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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 June 30, 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
------------------------------------------------------
(Address of principal executive offices)
(Zip Code)
(252) 946-4178
(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
----- -----
Indicate by check mark whether registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
Number of shares of common stock outstanding as of August 4, 2004:
6,222,216
CONTENTS
PART I. FINANCIAL INFORMATION PAGE
Item 1. Financial Statements
Consolidated Statements of Financial Condition as of June 30, 2004
(unaudited) and December 31, 2003 1
Consolidated Statements of Operations for the Three and Six Months Ended
June 30, 2004 and 2003 (unaudited) 2
Consolidated Statement of Stockholders' Equity for the Six Months Ended
June 30, 2004 (unaudited) 3
Consolidated Statements of Cash Flows for the Six Months Ended
June 30, 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 13
Item 4. Controls and Procedures 13
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 14
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 14
Item 3. Defaults Upon Senior Securities 14
Item 4. Submission of Matters to a Vote of Security Holders 14
Item 5. Other Information 15
Item 6. Exhibits and Reports on Form 8-K 15
Signatures 15
Exhibits 16
First South Bancorp, Inc.
Consolidated Statements of Financial Condition
June 30 December 31
2004 2003
------------- -------------
Assets (unaudited)
Cash and due from banks $ 36,233,293 $ 34,299,553
Interest-bearing deposits in financial institutions 1,387,137 625,051
Investment securities - available for sale 41,817,673 50,071,520
Mortgage-backed securities - available for sale 7,725,088 11,715,052
Mortgage-backed securities - held for investment 2,841,484 --
Loans and leases receivable, net:
Held for sale 7,224,474 10,924,148
Held for investment 595,513,670 542,275,778
Premises and equipment, net 7,912,115 7,922,588
Real estate owned 204,207 130,798
Federal Home Loan Bank of Atlanta
stock, at cost which approximates market 2,000,000 2,127,200
Accrued interest receivable 3,164,590 3,073,093
Goodwill 4,218,576 4,218,576
Mortgage servicing rights 1,792,082 1,886,522
Identifiable intangible assets 306,540 --
Prepaid expenses and other assets 6,230,973 5,313,528
Note receivable 1,205,230 1,252,703
------------- -------------
Total assets $ 719,777,132 $ 675,836,110
============= =============
Liabilities and Stockholders' Equity
Deposits:
Demand $ 238,432,694 $ 227,863,599
Savings 20,990,661 20,292,472
Large denomination certificates of deposit 106,974,644 107,354,231
Other time 230,186,484 227,662,871
------------- -------------
Total deposits 596,584,483 583,173,173
Borrowed money 43,309,385 19,338,059
Junior subordinated debentures 10,000,000 10,000,000
Deferred income taxes 654,860 1,114,567
Other liabilities 13,508,409 7,046,758
------------- -------------
Total liabilities 664,057,137 620,672,557
Common stock, $.01 par value, 25,000,000 and 8,000,000
shares authorized, respectively; 6,222,216 and 4,190,335
shares issued and outstanding, respectively 62,222 41,903
Additional paid-in capital 38,006,340 49,020,632
Retained earnings, substantially restricted 46,697,864 43,171,318
Treasury stock at cost (30,258,077) (39,326,931)
Accumulated other comprehensive income, net 1,211,646 2,256,631
------------- -------------
Total stockholders' equity 55,719,995 55,163,553
------------- -------------
Total liabilities and stockholders' equity $ 719,777,132 $ 675,836,110
============= =============
See Notes to Consolidated Financial Statements.
1
First South Bancorp, Inc.
Consolidated Statements of Operations
(unaudited)
Three Months Ended Six Months Ended
June 30 June 30
------------------------- -------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Interest income:
Interest and fees on loans $ 8,915,319 $ 8,045,728 $17,301,440 $15,958,368
Interest and dividends on investments and deposits 894,675 1,203,817 1,869,599 2,432,509
----------- ----------- ----------- -----------
Total interest income 9,809,994 9,249,545 19,171,039 18,390,877
Interest expense:
Interest on deposits 2,081,401 2,648,485 4,202,136 5,352,914
Interest on borrowings 103,712 35,310 142,534 72,846
Interest on junior subordinated notes 103,756 -- 207,900 --
----------- ----------- ----------- -----------
Total interest expense 2,288,869 2,683,795 4,552,570 5,425,760
Net interest income before provision for loan losses 7,521,125 6,565,750 14,618,469 12,965,117
Provision for loan losses 400,000 122,000 400,000 455,918
----------- ----------- ----------- -----------
Net interest income 7,121,125 6,443,750 14,218,469 12,509,199
----------- ----------- ----------- -----------
Non-interest income:
Loan fees and service charges 1,733,426 1,533,383 3,246,849 2,876,527
Loan servicing fees 178,979 156,470 358,332 295,087
Gain (loss) on sale of real estate, net 14,986 (6,388) 16,486 42,240
Gain on sale of mortgage loans 98,381 783,394 245,220 1,800,091
Gain on sale of mortgage-backed securities 42,928 -- 88,844 168,938
Other income 219,182 219,589 488,509 423,331
----------- ----------- ----------- -----------
Total non-interest income 2,287,882 2,686,448 4,444,240 5,606,214
----------- ----------- ----------- -----------
Non-interest expense:
Compensation and fringe benefits 2,856,106 2,632,700 5,832,255 5,277,480
Federal insurance premiums 21,936 21,092 43,592 43,130
Premises and equipment 405,601 377,753 807,881 740,311
Advertising 44,095 46,964 82,801 95,492
Payroll and other taxes 257,802 243,259 532,957 482,238
Data processing 504,098 484,888 1,034,059 948,732
Amortization of intangible assets 77,088 57,215 142,839 109,409
Other 624,368 641,795 1,180,038 1,228,277
----------- ----------- ----------- -----------
Total non-interest expense 4,791,094 4,505,666 9,656,422 8,925,069
----------- ----------- ----------- -----------
Income before income taxes 4,617,913 4,624,532 9,006,287 9,190,344
Income taxes 1,713,792 1,737,255 3,326,392 3,460,162
----------- ----------- ----------- -----------
Net income $ 2,904,121 $ 2,887,277 $ 5,679,895 $ 5,730,182
=========== =========== =========== ===========
Per share data: (*)
Basic earnings per share $ 0.47 $ 0.47 $ 0.91 $ 0.92
Diluted earnings per share $ 0.44 $ 0.44 $ 0.87 $ 0.87
Dividends per share $ 0.17 $ 0.13 $ 0.34 $ 0.27
Weighted average shares Basic 6,241,314 6,200,401 6,261,764 6,221,802
Weighted average shares Diluted 6,579,166 6,570,394 6,545,347 6,602,520
(*) Adjusted for April 23, 2004 three-for-two stock split.
See Notes to Consolidated Financial Statements.
2
First South Bancorp, Inc.
Consolidated Statement of Stockholders' Equity
Six Months Ended June 30, 2004
(unaudited)
Retained Accumulated
Additional Earnings, Other
Common Paid-in Substantially Treasury Comprehensive
Stock Capital Restricted Stock Income, 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 5,679,895 5,679,895
Three-for-two stock split,
including fractional shares * 20,828 (10,832,989) (20,828) 10,832,989 0
Other comprehensive loss,
net of taxes (1,044,985) (1,044,985)
Exercise of stock options 263 (181,303) 445,869 264,829
Acquisition of treasury shares (772) (2,210,004) (2,210,776)
Dividends ($ .34 per share) (2,132,521) (2,132,521)
------------ ------------ ------------ ------------ ------------ ------------
Balance, June 30, 2004 $ 62,222 $ 38,006,340 $ 46,697,864 $(30,258,077) $ 1,211,646 $ 55,719,995
------------ ------------ ------------ ------------ ------------ ------------
*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)
Six Months Ended
June 30
------------------------------
2004 2003
------------- -------------
Operating activities
Net Income $ 5,679,895 $ 5,730,182
Adjustments to reconcile net income to net cash provided
in operating activities:
Provision for loan losses 400,000 455,918
Depreciation 357,162 339,359
Impairment of servicing asset 98,403 414,668
Impairment of real estate owned -- 80,000
Amortization of discounts on securities, net (64,224) (88,889)
Gain on disposal of premises and equipment and real estate owned (16,486) (41,509)
Gain on sales of loans held for sale and mortgage-backed securities (334,064) (1,969,029)
Originations of loans held for sale, net (19,034,114) (76,092,963)
Proceeds from sale of loans held for sale 20,137,524 78,980,794
Other operating activities 5,168,502 (4,062,450)
------------- -------------
Net cash provided in operating activities 12,392,598 3,746,081
------------- -------------
Investing activities:
Proceeds from maturities of investment securities available for sale 7,000,000 2,000,000
Proceeds from principal repayments and sales of
mortgage-backed securities available for sale 3,892,187 10,068,728
Originations of loans held for investment, net of principal repayments (51,528,056) (48,074,719)
Proceeds from disposal of premises and equipment and real estate owned 38,647 444,148
Redemption of FHLB stock 127,200 275,300
Purchases of premises and equipment (276,053) (68,254)
Repayment of note receivable 47,473 37,187
Acquisition of two Central Carolina Bank branches 15,817,778 --
------------- -------------
Net cash used in investing activities (24,880,824) (35,317,610)
------------- -------------
Financing activities:
Net increase (decrease) in deposits (4,934,963) 54,496,352
Proceeds from FHLB borrowings 154,300,000 115,400,000
Repayments of FHLB borrowings (130,800,000) (134,400,000)
Purchase of treasury shares (2,210,890) (3,460,263)
Proceeds from exercise of stock options 264,829 406,087
Cash dividends paid (1,906,250) (1,541,612)
Net change in repurchase agreements 471,326 16,437
------------- -------------
Net cash provided by financing activities 15,184,052 30,917,001
------------- -------------
Increase (decrease) in cash and cash equivalents 2,695,826 (654,528)
Cash and cash equivalents, beginning of period 34,924,604 34,472,159
------------- -------------
Cash and cash equivalents, end of period $ 37,620,430 $ 33,817,631
============= =============
Supplemental disclosures:
Real estate acquired in settlement of loans $ 91,206 $ 309,909
Exchange of loans for mortgage-backed securities-held for investment$ 2,841,484 $ 8,952,095
Dividends declared, not paid $ 1,057,777 $ 826,706
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 Company's common stock is traded on The Nasdaq National Market
under the symbol "FSBK".
Note 2. Basis of Presentation. The accompanying unaudited consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America 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 accounting principles generally accepted the United States
of America 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 three and six month periods ended June 30, 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. 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 reviewed for potential impairment on an annual basis. The
Company has performed its annual impairment test and has determined there has
been no impairment of goodwill.
Note 5. Earnings Per Share. Basic and diluted earnings per share for the three
and six month periods ended June 30, 2004 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. 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 June 30,
2004, no options were granted under the Plan. The weighted average remaining
contractual life of currently outstanding options under the Plan is 52 months.
At June 30, 2004, 825,582 options were outstanding and 703,268 options were
reserved for future issuance, adjusted for the stock split. In addition, 223,683
options had been exercised under the Plan, adjusted for the stock split.
5
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 June 30, 2004 As Reported Pro Forma
- -------------------------------- ----------- ---------
Net income attributable to common shareholders $2,904,121 $2,884,298
Stock based compensation $ 0 $ 30,035
Net income per share - basic $ .47 $ .46
Net income per share - diluted $ .44 $ .44
Six Months Ended June 30, 2004 As Reported Pro Forma
- ------------------------------ ----------- ---------
Net income attributable to common shareholders $5,679,895 $5,640,249
Stock based compensation $ 0 $ 60,070
Net income per share - basic $ .91 $ .90
Net income per share - diluted $ .87 $ .86
Three Months Ended June 30, 2003 As Reported Pro Forma
- -------------------------------- ----------- ---------
Net income attributable to common shareholders $2,887,277 $2,857,096
Stock based compensation $ 0 $ 45,728
Net income per share - basic $ .47 $ .46
Net income per share - diluted $ .44 $ .43
Six Months Ended June 30, 2003 As Reported Pro Forma
- ------------------------------ ----------- ---------
Net income attributable to common shareholders $5,730,182 $5,669,821
Stock based compensation $ 0 $ 91,456
Net income per share - basic $ .92 $ .91
Net income per share - diluted $ .87 $ .86
Note 7. 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 three and six month periods
ended June 30, 2004 and 2003 is as follows:
Three Months Ended June 30, Six Months Ended June 30,
2004 2003 2004 2003
------------ ----------- ----------- -----------
Net income $ 2,904,121 $ 2,887,277 $ 5,679,895 $ 5,730,182
Reclassification of gain on
sale of securities (42,928) 0 (88,844) (168,938)
Losses unrealized, net
of income taxes (859,901) (126,511) (956,101) (226,126)
------------ ----------- ----------- -----------
Other comprehensive income (loss) (902,829) (126,511) (1,044,985) (435,064)
------------ ----------- ----------- -----------
Comprehensive income $ 2,001,292 $ 2,760,766 $ 4,634,910 $ 5,295,118
============ =========== =========== ===========
6
Note 8. Reclassifications. Certain amounts reported in the Consolidated
Statements of Financial Condition as of December 31, 2003 have been reclassified
to conform to the presentation for the period ended June 30, 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. Acquisitions. 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. 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) (in thousands):
Loans receivable $2,212
Premises and equipment 75
Identifiable intangible assets 314
Other assets 46
Deposits (18,373)
-------
Net cash received $15,818
=======
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations. The Company has engaged 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 Bank's results of
operations.
Comparison of Financial Condition at June 30, 2004 and December 31, 2003
Total assets increased to $719.8 million at June 30, 2004 from $675.8 million at
December 31, 2003, reflecting a 13.0% annualized internal growth rate. Earning
assets increased to $658.5 million at June 30, 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 91.5% of total assets
at June 30, 2004 compared to 91.4% at December 31, 2003.
Interest-bearing overnight deposits in financial institutions were $1.4 million
at June 30, 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 $49.5 million
at June 30, 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 sufficient liquidity levels. The
Bank sold $916,000 and $2.5 million of securities available for sale during the
three and six months ended June 30, 2004, compared to no security sales during
the three months ended June 30, 2003 and $3.0 million sold during the six months
ended June 30, 2003. The Bank securitized $2.8 million of mortgage loans into
mortgage-backed securities held for investment during both the three and six
months ended June 30, 2004, compared to $5.3 million and $9.0 million of
mortgage loans securitized into mortgage-backed securities held for sale during
the three and six months ended June 30, 2003. The total mortgage-backed
securities portfolio was $10.6 million at June 30, 2004, compared to $11.7
million at December 31, 2003.
7
Loans held for sale declined to $7.2 million at June 30, 2004 from $10.9 million
at December 31, 2003. The sale of loans held for sale declined to $10.5 million
and $20.1 million during the three and six months ended June 30, 2004, compared
to $39.6 million and $79.0 million sold during the three and six months ended
June 30, 2003, reflecting a slow down in origination and refinancing volumes due
to a recent nominal rise in interest rates. Net loans and leases held for
investment increased to $595.5 million at June 30, 2004 from $542.3 million at
December 31, 2003, reflecting a 19.6% annualized net growth rate during the
period. This growth reflects the Bank's emphasis on structuring its loan
portfolio as a commercial banking entity.
Deposits increased to $596.6 million at June 30, 2004 from $583.2 million at
December 31, 2003, primarily reflecting the acquisition of two branch offices.
Checking accounts increased at an annualized growth of 9.3% to $238.4 million at
June 30, 2004 from $227.9 million at December 31, 2003, resulting from the
Bank's efforts to attract more lower costing core checking accounts. Time
deposits increased to $337.2 million at June 30, 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 $49.5 million at June 30, 2004,
compared to $26.0 million at December 31, 2003. Borrowings in the form of
repurchase agreements were $3.8 million at June 30, 2004 compared to $3.3
million at December 31, 2003. These borrowings represent funds held in cash
management accounts for commercial banking customers.
Stockholders' equity was $55.7 million at June 30, 2004, compared to $55.2
million at December 31, 2003. See "Consolidated Statements of Stockholders'
Equity" for additional information. At June 30, 2004, the Company's equity to
assets ratio was 7.7%, compared to 8.2% at December 31, 2003, primarily
reflecting the growth in earning assets as previously discussed.
Accumulated other comprehensive income declined to $1.2 million at June 30, 2004
from $2.3 million at December 31, 2003, reflecting the impact of the securities
sales and the recent nominal rise in interest rates, as previously discussed.
See "Note 8. 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 $64.3 million at June 30, 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 year and prior period
share and per share data has been adjusted to reflect the stock split.
On June 24, 2004, the Company also declared a cash dividend of $0.17 per share,
payable July 23, 2004 to stockholders of record as of July 5, 2004, adjusted for
the stock split. This dividend payment represents a payout ratio of 36.2% of the
basic earnings per share for the quarter ended June 30, 2004, and is the
Company's twenty-ninth consecutive quarterly cash dividend.
During the three and six months ended June 30, 2004, the Company acquired 72,643
and 77,179 shares of its common stock, respectively, through open market and
private purchases pursuant to a stock repurchase plan previously adopted by the
board of directors. Shares acquired via the stock repurchase plan are held as
treasury stock, at cost. At June 30, 2004, treasury shares held were 1,777,784
totaling $30.3 million, compared to 2,355,513 shares totaling $39.3 million at
December 31, 2003. During the quarter ended June 30, 2004, the Company used
628,610 shares of treasury shares to issue common stock for the stock split
previously discussed. 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 three and six months ended June 30, 2004, 23,143
and 27,769 shares, respectively, were issued as a result of the exercise of
stock options, compared to 14,350 and 30,500 shares, respectively, issued during
the three and six months ended June 30, 2003.
8
Comparison of Operating Results - Three and Six Months Ended June 30, 2004 and
2003
General. Net income for each of the three and six month periods ended June 30,
2004 and 2003 was $2.9 million and $5.7 million, respectively. Basic earnings
per share was $0.47 and $0.91 per share for the three and six months ended June
30, 2004, compared to $0.47 and $0.92 per share for the three and six months
ended June 30, 2003, adjusted for the stock split. Diluted earnings per share
was $0.44 and $0.87, respectively, for each of the three and six month periods
ended June 30, 2004 and 2003, adjusted for the stock split.
Core earnings during the three and six months ended June 30, 2004 were supported
by significant growth in net interest income, reflecting growth in both the
commercial and consumer loan portfolio and in lower costing core checking
accounts. During the three and six months ended June 30, 2004 the Company
experienced much less dependence on gains from mortgage loan sales, as compared
to the three and six months ended June 30, 2003, which was an advantageous
period for selling loans due to increased origination and refinance volumes
caused primarily by declining interest rates.
Interest Income. Interest income was $9.8 million and $19.2 million for the
three and six months ended June 30, 2004, compared to $9.2 million and $18.4
million for the three and six months ended June 30, 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 $655.5 million and
$641.2 million for the three and six months ended June 30, 2004, compared to
$595.8 million and $586.0 million for the three and six months ended June 30,
2003, reflecting the growth in loans and leases held for investment as
previously discussed. The yield on average interest-earning assets was 6.0% for
both the three and six months ended June 30, 2004, compared to 6.2% and 6.3% for
the three and six months ended June 30, 2003, primarily impacted by an overall
decrease in interest rates between the respective periods.
Interest Expense. Interest expense on deposits and borrowings was $2.3 million
and $4.6 million for the three and six months ended June 30, 2004, compared to
$2.7 million and $5.4 million for the three and six months ended June 30, 2003,
reflecting the impact of changing interest rates and the change in the core
deposit mix as previously discussed. Average deposits and borrowings were $637.9
million and $629.6 million for the three and six months ended June 30, 2004,
compared to $585.0 million and $576.1 million for the three and six months ended
June 30, 2003. The effective cost of average deposits and borrowings was 1.4%
and 1.5% for the three and six months ended June 30, 2004, compared to 1.8% and
1.9% for the three and six months ended June 30, 2003.
Net Interest Income. Net interest income was $7.5 million and $14.6 million for
the three and six months ended June 30, 2004, compared to $6.6 million and $13.0
million for the three and six months ended June 30, 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 4.6% and 4.5% for the
three and six months ended June 30, 2004, compared to 4.4% for both the three
and six months ended June 30, 2003. The net yield on interest-earning assets
(net interest income divided by average interest-earning assets) was 4.6% for
both the three and six months ended June 30, 2004, compared to 4.4% for both the
three and six months ended June 30, 2003.
9
Provision for Loan Losses. The Bank recorded $400,000 of provisions for loan
losses for both the three and six months ended June 30, 2004, compared to
$122,000 and $456,000 recorded in the three and six months ended June 30, 2003.
Provisions were necessary to support inherent losses and 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 maintained
reserves for loan losses of $7.9 million at June 30, 2004, compared to $7.6
million at December 31, 2003. The ratio of reserves for loan losses to loans
outstanding, net of loans in process and deferred loan fees, was 1.3% at June
30, 2004 compared to 1.4% at December 31, 2003. Non-performing assets increased
to $3.2 million at June 30, 2004 from $2.8 million at December 31, 2003, as
total loans and leases increased significantly between the respective periods as
previously discussed. Based on the credit quality of the loan and lease
portfolio, the Bank believes the current level of its reserves for loan losses
is adequate. 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 declined to $2.3 million and $4.4 million
for the three and six months ended June 30, 2004, from $2.7 million and $5.6
million for the three and six months ended June 30, 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. Fees and service charges increased to $1.9 million and
$3.6 million for the three and six months ended June 30, 2004, from $1.7 million
and $3.2 million for the three and six months ended June 30, 2003. The increase
in fees and service charges during the current periods is attributable to a
greater volume of loans and checking deposits as previously discussed. In
addition, the Bank recorded $98,000 and $245,000 of gains from sales of loans
during the three and six months ended June 30, 2004, compared to $783,000 and
$1.8 million during the three and six months ended June 30, 2003, reflecting the
slow down in origination and refinancing volumes.
Noninterest Expense. Noninterest expenses were $4.8 million and $9.7 million for
the three and six months ended June 30, 2004, compared to $4.5 million and $8.9
million for the three and six months ended June 30, 2003. The largest component
of these expenses, compensation and fringe benefits, was $2.9 million and $5.8
million for the three and six months ended June 30, 2004, compared to $2.6
million and $5.3 million for the three and six months ended June 30, 2003.
Fulltime equivalent employees increased to 250 at June 30, 2004 from 236 at June
30, 2003. This growth is due to additional personnel resulting from opening two
new de novo full-service branch offices, the acquisition of two branch offices,
and administrative staff required to support the greater volume of loans and
checking deposits as previously discussed. In addition, during the six months
ended June 30, 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. 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 $1.7 million and $3.3 million for the three
and six months ended June 30, 2004, compared to $1.7 million and $3.5 million
for the three and six months ended June 30, 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.
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, as
actual results may differ materially from management's expectations.
Liquidity and Capital Resources. 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 must
maintain certain regulatory liquidity requirements of liquid assets to deposits
and short-term borrowings. At June 30, 2004, the Bank had cash, deposits in
banks, investment securities, mortgage-backed securities, FHLB stock and loans
held for sale totaling $99.1 million, compared to $109.8 million at December 31,
2003, representing 15.5% and 18.2% of deposits and short-term borrowings for the
respective periods.
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 FHLB 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. In addition, the Bank
manages its deposit pricing in order to maintain a desired deposit mix.
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 North Carolina Office of the
Commissioner of Banks 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 regulatory capital requirements at June 30, 2004 and December 31, 2003.
11
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.
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.
Loans 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 adjustments to the allowance.
Income Taxes. Deferred tax asset and liability balances are determined by
application to 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.
12
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 June 30, 2004. The Company does not believe that
any material adverse changes in market risk exposures occurred since June 30,
2004.
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.
13
PART II. OTHER INFORMATION
Item l. 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, Use of Proceeds and Issuer Purchases of Equity
Securities
The following table sets forth information regarding the Company's repurchases
of its Common Stock during the quarter ended June 30, 2004.
Total Number
of Shares
Purchased Maximum
as Part of Number of Shares
Total Publicly that May Yet Be
Number of Average Announced Purchased Under
Shares Price Paid Plans or the Plans or
Period Purchased per Share Programs (1) Programs (1)
------ --------- --------- ------------ ------------
April 2004
Beginning date: April 1 24,504 $35.86 24,504 120,960
Ending date: April 30
May 2004
Beginning date: May 1 29,356 $24.35 29,356 91,604
Ending date: May 31
June 2004
Beginning date: June 1 18,783 $24.14 18,783 72,821
Ending date: June 30
--------------------
(1) Shares were purchased pursuant to a stock repurchase program
announced on January 8, 2004. This repurchase program will
expire on January 8, 2005. Subsequent to announcing the stock
repurchase program, on April 23, 2004 the Company paid a
three-for-two stock split. The maximum number of shares that
may yet be purchased under the plans or programs has been
adjusted for the effect of the three-for-two stock split.
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
At the Company's Annual Meeting of Stockholders held on May 20, 2004, the
following matters were submitted to a vote of stockholders with the following
results:
A. The election of two directors:
Name For Withheld
Three-year terms: --------- --------
Linley H. Gibbs, Jr. 3,561,310 17,504
Thomas A. Vann 3,523,732 55,082
14
B. An amendment to the Company's Articles of Incorporation to increase the
number of authorized shares of common stock from 8,000,000 to
25,000,000:
For Against Abstain
--------- ------- -------
Number of eligible votes cast 3,456,989 116,182 5,643
Item 5. Other Information
Not applicable
Item 6. Exhibits and Reports on Form 8-K
a) Exhibits
The following exhibits are filed herewith:
Exhibit
Number Title
------- -----
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Section 1350 Certification
b) Reports on Form 8-K:
A Form 8-K was filed on April 15, 2004 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 ended March 31, 2004.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FIRST SOUTH BANCORP, INC.
/s/ William L. Wall /s/ Kristie W. Hawkins
----------------------------- ----------------------
William L. Wall Kristie W. Hawkins
Executive Vice President Controller
Chief Financial Officer Treasurer
(Principal Financial Officer) (Principal Accounting Officer)
Date: August 5, 2004 Date: August 5, 2004
15