UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  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 March 31, 2005

 

OR

 

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

 

Commission File Number 0-18832

 

First Financial Service Corporation

(Exact Name of Registrant as specified in its charter)

 

2323 Ring Road

Elizabethtown, Kentucky  42701

(Address of principal executive offices)

(Zip Code)

 

(270) 765-2131

(Registrant’s telephone number, including area code)

 

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

 

Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes ý  No o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

 

 

 

 

FIRST FINANCIAL SERVICE CORPORATION

 

TABLE OF CONTENTS

 

 

PART I — FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements and Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of the Consolidated Statements of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II — OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
SIGNATURES
CERTIFICATIONS

 

 

 

2

 

 

Item 1.FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Financial Condition

 

		(Unaudited)
		March 31,
(Dollars in thousands, except share data)		2005			2004
ASSETS
Cash and due from banks		$	18,900		$	27,910
Federal funds sold		10,000			8,000
Cash and cash equivalents		28,900			35,910
Securities available-for-sale		38,130			21,928
Securities held-to-maturity, fair value of $33,794 Mar (2005)
and $34,557 Dec (2004)		34,539			34,915
Total securities		72,669			56,843
Loans held for sale		721			1,219
Loans receivable, net of unearned fees		599,846			604,698
Allowance for loan losses		(6,701		)	(6,489		)
Net loans receivable		593,866			599,428
Federal Home Loan Bank stock		6,921			6,845
Cash surrender value of life insurance		7,425			7,353
Premises and equipment, net		18,080			17,469
Real estate owned:
Acquired through foreclosure		913			681
Held for development		389			389
Other repossessed assets		59			40
Goodwill		8,384			8,384
Accrued interest receivable		2,563			2,487
Other assets		2,302			1,817
TOTAL ASSETS		$	742,471		$	737,646
LIABILITIES AND STOCKHOLDERS’ EQUITY LIABILITIES:
Deposits:
Non-interest bearing		$	39,961		$	38,441
Interest bearing		549,088			547,945
Total deposits		589,049			586,386
Advances from Federal Home Loan Bank		78,860			78,904
Subordinated debentures		10,000			10,000
Accrued interest payable		393			413
Accounts payable and other liabilities		1,943			637
Deferred income taxes		1,291			1,505
TOTAL LIABILITIES		681,536			677,845
STOCKHOLDERS’ EQUITY:
Serial preferred stock, 5,000,000 shares
authorized and unissued		—			—
Common stock, $1 par value per share; authorized 10,000,000 shares; issued and outstanding, 3,648,188 shares Mar (2005), and 3,645,438 shares Dec (2004)		3,648			3,645
Additional paid-in capital		8,280			8,226
Retained earnings		48,666			47,174
Accumulated other comprehensive
income, net of tax		341			756
TOTAL STOCKHOLDERS’ EQUITY		60,935			59,801
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	742,471		$	737,646

 

See notes to the unaudited consolidated financial statements.

 

 

3

 

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Income

(Unaudited)

 

 

		Three Months Ended
		March 31,
(Dollars in thousands, except per share data)		2005			2004
Interest Income:
Interest and fees on loans		$	9,954		$	9,107
Interest and dividends on investments and deposits		676			443
Total interest income		10,630			9,550
Interest Expense:
Deposits		2,892			2,725
Federal Home Loan Bank advances		944			928
Subordinated debentures		158			124
Total interest expense		3,994			3,777
Net interest income		6,636			5,773
Provision for loan losses		275			389
Net interest income after provision for loan losses		6,361			5,384
Non-interest Income:
Customer service fees on deposit accounts		1,120			1,135
Gain on sale of mortgage loans		184			218
Brokerage commissions		78			94
Gain on sale of investments		381			—
Other income		258			324
Total non-interest income		2,021			1,771
Non-interest Expense:
Employee compensation and benefits		2,778			2,398
Office occupancy expense and equipment		494			408
Marketing and advertising		188			139
Outside services and data processing		597			514
Bank franchise tax		203			212
Other expense		884			768
Total non-interest expense		5,144			4,439
Income before income taxes		3,238			2,716
Income taxes		1,052			878
Net Income		$	2,186		$	1,838
Shares applicable to basic income per share		3,647,500			3,690,438
Basic income per share		$	0.60		$	0.50
Shares applicable to diluted income per share		3,665,496			3,708,063
Diluted income per share		$	0.60		$	0.50

 

See notes to the unaudited consolidated financial statements.

 

 

4

 

FIRST  FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

 

		Three Months Ended March 31,
(Dollars in thousands)		2005			2004
Net Income		$	2,186		$	1,838
Other comprehensive income (loss):
Change in unrealized gain (loss)
on securities		(248		)	41
Reclassification of realized amount		(381		)	—
Net unrealized gain (loss) recognized in
comprehensive income		(629		)	41
Tax effect		214			(14		)
Total other comphrehensive income (loss)		(415		)	27
Comphrehensive Income		$	1,771		$	1,865

 

See notes to the unaudited consolidated financial statements.

 

5

 

 

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders’ Equity

Three Months Ended March 31, 2005

(Dollars In Thousands, Except Per Share Amounts)

(Unaudited)

 

													Accumulated Other
							Additional						Comprehensive
		Common Stock					Paid-in			Retained			Income, Net of
		Shares		Amount			Capital			Earnings			Tax			Total
Balance, December 31, 2004		3,645		$	3,645		$	8,226		$	47,174		$	756		$	59,801
Net income										2,186						2,186
Exercise of stock options		3		3			54									57
Net change in unrealized gains (losses) on securities available- for-sale, net of tax													(415		)	(415		)
Cash dividends declared ($.19 per share)		—		—			—			(694		)	—			(694		)
Stock repurchased
Balance, March 31, 2005		3,648		$	3,648		$	8,280		$	48,666		$	341		$	60,935

 

See notes to the unaudited consolidated financial statements.

 

 

 

6

 

 

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

 

		Three Months Ended March 31,
		2005			2004
Operating Activities:
Net income		$	2,186		$	1,838
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		275			389
Depreciation on premises and equipment		301			244
Federal Home Loan Bank stock dividends		(76		)	(66		)
Net amortization (accretion)		106			9
Gain on sale of investments available-for-sale		(381		)	—
Gain on sale of mortgage loans		(184		)	(218		)
Origination of loans held for sale		(9,758		)	(11,893		)
Proceeds on sale of loans held for sale		10,440			11,769
Changes in:
Cash surrender value of life insurance		(72		)	(70		)
Interest receivable		(76		)	167
Other assets		(486		)	(994		)
Interest payable		(20		)	(18		)
Accounts payable and other liabilities		1,306			566
Net cash from operating activities		3,561			1,723
Investing Activities:
Sales of securities available-for-sale		1,431			—
Purchases of securities available-for-sale		(18,185		)	—
Purchases of securities held-to-maturity		—			(10,000		)
Maturities of securities held-to-maturity		574			16,365
Net change in loans		4,539			(15,278		)
Net purchases of premises and equipment		(912		)	(1,335		)
Net cash from investing activities		(12,553		)	(10,248		)
Financing Activities
Net change in deposits		2,663			11,685
Repayments to Federal Home Loan Bank		(44		)	(73		)
Proceeds from stock options exercised		57			—
Dividends paid		(694		)	(667		)
Common stock repurchased		—			(1,560		)
Net cash from financing activities		1,982			9,385
(Decrease) Increase in cash and cash equivalents		(7,010		)	860
Cash and cash equivalents, beginning of period		35,910			48,030
Cash and cash equivalents, end of period		$	28,900		$	48,890

 

See notes to the unaudited consolidated financial statements.

 

 

7

 

 

Notes To Unaudited Consolidated Financial Statements

 

1.                                      BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation — The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, First Heartland Mortgage Company and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated.

 

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of 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-month period ending March 31, 2005 are not necessarily indicative of the results that may occur for the year ending December 31, 2005.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2004.

 

Stock Option Plans — Employee compensation expense under stock option plans is reported using the intrinsic value method.  No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to the market price of the underlying common stock at date of grant.  The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation.

 

		Three Months Ended March 31,
		2005			2004
		(Dollars in thousands, except per share data)
Net income:
As reported		$	2,186		$	1,838
Deduct: Stock-based compensation expense
determined under fair value based method		(33		)	(31		)
Pro-forma		$	2,153		$	1,807
Earnings per share:
Basic        As Reported		$	0.60		$	0.50
Pro-forma		0.59			0.49
Diluted    As Reported		$	0.60		$	0.50
Pro-forma		0.59			0.49

 

 

  Effect of Newly Issued But Not Yet Effective Accounting Standards — In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment.”  SFAS No. 123R is a revision of FASB Statement 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance.  SFAS No. 123R requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options.  This will apply to awards granted or modified for the year beginning January 1, 2006.  Compensation cost will also be recorded for prior option grants that vest after the date of adoption.  The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so they cannot currently be predicted.  Existing options that will vest after adoption date are expected to result in additional compensation expense of approximately $66,000 in 2006, $60,000 in 2007, $60,000 in 2008 and $45,000 in 2009.  There will be no significant effect on financial position as total equity will not change.

 

8

 

 

Reclassifications — Certain amounts have been reclassified in the prior period financial statements to conform to the current period classifications.

 

 

2.             SECURITIES

 

The amortized cost basis and fair values of securities are as follows:

 

(Dollars in thousands)		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Fair Value
Securities available-for-sale:
March 31, 2005:
U. S. Treasury and agencies		$	31,861		$	—		$	(117	)	$		31,744
Mortgage-backed		1,764			—			(52		)	1,712
Equity		1,033			653			—			1,686
State and municipal		924			32			—			956
Corporate		2,032			—			—			2,032
Total		$	37,614		$	685		$	(169	)	$		38,130
December 31, 2004:
U. S. Treasury and agencies		$	15,985		$	—		$	(56	)	$		15,929
Mortgage-backed		1,901			—			(22		)	1,879
Equity		1,898			1,181			—			3,079
State and municipal		999			42			—			1,041
Total		$	20,783		$	1,223		$	(78	)	$	21,928

 

		Amortized Cost			Gross Unrecognized Gains			Gross Unrecognized Losses			Fair Value
Securities held-to-maturity:
March 31, 2005:
U.S. Treasury and agencies		$	26,094		$	—		$	(582	)	$	25,512
Mortgage-backed		6,445			6			(169		)	6,282
Corporate		2,000			—			—			2,000
Total		$	34,539		$	6		$	(751	)	$	33,794
December 31, 2004:
U.S. Treasury and agencies		$	26,095		$	3		$	(244	)	$	25,854
Mortgage-backed		6,820			7			(124		)	6,703
Corporate		2,000			—			—			2,000
Total		$	34,915		$	10		$	(368	)	$	34,557

 

 

9

 

3.             LOANS RECEIVABLE

 

Loans receivable are summarized as follows:

 

(Dollars in thousands)		March 31, 2005			December 31, 2004
Commercial		$	32,616		$	32,228
Real estate commercial		305,840			302,567
Real estate construction		9,515			10,850
Residential mortgage		153,942			159,550
Consumer and home equity		68,071			70,143
Indirect consumer		31,167			30,798
Loans held for sale		721			1,219
		601,872			607,355
Less:
Net deferred loan origination fees		(1,305		)	(1,438		)
Allowance for loan losses		(6,701		)	(6,489		)
		(8,006		)	(7,927		)
Loans Receivable		$	593,866		$	599,428

 

 

            The allowance for losses on loans is summarized as follows:

 

		As of and For the Three Months Ended March 31,
(Dollars in thousands)		2005			2004
Balance, beginning of period		$	6,489		$	5,568
Provision for loan losses		275			389
Charge-offs		(140		)	(271		)
Recoveries		77			47
Balance, end of period		$	6,701		$	5,733

 

 

Investment in impaired loans is summarized below.  There were no impaired loans for the periods presented without an allowance allocation.

 

 

(Dollars in thousands)		As of and For the Three Months Ended March 31, 2005			As of and For the Year Ended December 31, 2004
End of period impaired loans		$	5,418		$	5,240
Amount of allowance for loan
loss allocated		1,022			928

 

 

 

10

 

 

We report non-performing loans as impaired.  Our non-performing loans are as follows:

 

(Dollars in thousands)		March 31, 2005			December 31, 2004
Restructured		$	3,185		$	3,218
Loans past due over 90 days still on accrual		—			—
Non accrual loans		2,233			2,022
Total		$	5,418		$	5,240

 

 

4.             EARNINGS PER SHARE

 

             The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

 

		Three Months Ended March 31,
(Dollars in thousands, except per share data)		2005			2004
Net income available to common shareholders		$	2,186		$	1,838
Basic EPS:
Weighted average common shares		3,647			3,690
Diluted EPS:
Weighted average common shares		3,647			3,690
Dilutive effect of stock options		18			18
Weighted average common and incremental shares		3,665			3,708
Earnings Per Share:
Basic		$	0.60		$	0.50
Diluted		$	0.60		$	0.50

 

 

Stock options for 10,000 shares of common stock were not included in the 2004 computation of diluted earnings per share because their impact was anti-dilutive.

 

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

GENERAL

 

We conduct operations in 14 full-service banking centers in six contiguous counties in Central Kentucky along the Interstate 65 corridor.  Our market presence ranges from the major metropolitan market of Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown.  Our market is supported by a diversified industry base and consists of a regional population of over 1 million.

 

We serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

 

Through our personal investment financial counseling services, we offer a wide variety of mutual funds, equity investments, and fixed and variable annuities.

 

 

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We invest in the wholesale capital markets through the management of our security portfolio and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations.

 

Our results of operations depend primarily on net interest income, which is the difference between interest income we earn on loans, investment securities and other interest-earning assets and interest expense we pay on deposits and other interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, insurance agency revenue, loan fees, gains and losses from the sale of mortgage loans and gains from the sale of real estate held for development. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense and provisions for loan losses.

 

This discussion and analysis covers material changes in the financial condition since December 31, 2004 and material changes in the results of operations for the three-month period ending, March 31, 2005 as compared to 2004.  It should be read in conjunction with “Management Discussion and Analysis of Financial Condition and Results of Operations” included in the Annual Report on Form 10-K for the period ended December 31, 2004.

 

Business Risk

 

We, like other financial companies, are subject to a number of risks, many of which are outside of management’s control, though we strive to manage those risks while optimizing returns.  Among the risks assumed are: (a) credit risk, which is the risk that loan and lease customers or other counter parties will be unable to perform their contractual obligations, (b) market risk, which is the risk that changes in market rates and prices will adversely affect our financial condition or results of operation, (c) liquidity risk, which is the risk that we will have insufficient cash or access to cash to meet our operating needs, and (d) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.

 

In addition to the other information included or incorporated by reference into this report, readers should consider that the following important factors, among others, could materially impact our business, future results of operations, and future cash flows.

 

(a)          Credit Risk

 

We extend credit to a variety of customers based on internally set standards and the judgment of management.  We manage the credit risk it takes through a program of underwriting standards that we follow, the review of certain credit decisions, and an on-going process of assessment of the quality of the credit we have already extended.  There can be no assurance that our credit standards and our on-going process of credit assessment will protect us from significant credit losses.

 

Our loans and deposits are focused in central Kentucky and adverse economic conditions in that state, in particular, could negatively impact results from operations, cash flows, and financial condition.  Adverse economic conditions and other factors, such as political or business development or natural hazards that may affect Kentucky, may reduce demand for credit or fee-based products and could negatively affect real estate and other collateral values, interest rate levels, and the availability of credit to refinance loans at or prior to maturity.

 

(b)          Market Risk

 

Changes in interest rates could negatively impact our financial condition or results of operations.

 

Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings).  Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions.  Conditions such as inflation, recession, unemployment, money supply, and other factors beyond our control may also affect interest rates.  If our interest-earning assets mature or reprice more quickly than interest-bearing liabilities in a given period, a decrease in market rates could adversely affect net interest income.  Likewise, if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, an increase in market rates could adversely affect net interest income.

 

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing.  Adjustable-rate loans decrease the

 

 

12

 

 

risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment.  At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interests rates.  In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates.  Under these circumstances, our results of operations could be negatively impacted.

 

When evaluating short-term interest rate risk exposure, the primary measurement represents scenarios that model a 200 basis point increasing (decreasing) parallel shift in rates over the next twelve-month period versus rates implied by the current yield curve.  For the quarter ended March 31, 2005, that scenario modeled net interest income to be approximately 12.5% lower than the internal forecast of net interest income using the baseline scenario if rates were to decrease 200 basis points in a parallel shift and 9.3% higher than the internal forecast of net interest income using the baseline scenario if rates were to increase 200 basis points in a parallel shift.

 

Although fluctuations in market interest rates are neither completely predictable nor controllable, our Asset Liability Committee meets periodically to monitor our interest rate sensitivity position and oversee its financial risk management by establishing policies and operating limits.  For further discussion, see the “Asset/Liability Management and Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

(c)          Liquidity Risk

 

If we are unable to borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation to fund corporate expansion or other activities.

 

Liquidity policies and limits are established by the board of directors, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits, the percentage of assets funded with non-core or wholesale funding.  ALCO regularly monitors the overall liquidity position of the Bank and holding company to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity.  Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost.  The liquidity of the Bank is used to make loans and to repay deposit liabilities as they become due or are demanded by customers.  The ALCO establishes board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source.  Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank (FHLB) advances that are collateralized with mortgage-related assets.

 

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other sources of liquidity should they be needed.  These include the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions.

 

If we were unable to access any of these funding sources when needed, we might be unable to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.  For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

(d)          Operational Risk

 

We have significant competition in both attracting and retaining deposits and in originating loans.

 

Competition is intense in most of the markets we serve.  We compete on price and service with other banks and financial companies such as savings and loans, credit unions, finance companies, mortgage banking companies, and brokerage firms.  Competition could intensify in the future as a result of industry consolidation, the increasing availability of products and services from non-banks, greater technological developments in the industry, and banking reform.

 

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions.  However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions.  If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

 

 

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We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk.  Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements.  This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

 

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk.  While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels.  We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed.  From time to time, we experience loss from operational risk, including the effects of operational errors.

 

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer such losses in the future.  New, or changes in existing tax, accounting, are regulatory laws, regulations, rules, standards, policies, and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition.

 

The financial services industry is extensively regulated.  Federal and state banking regulations are designed primarily to protect deposit insurance funds and consumers, not to benefit a financial company’s shareholders.  These regulations may sometimes impose significant limitations on operations.  The significant federal and state banking regulations that affect us are described in this report under the heading “Regulation”.  These regulations, along with currently existing tax, accounting, and monetary laws, regulations, rules, standards, policies and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures.  These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time.  Events that may not have a direct impact on us, such as the bankruptcy of U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board, and other various taxing authorities responding by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations.  The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations.  However, it is impossible to predict at this time, the extent to which any such adoption, change, or repeal would impact us.

 

OVERVIEW

 

During the quarter, we completed the redesign of our Mt. Washington facility in Bullitt County.  This follows the redesign of one of our Hardin County facilities and the opening of two new full-service facilities in the growing Louisville market.  We intend to start construction on a new full-service banking center in Elizabethtown during 2005 with plans of opening in early 2006.  The design of the new and enhanced facilities represents our state of the art prototype branch with a retail focused design, complimenting our commitment to providing superior customer service. We believe these facilities will allow us to more effectively support our lending relationships and to develop a larger presence within these markets in the future.  While we anticipate these facilities will significantly enhance the value of our franchise in the near future, the additional expense in operating these new facilities will continue to place pressure on earnings for a period of time.  We are optimistic that our expansion strategy will minimize this period and the long-term benefits will outweigh the initial investment.

 

While the commercial loan growth in the first quarter of 2005 was slower than recent quarters, our emphasis on commercial lending continued to produce positive results generating a $2.3 million increase in commercial loans to $348 million at March 31, 2005, compared to $346 million at December 31, 2004.  This favorable trend has resulted in a 34% annual compound growth rate over the past four years.  The percentage of commercial loans in our portfolio has increased from 57% at December 31, 2004, to 58% at March 31, 2005.  We intend to continue this commercial lending emphasis and anticipate continued increases in the commercial and commercial real estate portfolios.

 

In January 2003, we implemented a strategy to develop a bank-wide service and sales culture emphasizing expanded account relationships.  To achieve this goal, we increased the number of associates in banking centers, relationship bankers, business development officers, stockbrokers, and loan officers with experience in commercial lending.  The results of this effort as well as our transition from a federally chartered thrift to a state-chartered commercial bank in January 2003, have contributed to our growth.  The resulting increase in staff

 

 

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along with the expansion into the Louisville market have contributed to a $380,000, or 16% increase in employee compensation expense for the quarter ended March 31, 2005, compared to the quarter ended March 31, 2004.  We expect a continued increase in employee compensation expense in the 2005 calendar year as we continue our expansion into our current markets.

 

CRITICAL ACCOUNTING POLICIES

 

Our accounting and reporting policies comply with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry.  The accounting policy relating to the allowance for loan losses is critical to the understanding of our results of operations since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

 

Allowance for Loan Losses — We maintain an allowance sufficient to absorb probable incurred credit losses existing in the loan portfolio, and our Executive Loan Committee evaluates the adequacy of the allowance for loan losses on a quarterly basis.  We estimate the allowance required using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions.  While we estimate the allowance for loan losses, in part, based on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

 

The allowance consists of specific and general components.  The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful.  The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The methodology for allocating the allowance for loan and lease losses takes into account our strategic plan to increase our emphasis on commercial and consumer lending. We increase the amount of the allowance allocated to commercial loans and consumer loans in response to the growth of the commercial and consumer loan portfolios and management’s recognition of the higher risks and loan losses in these lending areas. Allowance estimates are developed in consultation with regulatory authorities and actual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

 

Based on our calculation, an allowance of $6.7 million or 1.12% of total loans was reserved for potential losses within the loan portfolio as of March 31, 2005.  This estimate resulted in a provision for loan losses on the income statement of $275,000 during the quarter.  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 and adversely affected.

 

RESULTS OF OPERATIONS

 

Net income for the quarter ended March 31, 2005 was $2.2 million or $0.60 per share diluted compared to $1.8 million or $0.50 per share diluted for the same period in 2004.  The increase in diluted earnings per share was the result of an increase in net-interest income of $863,000, a decrease in provision for loan loss expense and a $250,000 increase in non-interest income.  Our book value per common share increased from $15.35 at March 31, 2004 to $16.70 at March 31, 2005.  Annualized net income for 2005 generated a return on average assets of 1.18% and a return on average equity of 14.35%.  These compare with a return on average assets of 1.07% and a return on average equity of 12.99% for the 2004 period also annualized.

 

Net Interest Income-On an annualized basis, the net interest margin as a percent of average earning assets increased 26 basis points to 3.90% for the quarter ended March 31, 2005 compared to 3.64% for the 2004 period.  We were able to increase our net interest margin through an increase in the yield on earning assets, which increased 23 basis points from 6.02% for the 2004 quarter to 6.25% for the 2005 period. We have been successful in increasing the percentage of variable rate loans in the loan portfolio, which we expect to increase the yield in an increasing interest rate environment.  The prime lending rate increased 175 basis points since the Federal Open Market Committee began increasing short-term interest rates in June 2004.  Management expects its yield on loans to improve with additional increases in the prime-lending rate.

 

Our cost of funds averaged 2.53% during the 2005 quarter, a decrease of 2 basis points from the 2004 average cost of funds of 2.55%.  Going forward, our cost of funds is expected to increase as the general market deposit rates have become increasingly competitive with the recent upward trend in interest rates.

 

 

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The net result of the above factors was an increase in net interest income of $863,000 for the quarter ended March 31, 2005 compared to the same three-month period a year ago.

 

AVERAGE BALANCE SHEET

 

The following table sets forth information relating to the Bank’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated.  Dividing income or expense by the average monthly balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.

 

		Quarter Ended March 31,
		2005									2004
(Dollars in thousands)		Average Balance				Interest			Average Yield/Cost (5)		Average Balance			Interest			Average Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Treasury and agencies		$		49,623		$	324		2.65	%	$	17,168		$	149		3.49	%
Mortgage-backed securities		8,445				80			3.84		8,751			84			3.86
Equity securities		2,673				40			6.07		2,950			33			4.50
State and political subdivision securities (1)		991				15			6.14		1,071			18			6.76
Corporate bonds		2,065				23			4.52		2,000			15			3.02
Loans receivable (2) (3) (4)		599,006				9,954			6.74		562,049			9,108			6.52
FHLB stock		6,846				76			4.50		6,571			65			3.98
Interest bearing deposits		20,409				123			2.44		38,145			85			0.90
Total interest earning assets		690,058				10,635			6.25		638,705			9,557			6.02
Less: Allowance for loan losses		(6,502			)						(5,581		)
Non-interest earning assets		59,880									54,059
Total assets		$	743,436								$	687,183
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts		$	78,122			$	222		1.15	%	$	91,137		$	188		0.83	%
NOW and money market
accounts		155,938				512			1.33		121,619			221			0.73
Certificates of deposit and
other time deposits		316,494				2,158			2.77		294,471			2,316			3.16
FHLB advances		78,877				944			4.85		78,243			928			4.77
Trust preferred securities		10,000				158			6.41		10,000			124			4.99
Total interest bearing liabilities		639,431				3,994			2.53		595,470			3,777			2.55
Non-interest bearing liabilities:
Non-interest bearing deposits		39,442									31,918
Other liabilities		3,617									3,200
Total liabilities		682,490									630,588
Stockholders’ equity		60,946									56,595
Total liabilities and stockholders’ equity		$	743,436								$	687,183
Net interest income						$	6,641							$	5,780
Net interest spread									3.72	%							3.47	%
Net interest margin									3.90	%							3.64	%

 

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

 

 

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