UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
--- SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004.
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
--- SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
-------- ---------
Commission File Number: 0-22219
FIRST SOUTH BANCORP, INC.
-------------------------
(Exact name of registrant as specified in its charter)
VIRGINIA 56-1999749
----------------------- -----------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
1311 CAROLINA AVENUE, WASHINGTON, NORTH CAROLINA 27889
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(Address of principal executive offices)
(Zip Code)
(252) 946-4178
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
------- ------
Number of shares of common stock outstanding as of April 30, 2004: 6,247,211
CONTENTS
PART I. FINANCIAL INFORMATION PAGE
---------------------
Item 1. Financial Statements
Consolidated Statements of Financial Condition as of March 31, 2004
(unaudited) and December 31, 2003 1
Consolidated Statements of Operations for the Three Months Ended
March 31, 2004 and 2003 (unaudited) 2
Consolidated Statements of Stockholders' Equity for the Three Months Ended
March 31, 2004 (unaudited) 3
Consolidated Statements of Cash Flows for the Three Months Ended
March 31, 2004 and 2003 (unaudited) 4
Notes to Consolidated Financial Statements (unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 7
Item 3. Quantitative and Qualitative Disclosures About Market Risk 14
Item 4. Controls and Procedures 14
PART II. OTHER INFORMATION
-----------------
Item 1. Legal Proceedings 15
Item 2. Changes in Securities and Use of Proceeds 15
Item 3. Defaults Upon Senior Securities 15
Item 4. Submission of Matters to a Vote of Security Holders 15
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 15
Signatures 16
Exhibits 17
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
MARCH 31 DECEMBER 31
2004 2003
------------- -------------
Assets (UNAUDITED)
Cash and due from banks $ 27,504,275 $ 34,299,553
Interest-bearing deposits in financial institutions 17,096,618 625,051
Investment securities - available for sale 49,815,383 50,071,520
Mortgage-backed securities - available for sale 9,644,690 11,715,052
Loans and leases receivable, net:
Held for sale 9,669,456 10,924,148
Held for investment 569,705,021 542,275,778
Premises and equipment, net 7,997,857 7,922,588
Real estate owned 125,001 130,798
Federal Home Loan Bank of Atlanta stock, at cost
which approximates market 1,992,500 2,127,200
Accrued interest receivable 3,172,880 3,073,093
Goodwill 4,218,575 4,218,576
Mortgage servicing rights 1,847,347 1,886,522
Identifiable intangible assets 314,488 --
Prepaid expenses and other assets 5,534,053 5,313,528
Note receivable 1,229,115 1,252,703
------------- -------------
Total assets $ 709,867,259 $ 675,836,110
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand $ 233,944,125 $ 227,863,599
Savings 21,235,744 20,292,472
Large denomination certificates of deposit 110,800,036 107,354,231
Other time 235,838,021 227,662,871
------------- -------------
Total deposits 601,817,926 583,173,173
Borrowed money 30,940,814 19,338,059
Junior subordinated debentures 10,000,000 10,000,000
Deferred income taxes 1,027,439 1,114,567
Other liabilities 9,459,317 7,046,758
------------- -------------
Total liabilities 653,245,496 620,672,557
Common stock, $.01 par value, 8,000,000 shares authorized,
6,283,183* and 4,190,335 shares issued and outstanding 62,832 * 41,903
Additional paid-in capital 49,024,504 49,020,632
Retained earnings, substantially restricted 44,857,966 * 43,171,318
Treasury stock at cost (39,438,014) (39,326,931)
Accumulated other comprehensive income, net 2,114,475 2,256,631
------------- -------------
Total stockholders' equity 56,621,763 55,163,553
------------- -------------
Total liabilities and stockholders' equity $ 709,867,259 $ 675,836,110
============= =============
*Adjusted for April 23, 2004 three-for-two stock split.
See Notes to Consolidated Financial Statements.
1
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31
-----------------------
2004 2003
---------- ----------
Interest income:
Interest and fees on loans $8,386,121 $7,912,639
Interest and dividends on investments and deposits 974,924 1,228,693
---------- ----------
Total interest income 9,361,045 9,141,332
Interest expense:
Interest on deposits 2,120,735 2,704,429
Interest on borrowings 38,821 37,536
Interest on junior subordinated notes 104,145 --
---------- ----------
Total interest expense 2,263,701 2,741,965
Net interest income before provision for possible loan losses 7,097,344 6,399,367
Provision for possible loan losses -- 333,919
---------- ----------
Net interest income 7,097,344 6,065,448
---------- ----------
Non-interest income:
Loan fees and service charges 1,513,423 1,343,143
Loan servicing fees 179,353 138,616
Gain on sale of real estate, net 1,501 48,629
Gain on sale of mortgage loans 146,838 1,016,698
Gain on sale of mortgage-backed securities 45,916 168,938
Other income 269,326 203,992
---------- ----------
Total non-interest income 2,156,357 2,920,016
---------- ----------
Non-interest expense:
Compensation and fringe benefits 2,976,149 2,644,781
Federal insurance premiums 21,655 22,038
Premises and equipment 402,280 362,808
Advertising 38,706 48,527
Payroll and other taxes 275,155 238,978
Data processing 529,960 463,845
Amortization of mortgage servicing rights 65,751 52,194
Other 555,671 586,481
---------- ----------
Total non-interest expense 4,865,327 4,419,652
---------- ----------
Income before income taxes 4,388,374 4,565,812
Income taxes 1,612,600 1,722,907
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NET INCOME $2,775,774 $2,842,905
========== ==========
Per share data: (*)
Basic earnings per share $ 0.44 $ 0.46
Diluted earnings per share $ 0.42 $ 0.43
Dividends per share $ 0.17 $ 0.13
Weighted average shares Basic 6,281,980 6,242,537
Weighted average shares Diluted 6,625,951 6,634,978
(*) Adjusted for April 23, 2004 three-for-two stock split.
See Notes to Consolidated Financial Statements.
2
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
THREE MONTHS ENDED MARCH 31, 2004
(UNAUDITED)
Accumulated
Retained Other
Additional Earnings, Comprehensive
Common Paid-in Substantially Treasury Income (Loss),
Stock Capital Restricted Stock Net Total
----------- -------------- -------------- -------------- -------------- -----------
Balance, December 31, 2003 $ 41,903 $ 49,020,632 $ 43,171,318 $ (39,326,931) $ 2,256,631 $55,163,553
Net income 2,775,774 2,775,774
Three-for-two stock split paid in
form of a 50% stock dividend * 20,942 (20,942) 0
Other comprehensive income, net
of taxes (142,156) (142,156)
Exercise of stock options 32 3,872 52,731 56,635
Acquisition of treasury shares (45) (163,814) (163,859)
Dividends ($ .17 per share)* (1,068,184) (1,068,184)
----------- -------------- -------------- -------------- -------------- -----------
Balance, March 31, 2004 $ 62,832 $ 49,024,504 $ 44,857,966 $ (39,438,014) $ 2,114,475 $56,621,763
----------- -------------- -------------- -------------- -------------- -----------
*Adjusted for April 23, 2004 three-for-two stock split.
See Notes to Consolidated Financial Statements.
3
FIRST SOUTH BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
March 31
----------------------------
2004 2003
------------ ------------
Operating activities
Net Income $ 2,775,774 $ 2,842,905
Adjustments to reconcile net income to net cash provided
in operating activities:
Provision for loan losses -- 333,919
Depreciation 173,443 168,868
Impairment of servicing asset 42,338 135,336
Impairment of real estate owned -- 15,000
Amortization of discounts on securities, net (34,573) (46,632)
Gain on disposal of premises and equipment and real estate owned (1,501) (48,629)
Gain on sales of loans held for sale and mortgage-backed securities (192,754) (1,185,636)
Originations of loans held for sale, net (8,240,038) (32,382,838)
Proceeds from sale of loans held for sale 9,641,568 39,368,328
Other operating activities 1,796,933 (4,645,655)
------------ ------------
Net cash provided in operating activities 5,961,190 4,554,966
------------ ------------
Investing activities:
Proceeds from principal repayments and sales of
mortgage-backed securities available for sale 2,177,704 6,982,359
Originations of loans held for investment, net of principal repayments (25,228,201) (21,445,578)
Proceeds from disposal of premises and equipment and real estate owned 11,662 338,250
Redemption of FHLB stock 134,700 --
Purchases of premises and equipment (178,076) (33,930)
Repayment of note receivable 23,588 14,465
Acquisition of two Central Carolina Bank branches 15,622,724 --
------------ ------------
Net cash used in investing activities (7,435,899) (14,144,434)
------------ ------------
Financing activities:
Net increase in deposits 298,480 35,518,274
Proceeds from FHLB borrowings 71,000,000 58,400,000
Repayments of FHLB borrowings (60,000,000) (85,400,000)
Purchase of treasury shares (163,874) (2,427,993)
Proceeds from exercise of stock options 56,650 223,116
Cash dividends paid (838,067) (712,992)
Net change in repurchase agreements 602,755 (177,101)
------------ ------------
Net cash provided by financing activities 10,955,944 5,423,304
------------ ------------
Increase (decrease) in cash and cash equivalents 9,481,235 (4,166,164)
Cash and cash equivalents, beginning of period 34,924,604 34,472,159
------------ ------------
Cash and cash equivalents, end of period $ 44,405,839 $ 30,305,995
============ ============
Supplemental disclosures:
Real estate acquired in settlement of loans $ -- $ 18,784
Exchange of loans for mortgage-backed securities $ -- $ 3,644,085
Dividends declared, not paid $ 1,074,799 $ 830,120
See Notes to Consolidated Financial Statements.
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1. NATURE OF BUSINESS. First South Bancorp, Inc. (the "Company") was formed
for the purpose of issuing common stock and owning 100% of the stock of First
South Bank (the "Bank") and operating through the Bank a commercial banking
business. The Bank has one significant operating segment, the providing of
general commercial banking services to its markets located in the state of North
Carolina. The common stock of the Company is traded on the Nasdaq National
Market System under the symbol "FSBK".
NOTE 2. BASIS OF PRESENTATION. The accompanying unaudited consolidated financial
statements have been prepared in accordance with generally accepted accounting
principles and with the instructions to Form 10-Q of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments necessary for a fair presentation
of the financial position and results of operations for the periods presented
have been included, none of which were other than normal recurring accruals. The
financial statements of the Company are presented on a consolidated basis with
those of the Bank. The results of operations for the quarter ended March 31,
2004 are not necessarily indicative of the results of operations that may be
expected for the year ended December 31, 2004.
NOTE 3. STOCK SPLIT. On March 18, 2004 the Company declared a three-for-two
stock split, in the form of a 50% stock dividend, payable April 23, 2004 to
stockholders of record as of April 2, 2004. Stockholders received one additional
share of common stock for every two shares held on the record date. All current
and prior period share and per share data has been adjusted to reflect the stock
split.
NOTE 4. DIVIDENDS DECLARED. On March 18, 2004, the Company declared a cash
dividend of $0.17 per share, payable April 23, 2004 to stockholders of record as
of April 2, 2004, adjusted for the stock split. This dividend payment represents
a payout ratio of 38.6% of the basic earnings per share for the quarter ended
March 31, 2004, and is the Company's twenty-eighth consecutive quarterly cash
dividend.
NOTE 5. EARNINGS PER SHARE. Basic and diluted earnings per share for the quarter
ended March 31, 2004 and 2003 are based on weighted average shares of common
stock outstanding, excluding treasury shares. Diluted earnings per share include
the potentially dilutive effects of the Company's stock option plan.
NOTE 6. GOODWILL. The Company applies the provisions of Statement of Financial
Accounting Standards No. 142 (SFAS No. 142), "Goodwill and Other Intangible
Assets", and Statement of Financial Accounting Standards No. 147 (SFAS No. 147),
"Acquisition of Certain Financial Institutions", effective as of January 1,
2002. As a result of applying the provisions of SFAS No.'s 142 and 147, goodwill
is not amortized, but is reviewed for potential impairment on an annual basis.
The Company has performed its annual impairment test and has determined that
there has been no impairment of goodwill.
NOTE 7. STOCK OPTIONS. The Company's 1997 Stock Option Plan (the "Plan")
provides for the issuance of options to purchase shares of the Company's common
stock to selected key employees and Directors of the Company and the Bank. The
options have an original term of ten years with an exercise price equal to the
market price of the common stock on the date of grant, as defined by the Plan.
Vesting is determined on the date of grant. During the quarter ended March 31,
2004, 750
5
options were granted under the Plan, adjusted for the stock split. The weighted
average remaining contractual life of currently outstanding options under the
Plan is 57 months. At March 31, 2004, 847,980 options were outstanding and
704,013 options were reserved for future issuance, adjusted for the stock split.
In addition, 219,540 options had been exercised under the Plan, adjusted for the
stock split.
The Company accounts for the Plan under the provision of SFAS No. 123,
"Accounting for Stock Based Compensation". As permitted by SFAS No. 123, the
Company has chosen to apply APB Opinion No. 25, "Accounting for Stock Issued to
Employees" and related interpretations in accounting for its plans. Accordingly,
no compensation cost had been recognized for options granted under the plans.
Had compensation cost for the Company's plans been determined based on the fair
value at the grant dates for awards under the plans consistent with the method
of SFAS No. 123, the Company's net income and net income per share - basic would
have been adjusted to the pro forma amounts indicated below.
Three Months Ended March 30, 2004 As Reported Pro Forma
- --------------------------------- ----------- -----------
Net income attributable to common shareholders $ 2,775,774 $ 2,753,811
Stock based compensation $ 0 $ 33,184
Net income per share - basic* $ .44 $ .44
Net income per share - diluted* $ .42 $ .42
*Adjusted for April 23, 2004 three-for-two stock split
NOTE 8. RECLASSIFICATIONS. Certain amounts reported in Consolidated Statements
of Financial Condition as of December 31, 2003 have been reclassified to conform
with the presentation for the period ended March 31, 2004. These
reclassifications had no effect on net income or shareholders' equity for the
periods presented, nor did they materially impact trends in financial
information.
NOTE 9. COMPREHENSIVE INCOME. The Company applies the provisions of Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income".
Comprehensive income includes net income and all other changes to the Company's
equity, with the exception of transactions with shareholders ("other
comprehensive income"). The Company's only component of other comprehensive
income relates to unrealized gains and losses on available for sale securities.
Unrealized gains and losses on available for sale securities is primarily
impacted by purchases and sales of available for sale securities and changes in
interest rates between the respective reporting periods. Information concerning
the Company's other comprehensive income for the quarter ended March 31, 2004
and 2003 is as follows:
Quarter Ended
March 31,
2004 2003
---- ----
Net income $ 2,775,774 $ 2,842,905
Reclassification of gain on
sale of mortgage-backed securities (45,916) (168,938)
Losses unrealized, net of income taxes (96,240) (139,615)
----------- -----------
Other comprehensive loss (142,156) (308,553)
----------- -----------
Comprehensive income $ 2,633,618 $ 2,534,352
=========== ===========
NOTE 10. SIGNIFICANT ACTIVITIES. On February 20, 2004, the Bank completed its
acquisition of two of Central Carolina Bank's ("CCB") branch offices located in
Greenville and New Bern, North Carolina.
6
Pursuant to a Purchase and Assumption Agreement ("Agreement") executed on
October 29, 2003, the Bank assumed the deposits of these offices for a premium
of approximately 1.5% of the assumed deposits, and purchased loans, fixed assets
and certain other assets associated with the branch offices. Summary financial
information related to the branch purchase transaction as of February 20, 2004
is as follows (unaudited): deposits - $18.4 million, cash and other assets -
$15.8 million, loans receivable - $2.2 million, identifiable intangible assets -
$314,000, and premises and equipment - $75,000.
NOTE 11. FORWARD LOOKING STATEMENTS. The Private Securities Litigation Reform
Act of 1995 states that the disclosure of forward looking information is
desirable for investors and encourages such disclosure by providing a safe
harbor for forward looking statements by corporate management. This Form 10-Q,
including Management's Discussion and Analysis of Financial Condition and
Results of Operations, contains forward looking statements that involve risk and
uncertainty. In order to comply with the terms of the safe harbor, the Company
notes that a variety of risks and uncertainties could cause its actual results
and experience to differ materially from the anticipated results or other
expectations expressed in the Company's forward looking statements. There are
risks and uncertainties that may affect the operations, performance,
development, growth projections and results of the Company's business. They
include, but are not limited to, economic growth, interest rate movements,
timely development of technology enhancements for products, services and
operating systems, the impact of competitive products, services and pricing,
customer requirements, regulatory changes and similar matters. Readers of this
report are cautioned not to place undue reliance on forward looking statements
that are subject to influence by these risk factors and unanticipated events.
Accordingly, actual results may differ materially from management's
expectations.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The Company engages in no activity other than holding the stock of the Bank and
operating through the Bank a commercial banking business, therefore, the
discussion below focuses primarily on the results of operations of the Bank.
COMPARISON OF FINANCIAL CONDITION AT MARCH 31, 2004 AND DECEMBER 31, 2003
Total assets increased to $709.9 million at March 31, 2004 from $675.8 million
at December 31, 2003. Earning assets increased to $657.9 million at March 31,
2004 from $617.7 million at December 31, 2003, reflecting growth of the
commercial and consumer loan portfolio, as further discussed below. Earning
assets were 92.7% and 91.4% of total assets at March 31, 2004 and December 31,
2003, respectively.
Interest-bearing overnight deposits in financial institutions were $17.1 million
at March 31, 2004, compared to $625,000 at December 31, 2003. Overnight funds
are available to fund loan originations, liquidity management activities and
daily operations of the Bank.
Investment and mortgage-backed securities available for sale were $59.5 million
at March 31, 2004 and $61.8 million at December 31, 2003. The Bank has
implemented strategies to sell certain securities during favorable interest rate
windows, and securitize certain mortgage loans held for sale into
mortgage-backed securities in order to maintain its regulatory liquidity at
required levels.
7
During the quarter ended March 31, 2004, the Bank sold $2.2 million of
mortgage-backed securities, compared to $3.0 million of mortgage-backed
securities sales during the quarter ended March 31, 2003. No mortgage loans were
securitized into mortgage-backed securities during the quarter ended March 31,
2004, compared to $3.6 million securitized during the quarter ended March 31,
2003. The mortgage-backed securities portfolio declined to $9.6 million at March
31, 2004, compared to $11.7 million at December 31, 2003.
Loans held for sale declined to $9.7 million at March 31, 2004 from $10.9
million at December 31, 2003. During the quarter ended March 31, 2004 the Bank
sold $9.6 million of mortgage loans, compared to $39.4 million of sales during
the quarter ended March 31, 2003. Net originations of loans held for sale
declined to $8.2 million during the quarter ended March 31, 2004 from $32.4
million during the quarter ended March 31, 2003, reflecting a slow down in
origination and refinancing volumes due to a recent nominal rise in interest
rates.
Loans and leases held for investment increased to $569.7 million at March 31,
2004 from $542.3 million at December 31, 2003, reflecting a 20.2% annualized
growth rate during the current quarter. This growth reflects the Bank's emphasis
placed on structuring itself as a commercial banking entity.
Deposits increased to $601.8 million at March 31, 2004 from $583.2 million at
December 31, 2003, primarily reflecting the CCB branch offices acquisition.
Checking accounts increased to $233.9 million at March 31, 2004 from $227.9
million at December 31, 2003, and represent 38.9% of total deposits at March 31,
2004, resulting from the Bank's efforts to attract more lower costing core
checking accounts, while time deposits increased to $346.6 million at March 31,
2004 from $335.0 million at December 31, 2003.
FHLB advances and junior subordinated debentures, used primarily to fund loan
originations and general banking operations, were $37.0 million at March 31,
2004, compared to $26.0 million at December 31, 2003. Borrowings, in the form of
repurchase agreements, were $3.9 million at March 31, 2004 compared to $3.3
million at December 31, 2003. These borrowings represent funds in cash
management accounts for commercial banking customers.
Stockholders' equity was $56.6 million at March 31, 2004, compared to $55.2
million at December 31, 2003. See "Consolidated Statements of Stockholders'
Equity" for additional information. At March 31, 2004, the Company's equity to
assets ratio was 8.0%, compared to 8.2% at December 31, 2003, primarily
reflecting the growth in earning assets as previously discussed.
Accumulated other comprehensive income declined to $2.1 million at March 31,
2004 from $2.3 million at December 31, 2003, reflecting the impact of the
mortgage-backed securities sale and the recent nominal rise in interest rates as
previously discussed. See "Note 9. Comprehensive Income" of "Notes to
Consolidated Financial Statements (Unaudited)" above for additional information.
As a North Carolina chartered commercial bank, the Bank must meet various
capital standards required by federal and state banking regulatory agencies. The
Bank's stand-alone capital was $65.5 million at March 31, 2004, substantially in
excess of all regulatory capital requirements. See "Liquidity and Capital
Resources" below for additional information.
On March 18, 2004 the Company declared a three-for-two stock split, in the form
of a 50% stock dividend, payable April 23, 2004 to stockholders of record as of
April 2, 2004. Stockholders received one additional share of common stock for
every two shares held on the record date. All current and prior period share and
per share data has been adjusted to reflect the stock split.
8
On March 18, 2004, the Company also declared a cash dividend of $0.17 per share,
payable April 23, 2004 to stockholders of record as of April 2, 2004, adjusted
for the stock split. This dividend payment represents a payout ratio of 38.6% of
the basic earnings per share for the quarter ended March 31, 2004, and is the
Company's twenty-eighth consecutive quarterly cash dividend.
During the quarter ended March 31, 2004, the Company acquired 4,536 shares of
its common stock totaling $164,000 through open market and private purchases,
pursuant to a stock repurchase plan adopted by the board of directors. Shares
acquired via the stock repurchase plan are held as treasury stock, at cost. At
March 31, 2004, treasury shares held were 2,356,894 totaling $39.4 million,
compared to 2,355,513 shares totaling $39.3 million at December 31, 2003. The
Company believes the repurchase of its outstanding common stock will decrease
the potential dilutive effect caused by the exercise of stock options. During
the quarter ended March 31, 2004, 4,732 shares were issued as a result of the
exercise of stock options compared to and 24,225 shares during the quarter ended
March 31, 2003, adjusted for the stock split.
COMPARISON OF OPERATING RESULTS FOR THE QUARTER ENDED MARCH 31, 2004 AND 2003
GENERAL. Net income for each of the quarters ended March 31, 2004 and March 31,
2003 was $2.8 million, respectively. Basic earnings per share for the quarter
ended March 31, 2004 was $0.44, compared to $0.46 per share for the quarter
ended March 31, 2003, adjusted for the stock split. Diluted earnings per share
for the quarter ended March 31, 2004 was $0.42 per share, compared to $0.43 per
share for the quarter March 31, 2003, adjusted for the stock split.
INTEREST INCOME. Interest income was $9.4 million for the quarter ended March
31, 2004, compared to $9.1 million for the quarter ended March 31, 2003. This
increase is due to the increase in the volume of average interest-earning assets
between the respective periods. Average interest-earning assets were $624.4
million for the quarter ended March 31, 2004, compared to $575.3 million for the
quarter ended March 31, 2003, reflecting the growth of loans and leases held for
investment as discussed above. The yield on average interest-earning assets was
6.0% for the quarter ended March 31, 2004, compared to 6.4% for quarter ended
March 31, 2003, primarily impacted by an overall decrease in interest rates
between the respective periods.
INTEREST EXPENSE. Interest expense on deposits and borrowings declined to $2.3
million for the quarter ended March 31, 2004, from $2.7 million for the quarter
ended March 31, 2003, reflecting the impact of changing interest rates and the
change in the deposit mix as previously discussed. Average deposits and
borrowings were $612.6 million for the quarter ended March 31, 2004, compared to
$566.3 million for the quarter ended March 31, 2003. The effective cost of
average deposits and borrowings was 1.5% for the quarter ended March 31, 2004,
compared to 1.9% for the quarter ended March 31, 2003, primarily impacted by an
overall decrease in interest rates between the respective periods and the
increase in lower costing core checking accounts previously discussed.
NET INTEREST INCOME. Net interest income increased to $7.1 million for the
quarter ended March 31, 2004 from $6.4 million for the quarter ended March 31,
2003. The interest rate spread (the difference between the effective yield on
average earning assets and the effective cost of average deposits and
borrowings) was 4.5% for the quarter ended March 31, 2004, compared to 4.4% for
the quarter ended March 31, 2003. The net yield on interest-earning assets (net
interest income divided by average interest-earning assets) was 4.6% for the
quarter ended March 31, 2004, compared to 4.5% for the quarter ended March 31,
2003.
9
PROVISION FOR LOAN LOSSES. During the quarter ended March 31, 2004, the Bank
recorded no provisions for loan losses compared to $334,000 recorded during the
quarter ended March 31, 2003. Provisions are necessary to support inherent
losses and the risk associated with the growth in the Bank's loan portfolio.
Provisions are charged to current operations and the Bank believes the resulting
reserve for loan losses is adequate to absorb probable losses on loans that may
become uncollectible. Additions to the reserve for loan losses are based on a
review and classification of the loan portfolio and other factors, such as past
collection experience, changes in the nature and volume of the loan portfolio,
risk characteristics of individual loans or groups of similar loans and
underlying collateral, overall portfolio quality and current and prospective
economic conditions.
To support the risk associated with its loan portfolio, the Bank had reserves
for potential loan losses of $7.6 million at March 31, 2004 and December 31,
2003, respectively. The ratio of reserves for loan losses to loans outstanding
was 1.3% at March 31, 2004 and 1.4% at December 31, 2003. Non-performing assets
declined to $2.6 million at March 31, 2004 from $2.8 million at December 31,
2003, although the total loans and leases increased significantly between the
respective periods as previously discussed. Based on the improvement in credit
quality, the Bank believes the current level of its reserves for loan losses is
adequate and no additional provision was required during the quarter ended March
31, 2004. However, there are no assurances that probable future losses, if any,
will not exceed estimated amounts of the current level of reserves for loan
losses.
NONINTEREST INCOME. Noninterest income was $2.2 million for the quarter ended
March 31, 2004, compared to $2.9 million for the quarter ended March 31, 2003.
Noninterest income consists of fees and service charges earned on loans, service
charges on deposit accounts, gains from sales of loans and mortgage-backed
securities and other miscellaneous income. The increase in fees and service
charges to $1.7 million for the quarter ended March 31, 2004 from $1.5 million
for the quarter ended March 31, 2003 is attributable to the increased volume of
loans and checking account deposits previously discussed. The Bank recorded
$46,000 of gains from the sale of mortgage-backed securities during the quarter
ended March 31, 2004, compared to $169,000 during the quarter ended March 31,
2003. Gains from the sales of mortgage loans declined to $147,000 for the
quarter ended March 31, 2004 from $1.0 million for the quarter ended March 31,
2003. The quarter ended March 31, 2003 was a more advantageous period for
selling mortgage loans due to increased origination and refinance volumes caused
primarily by declining interest rates.
NONINTEREST EXPENSE. Noninterest expense was $4.9 million for the quarter ended
March 31, 2004, compared to $4.4 million for the quarter ended March 31, 2003.
The largest component of these expenses, compensation and fringe benefits, was
$3.0 million for the quarter ended March 31, 2004, compared to $2.6 million for
the quarter ended March 31, 2003. Full-time equivalent employees increased to
252 at March 31, 2004 from 238 at March 31, 2003. This growth is due to
additional personnel resulting from opening two new full-service branch offices,
the acquisition of the two CCB branch offices, and administrative staff required
to support the 12.0% growth in assets between the periods. In addition, during
the quarter ended March 31, 2004 the Bank recorded an expense of approximately
$229,000 to eliminate a defined benefit pension plan unfunded liability.
Premises and equipment and data processing expenses have grown proportionately
with the growth in the number of customer accounts and transaction activity,
primarily attributable to both internal growth and the new offices opened since
March 31, 2003. Other noninterest expenses including premises and equipment,
repairs, printing, advertising, and office supplies have also grown
proportionately with the growth in earning assets, deposits and branch office
locations.
10
INCOME TAXES. Income tax expense was $1.6 million for the quarter ended March
31, 2004, compared to $1.7 million for the quarter ended March 31, 2003. The
changes in the amounts of income tax provisions reflect the changes in pretax
income and the estimated income tax rates in effect during the respective
periods.
LIQUIDITY AND CAPITAL RESOURCES
The Bank must meet a 15% regulatory liquidity requirement of liquid assets to
deposits and short-term borrowings. At March 31, 2004, the Bank had cash,
deposits in banks, investment securities, mortgage-backed securities, FHLB stock
and loans held for sale totaling $115.7 million, compared to $109.8 million at
December 31, 2003, representing 18.3% and 18.2% of deposits and short-term
borrowings at March 31,2004 and December 31,2003, respectively.
Liquidity generally refers to the Bank's ability to generate adequate amounts of
funds to meet its cash needs. Adequate liquidity guarantees that sufficient
funds are available to meet deposit withdrawals, fund future loan commitments,
maintain adequate reserve requirements, pay operating expenses, provide funds
for debt service, pay dividends to stockholders, and meet other general
commitments. The Bank believes it can meet future liquidity needs with existing
funding sources. The Bank's primary source of funds are deposits, payments on
loans and mortgage-backed securities, maturities of investment securities,
earnings and funds provided from operations, the ability to borrow from the
Federal Home Loan Bank of Atlanta and the availability of loans held for sale.
While scheduled repayments of loans and mortgage-backed securities are
relatively predictable sources of funds, deposit flows and general market
interest rates, economic conditions and competition substantially influence loan
prepayments.
The FDIC requires the Bank to meet a minimum leverage capital requirement of
Tier I capital (consisting of retained earnings and common stockholder's equity,
less any intangible assets) to assets ratio of 4%. The FDIC also requires the
Bank to meet a ratio of total capital to risk-weighted assets of 8%, of which at
least 4% must be in the form of Tier I capital. The Commissioner requires the
Bank at all times to maintain a capital surplus of not less than 50% of common
capital stock. The Bank was in compliance with all capital requirements of the
FDIC and the Commissioner at March 31, 2004 and December 31, 2003.
IMPACT OF INFLATION AND CHANGING PRICES. The consolidated financial statements
of the Company have been prepared in accordance with generally accepted
accounting principles, which require the measurement of financial position and
operating results in terms of historical dollars without considering the change
in relative purchasing power of money over time and due to inflation. Unlike
most industrial companies, nearly all assets and liabilities of the Company are
monetary, causing interest rates to have greater impact on the Company's
performance than general levels of inflation. Interest rates do not necessarily
move in the same direction or to the same extent as the price of goods and
services. The impact of inflation upon the Company is reflected in the cost and
prices it pays for goods and services.
CRITICAL ACCOUNTING POLICIES. The Company has identified the policies below as
critical to its business operations and the understanding of its results of
operations. The impact and any associated risks related to these policies on the
Company's business operations is discussed throughout Management's Discussion
and Analysis of Financial Condition and Results of Operations where such
policies affect reported and expected financial results.
11
USE OF ESTIMATES. The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions. Estimates affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could
differ from those estimates.
LOAN IMPAIRMENT AND ALLOWANCE FOR LOAN LOSSES. A loan is considered
impaired, based on current information and events, if it is probable that the
Bank will be unable to collect the scheduled payments of principal or interest
when due according to the contractual terms of the loan agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all collateral-dependent loans are measured for impairment based on the
fair value of the collateral.
The Bank uses several factors in determining if a loan is impaired. The internal
asset classification procedures include a thorough review of significant loans
and lending relationships and include the accumulation of related data. This
data includes loan payment status, borrowers' financial data and borrowers'
operating factors such as cash flows, operating income or loss, etc.
The allowance for loan losses is increased by charges to income and decreased by
charge-offs (net of recoveries). Management's periodic evaluation of the
adequacy of the allowance is based on the Bank's past loan loss experience,
known and inherent risks in the portfolio, adverse situations that may affect
the borrower's ability to repay, the estimated value of any underlying
collateral, and current economic conditions. While management believes that it
has established the allowance in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of
its regulators and the current economic environment, there can be no assurance
that in the future the Bank's regulators or risks in its portfolio will not
require further increases in the allowance.
INCOME TAXES. Deferred tax asset and liability balances are determined
by application of temporary differences of the tax rate expected to be in effect
when taxes will become payable or receivable. Temporary differences are
differences between the tax basis of assets and liabilities and their reported
amounts in the financial statements that will result in taxable or deductible
amounts in future years. The effect on deferred taxes of a change in tax rates
is recognized in income in the period that includes the enactment date.
OFF-BALANCE SHEET RISK. The Company is a party to financial instruments
with off-balance sheet risk in the normal course of business to meet the
financing needs of its customers and to reduce its own exposure to fluctuations
in interest rates. These financial instruments include commitments to extend
credit and involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the balance sheet.
The Company's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit is
represented by the contractual amount of those instruments. The Company uses the
same credit policies in making commitments and conditional obligations as it
does for on-balance sheet instruments.
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NEW ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 149 "Amendment of Statement 133 on Derivative
Instruments and Hedging Activities" ("SFAS No. 149"). FASB Statements No. 133
"Accounting for Derivative Instruments and Hedging Activities" and No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities",
establish accounting and reporting standards for derivative instruments
including derivatives embedded in other contracts and for hedging activities.
SFAS No. 149 amends Statement 133 for certain decisions made by the Board as
part of the Derivatives Implementation Group (DIG) process. This Statement
contains amendments relating to FASB Concepts Statement No. 7, "Using Cash Flow
Information and Present Value in Accounting Measurements", and FASB Statements
No. 65, "Accounting for Certain Mortgage Banking Activities", No. 91 "Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases", No. 95, "Statement of Cash Flows", and No.
126, "Exemption from Certain Required Disclosures about Financial Instruments
for Certain Nonpublic Entities". The provisions of SFAS No. 149 are effective
for contracts entered into or modified after June 30, 2003. The adoption of SFAS
No. 149 did not have any material impact on the Company's financial statements
or results of operations.
In May 2003, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 150 "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS No.
150"). SFAS No. 150 establishes standards for classification and measurement in
the statement of financial position of certain financial instruments with
characteristics of both liabilities and equity. It requires classification of a
financial instrument that is within its scope as a liability (or an asset in
some circumstances) because that financial instrument embodies an obligation of
the issuer. SFAS No. 150 is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise effective on July 1, 2003. The
adoption of SFAS No. 150 did not have any material impact on the Company's
financial statements or results of operations.
In January 2003, the Financial Accounting Standards Board issued Financial
Accounting Series FASB Interpretation No. 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51" ("FIN No. 46"). The primary
objective of the Interpretation is to provide guidance on the identification of,
and financial reporting for, entities over which control is achieved through
means other than voting rights; such entities are known as variable-interest
entities (VIEs). FIN No. 46 has far-reaching effects and applies immediately to
new entities created after January 31, 2003, as well as applies to existing
entities in which an enterprise obtains an interest after that date. The
provisions of FIN No. 46 are effective at the end of the first interim or annual
period ending after December 15, 2003, to variable-interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
FIN No. 46 is the guidance that determines (1) whether consolidation is required
under the "controlling financial interest" model of Accounting Research Bulletin
No. 51, "Consolidated Financial statements", or other existing authoritative
guidance, or, alternatively, (2) whether the variable-interest model under FIN
No. 46 should be used to account for existing and new entities. The adoption of
FIN No. 46 did not have any material impact on the Company's financial
statements or results of operations.
In December 2003, the FASB reissued FIN 46 with certain modifications and
clarifications. Application of this guidance was effective for interests in
certain VIEs commonly referred to as special-purpose entities (SPEs) as of
December 31, 2003. Application for all other types of entities is required for
periods ending after March 15, 2004, unless previously applied.
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During the fourth quarter of 2003, the Company applied the provisions of FIN 46R
to a wholly owned subsidiary trust that issued trust preferred securities to
third-party investors. The application of FIN 46R resulted in the
deconsolidation of the wholly owned subsidiary trust. The assets and liabilities
of the subsidiary trust that was deconsolidated totaled $10.2 million and $9.9
million, respectively.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the possible chance of loss from unfavorable changes in market
prices and rates. These changes may result in a reduction of current and future
period net interest income, which is the favorable spread earned from the excess
of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.
The Company considers interest rate risk to be its most significant market risk,
which could potentially have the greatest impact on operating earnings. The
structure of the Company's loan and deposit portfolios is such that a
significant decline in interest rates may have a negative impact on net market
values and net interest income. The Company monitors whether material changes in
market risk have occurred since December 31, 2003. The Company does not believe
that any material adverse changes in market risk exposures have occurred since
December 31, 2003.
The current period earnings growth reflects the Company's success in increasing
its net interest income during an environment of declining interest rates. The
Company has made significant progress in restructuring its loan portfolio, in
attracting lower costing core checking accounts and repricing higher costing
certificates of deposit at lower rates, collectively allowing the Company to
maintain more consistent net interest income.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management of the Company
carried out an evaluation, under the supervision and with the participation of
the Company's principal executive officer and principal financial officer, of
the effectiveness of the Company's disclosure controls and procedures. Based on
this evaluation, the Company's principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures are effective in ensuring that information required to be disclosed
by the Company in reports that it files or submits under the Securities Exchange
Act of 1934, as amended, is recorded, processed, summarized and reported, within
the time periods specified in the Securities and Exchange Commission's rules and
forms. It should be noted that the design of the Company's disclosure controls
and procedures is based in part upon certain reasonable assumptions about the
likelihood of future events, and there can be no reasonable assurance that any
design of disclosure controls and procedures will succeed in achieving its
stated goals under all potential future conditions, regardless of how remote,
but the Company's principal executive and financial officers have concluded that
the Company's disclosure controls and procedures are, in fact, effective at a
reasonable assurance level.
In addition, there have been no changes in the Company's internal control over
financial reporting (to the extent that elements of internal control over
financial reporting are subsumed within disclosure controls and procedures)
identified in connection with the evaluation described in the above paragraph
that occurred during the Company's last fiscal quarter, that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is currently not engaged in any material legal proceedings. From
time to time, the Bank is a party to legal proceedings within the ordinary
course of business wherein it enforces its security interest in loans, and other
matters of similar nature.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
ITEM 5. OTHER INFORMATION
Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
The following exhibit is filed herewith:
Exhibit
Number Title
- ----- -----
31 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002
b) Reports on Form 8-K:
A Form 8-K was filed on January 8, 2004 under Item 5. Other Events and Required
FD Disclosure, and Item 7. Financial Statements, Pro Forma Financial Information
and Exhibits, reporting the Company had completed a previously announced 5%
stock repurchase program and had adopted a new program to repurchase an
additional 100,000 shares of common stock, representing 2.4% of its issued and
outstanding shares.
A Form 8-K was filed on January 15, 2004 under Item 7. Financial Statements, Pro
Forma Financial Information and Exhibits, and Item 9. Regulation FD Disclosure,
reporting the Company announced its unaudited financial results for the quarter
ended December 31, 2003 and the year ended December 31, 2003.
15
A Form 8-K/A was filed on January 20, 2004, as Amendment No. 1 to the Form 8-K
filed on January 15, 2004 to correctly file the Form 8-K under Item 7. Financial
statements, Pro Forma Financial Information and Exhibits, and Item 12. Results
of Operations and Financial Condition, reporting the Company announced its
unaudited financial results for the quarter and year ended December 31, 2003,
rather than under Items 7 and 9 as previously reported on the Form 8-K.
A Form 8-K was filed on January 8, 2004 under Item 5. Other Events and Required
FD Disclosure, and Item 7. Financial Statements, Pro Forma Financial Information
and Exhibits, reporting the Bank had completed the acquisition of two branch
offices from Central Carolina Bank, a Division of National Bank of Commerce,
located in New Bern, North Carolina and Greenville, North Carolina.
A Form 8-K was filed on March 24, 2004 under Item 5. Other Events and Required
FD Disclosure, and Item 7. Financial Statements, Pro Forma Financial Information
and Exhibits, reporting a 3-for-2 common stock split in the form of a 50% stock
dividend, payable on April 23, 2004.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on
its behalf by the undersigned thereunto duly authorized.
FIRST SOUTH BANCORP, INC.
/s/ William L. Wall
-------------------
William L. Wall
Executive Vice President
Chief Financial Officer
(Principal Financial Officer)
/s/ Kristie W. Hawkins
----------------------
Kristie W. Hawkins
Controller
Treasurer
(Principal Accounting Officer)
Date: May 7, 2004
16