in association with any future acquisitions, which, among other things, may be more dilutive to earnings per share than if the capital requirements of such acquisitions were funded through the issuance of additional trust preferred securities.

 

Off-Balance Sheet Arrangements

 

At September 30, 2004, the Company had outstanding unused lines of credit and standby letters of credit totaling $204,009 and unfunded loan commitments outstanding of $57,631.  Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements.  If needed to fund these outstanding commitments, the Company has the ability to liquidate Federal funds sold or securities available-for-sale or, on a short-term basis, to borrow from the FHLB and/or purchase Federal funds from other financial institutions.  At September 30, 2004, the Company had accommodations with upstream correspondent banks for unsecured Federal funds lines.  These accommodations have various covenants related to their term and availability, and in most cases must be repaid within less th an a month.  The following table presents additional information about the Company’s off-balance sheet commitments as of September 30, 2004, which by their terms have contractual maturity dates subsequent to September 30, 2004:

 

		Less than 1 Year			1-3 Years			3-5 Years			More than 5 Years			Total
Commitments to make loans - fixed		$	37,795		$	—		$	—		$	—		$	37,795
Commitments to make loans – variable		19,836			—			—			—			19,836
Unused lines of credit		115,581			23,968			1,990			35,540			177,079
Letters of credit		5,692			18,438			—			2,800			26,930
Total		$	178,904		$	42,406		$	1,990		$	38,340		$	261,640

 

Disclosure of Contractual Obligations

 

In the ordinary course of operations, the Company enters into certain contractual obligations.  Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment.  The following table summarizes the Company’s significant fixed and determinable contractual obligations as of September 30, 2004:

 

		Less than 1 Year			1-3 Years			3-5 Years			More than 5 Years			Total
Deposits without a stated maturity		$	430,498		$	—		$	—		$	—		$	430,498
Certificate of deposits		317,582			122,368			7,315			325			447,590
Repurchase agreements		10,470			—			—			—			10,470
FHLB advances and notes payable		45,640			2,096			5,289			47,732			100,757
Subordinated debentures		—			—			—			10,310			10,310
Operating lease obligations		389			549			169			231			1,338
Deferred compensation		—			—			—			2,050			2,050
Purchase obligations		142			—			—			—			142
Total		$	804,721		$	125,013		$	12,773		$	60,648		$	1,003,155

 

Additionally, the Company routinely enters into contracts for services.  These contracts may require payment for services to be provided in the future and may also contain penalty clauses for early termination of the contract.  Management is not aware of any additional commitments or contingent liabilities which may have a material adverse impact on the liquidity or capital resources of the Company.

 

Changes in Results of Operations

 

Net income.  Net income for the three months ended September 30, 2004 was $3,213, as compared to $2,600 for the same period in 2003. This increase of $613, or 23.58%, resulted primarily from a $2,255 or 22.20%, increase in net interest income resulting principally from increased volume of interest-earning assets as a result primarily of the Company’s acquisition of IBC and growth in the Blount County and Knoxville, Tennessee markets.  In addition, the Company’s provision for loan losses decreased $593, or 35.83%, from $1,655 for the three months ended September 30, 2003 to $1,062 for the same period in 2004. Offsetting these increases, in part, was a $1,832,

 

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