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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________________________
 
FORM 10-K

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

For the Year Ended December 31, 2004

Commission File No. 0-22345

SHORE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)

Maryland
  
52-1974638
(State or Other Jurisdiction of Incorporation or Organization)
  
(I.R.S. Employer Identification No.)
     
     
18 East Dover Street, Easton, Maryland
  
21601
(Address of Principal Executive Offices)
  
(Zip Code)

(410) 822-1400
Registrant’s Telephone Number, Including Area Code

Securities Registered pursuant to Section 12(b) of the Act: None.

Securities Registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No o

The aggregate market value of the Corporation’s voting stock held by non-affiliates of the registrant as of June 30, 2004 was $132,640,822.

The number of shares outstanding of the registrant’s common stock as of March 1, 2005 was 5,515,622.

Documents Incorporated by Reference

Certain information required by Part III of this annual report is incorporated herein by reference to the definitive proxy statement for the 2005 Annual Meeting of Stockholders to be held on April 27, 2005.



 
INDEX
 
Part I
    
Item 1.
Business
2
Item 2.
Properties
10
Item 3.
Legal Proceedings
11
Item 4.
Submission of Matters to a Vote of Security Holders
11
     
Part II
    
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and
  
 
Issuer Purchases of Equity Securities
11
Item 6.
Selected Financial Data
13
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
14
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
28
Item 8.
Financial Statements and Supplementary Data
29
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
57
Item 9A.
Controls and Procedures
57
Item 9B.
Other Information
60
     
Part III
    
Item 10.
Directors and Executive Officers of the Registrant
60
Item 11.
Executive Compensation
60
Item 12.
Security Ownership of Certain Beneficial Owners and Management and
 
 
Related Stockholder Matters
60
Item 13.
Certain Relationships and Related Transactions
60
Item 14.
Principal Accountant Fees and Services
60
     
Part IV
    
Item 15.
Exhibits and Financial Statement Schedules
60
     
SIGNATURES
62
     
EXHIBIT LIST
63


 
This Annual Report of Shore Bancshares, Inc. (the “Company”) on Form 10-K may contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Readers of this report should be aware of the speculative nature of “forward-looking statements.” Statements that are not historical in nature, including the words “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend,” and similar expressions, are based on current expectations, estimates and projections about (among other things) the industry and the markets in which the Company operates; they are not guarantees of future performance. Whether actual results will conform to expectations and predictions is subject to known and unknown risks and uncertainties, including risks and uncertainties discussed in this Form 10-K, general economic, market or business conditions; changes in interest rates, deposit flow, the cost of funds, and demand for loan products and financial services; changes in our competitive position or competitive actions by other companies; changes in the quality or composition of loan and investment portfolios; the ability to mange growth; changes in laws or regulations or policies of federal and state regulators and agencies; and other circumstances beyond the Company’s control. Consequently, all of the forward-looking statements made in this document are qualified by these cautionary statements, and there can be no assurance that the actual results anticipated will be realized, or if substantially realized, will have the expected consequences on the Company’s business or operations. Except as required by applicable laws, we do not intend to publish updates or revisions of any forward-looking statements we make to reflect new information, future events or otherwise. Exhibit 99.1 to this report, entitled “Risk Factors”, contains a discussion of the risks and uncertainties that could cause actual results to differ materially from those contained in the forward looking statements.

PART I

Item 1.    Business.

BUSINESS

General

The Company was incorporated under the laws of Maryland on March 15, 1996 and is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company’s primary business is acting as the parent company to three bank subsidiaries, The Centreville National Bank of Maryland (“Centreville National Bank”), The Talbot Bank of Easton, Maryland (“Talbot Bank”), and The Felton Bank (“Felton Bank”) (collectively, the “Banks”), two insurance producer firms, The Avon-Dixon Agency, LLC and Elliott Wilson Insurance, LLC, one insurance premium finance company, Mubell Finance, LLC (together with The Avon-Dixon Agency, LLC and Elliot Wilson Insurance, LLC, the “Insurance Subsidiaries”), and an investment adviser firm, Wye Financial Services, LLC (“Wye Financial”). The Company also has a non-active subsidiary, Shore Pension Services, LLC. Felton Bank was acquired on April 1, 2004 when the Company merged with Midstate Bancorp, Inc., a Delaware bank holding company.

Talbot Bank owns all of the issued and outstanding securities of Dover Street Realty, Inc., a Maryland corporation that engages in the business of holding and managing real property acquired by Talbot Bank as a result of loan foreclosures. Centreville National Bank owns 20% of the issued and outstanding common stock of Delmarva Data Bank Processing Center, Inc. (“Delmarva Data”). Delmarva Data is a Maryland corporation located in Easton, Maryland that provides data processing services to banks located in Maryland, Delaware, Virginia and the District of Columbia, including the Banks.

Banking Products and Services

Centreville National Bank is a national banking association that commenced operations in 1876. Talbot Bank is a Maryland commercial bank and commenced operations in 1885. Felton Bank is a Delaware commercial bank that commenced operations in 1908. The Banks operate fifteen full service branches and seventeen ATMs and provides a full range of commercial and consumer banking products and services to individuals, businesses, and other organizations in the Maryland counties of Kent, Queen Anne’s, Caroline, Talbot and Dorchester and in Kent County, Delaware. The Banks’ deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”).

The Banks are independent community banks and serve businesses and individuals in their respective market areas. Services offered are essentially the same as those offered by larger regional institutions that compete with the Banks. Services provided to businesses include commercial checking, savings, certificate of deposit and overnight investment sweep accounts. The Banks offer all forms of commercial lending, including secured and unsecured loans, working capital loans, lines of credit, term loans, accounts receivable financing, real estate acquisition development, construction loans and letters of credit. Merchant credit card clearing services are available as well as direct deposit of payroll, internet banking and telephone banking services.
 
 
2
 
Services to individuals include checking accounts, various savings programs, mortgage loans, home improvement loans, installment and other personal loans, credit cards, personal lines of credit, automobile and other consumer financing, safe deposit boxes, debit cards, 24 hour telephone banking, PC and internet banking, and 24-hour automatic teller machine services. The Banks also offer nondeposit products, such as mutual funds and annuities, and discount brokerage services to their customers. Additionally, the Banks have Saturday hours and extended hours on certain evenings during the week for added customer convenience.

Lending Activities

The Company’s lending operations are conducted through the Banks.

The Company originates secured and unsecured loans for business purposes. It is typical for commercial loans to be secured by real estate, accounts receivable, inventory equipment or other assets of the business. Commercial loans generally involve a greater degree of credit risk than one to four family residential mortgage loans. Repayment is often dependent on the successful operation of the business and may be affected by adverse conditions in the local economy or real estate market. The financial condition and cash flow of commercial borrowers is therefore carefully analyzed during the loan approval process, and continues to be monitored by obtaining business financial statements, personal financial statements and income tax returns. The frequency of this ongoing analysis depends upon the size and complexity of the credit and collateral that secures the loan. It is also the Company’s general policy to obtain personal guarantees from the principals of the commercial loan borrowers.

The Company provides residential real estate construction loans to builders and individuals for single family dwellings. Residential construction loans are usually granted based upon “as completed” appraisals and are secured by the property under construction. Additional collateral may be taken if loan to value ratios exceed 80%. Site inspections are performed to determine pre-specified stages of completion before loan proceeds are disbursed. These loans typically have maturities of six to 12 months and may be fixed or variable rate. Permanent financing for individuals offered by the Company includes fixed and variable rate loans with three-year or five-year balloons, and one-, three- or five-year adjustable rate mortgages.

The risk of loss associated with real estate construction lending is controlled through conservative underwriting procedures such as loan to value ratios of 80% or less, obtaining additional collateral when prudent, and closely monitoring construction projects to control disbursement of funds on loans.

The Company originates fixed and variable rate residential mortgage loans. As with any consumer loan, repayment is dependent on the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy. Underwriting standards recommend loan to value ratios not to exceed 80% based on appraisals performed by approved appraisers of the Company. Title insurance protecting the Company’s lien priority, as well as fire and casualty insurance, is required.

The Company also originates and sells long-term fixed rate residential mortgage loans on the secondary market. These loans are not typically funded by the Company, but the Company receives a commission upon settlement.

Commercial real estate loans are primarily those secured by office condominiums, retail buildings, warehouses and general purpose business space. Low loan to value ratio standards, as well as the thorough financial analysis performed and the Company’s knowledge of the local economy in which it lends, can reduce the risk associated with these loans.

A variety of consumer loans are offered to customers, including home equity loans, credit cards and other secured and unsecured lines of credit and term loans. Careful analysis of an applicant’s creditworthiness is performed before granting credit, and on going monitoring of loans outstanding is performed in an effort to minimize risk of loss by identifying problem loans early.

Insurance Activities

The Insurance Subsidiaries were formed as a result of the Company’s acquisition of the assets of The Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company on May 1, 2002. On November 1, 2002, The Avon-Dixon Agency, LLC acquired certain assets of W. M. Freestate & Son, Inc., a full-service insurance producer firm located in Centreville, Maryland. The Insurance Subsidiaries offer a full range of insurance products and services to customers, including insurance premium financing.

  
3
 
Investment Adviser Activities

Through Wye Financial, which was formed in 2002, the Company offers a variety of financial planning products and services to customers within its market areas.
 
Seasonality

Management does not believe that the business activities of the Company are seasonal in nature. Deposits may vary depending on local and national economic conditions, but management believes that any variation will not have a material impact on the Company’s planning or policy-making strategies.

Employees

At March 1, 2005, the Company and its subsidiaries employed 284 persons, of which 246 were employed on a full-time basis.

COMPETITION

The banking business, in all of its phases, is highly competitive. Within their market areas, the Company and its subsidiaries compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with money market and mutual funds and other investment alternatives for deposits, with consumer finance companies for loans, with insurance companies, agents and brokers for insurance products, and with other financial institutions for various types of products and services. There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas.

The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. The primary factors in competing for insurance customers are competitive rates, the quality and range of insurance products offered, and quality, personalized service.

To compete with other financial services providers, the Company relies principally upon local promotional activities, including advertisements in local newspapers, trade journals and other publications and on the radio, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet its customers’ needs. The Company also relies on referrals from satisfied customers. In those instances in which the Company is unable to accommodate a customer’s needs, the Company will arrange for those services to be provided by other financial services providers with which it has relationships.

Current banking laws facilitate interstate branching and merger activity among banks. Since September 1995, certain bank holding companies are authorized to acquire banks throughout the United States. In addition, on and after June 1, 1997, certain banks are permitted to merge with banks organized under the laws of different states. As a result, interstate banking is now an accepted element of competition in the banking industry and the Company may be brought into competition with institutions with which it does not presently compete.


4

The following table sets forth deposit data for Kent, Queen Anne’s, Caroline, Talbot and Dorchester Counties in Maryland and Kent County, Delaware as of June 30, 2004, the most recent date for which comparative information is available.

       
% of
  
Kent County, Maryland
  
Deposits
  
Total
  
   
(in thousands)
      
Peoples Bank of Kent County, Maryland
  
$
151,157
    
35.42
%
The Chestertown Bank of Maryland
    
139,383
    
32.66
  
Chesapeake Bank and Trust Co.
    
60,560
    
14.19
  
Branch Banking & Trust
    
32,887
    
7.71
  
The Centreville National Bank of Maryland
    
23,032
    
5.40
  
SunTrust Bank
    
19,711
    
4.62
  
Total
  
$
426,730
    
100.00
%
               
Source: FDIC DataBook

   
 
 
% of
 
Queen Anne’s County, Maryand
Deposits
Total
  
   
(in thousands)
      
The Queenstown Bank of Maryland
  
$
247,925
    
41.40
%
The Centreville National Bank of Maryland
    
174,370
    
29.12
  
Bank of America, National Association
    
58,161
    
9.71
  
The Chestertown Bank of Maryland
    
45,447
    
7.59
  
M&T
    
35,304
    
5.90
  
BankAnnapolis
    
21,346
    
3.56
  
Branch Banking & Trust
    
16,326
    
2.72
  
Total
  
$
598,879
    
100.00
%
               
Source: FDIC DataBook

   
 
 
% of
 
Caroline County, Maryland
Deposits
Total
  
   
(in thousands)
      
Provident State Bank of Preston, Maryland
  
$
108,042
    
32.18
%
Peoples Bank of Maryland
    
90,468
    
26.95
  
Branch Banking & Trust
    
46,572
    
13.87
  
The Centreville National Bank of Maryland
    
38,823
    
11.57
  
M& T
    
28,328
    
8.44
  
Bank of America, National Association
    
16,068
    
4.79
 
Easton Bank & Trust
    
7,390
    
2.20
  
Total
  
$
335,691
    
100.00
%
               
Source: FDIC DataBook
 
 

5


   
 
 
% of
 
Talbot County, Maryland
Deposits
Total
 
 
 
(in thousands)
 
 
  
The Talbot Bank of Easton, Maryland
  
$
352,887
    
42.72
%
St. Michaels Bank
    
170,186
    
20.60
  
Easton Bank & Trust
    
83,825
    
10.15
  
Bank of America, National Association
    
79,673
    
9.65
  
SunTrust Bank
    
45,332
    
5.49
  
M&T
    
29,957
    
3.63
 
Branch Banking & Trust
    
25,262
    
3.06
 
First Mariner Bank
    
19,263
    
2.33
 
The Queenstown Bank of Maryland
    
14,836
    
1.80
  
Chevy Chase Bank
    
4,824
    
0.57
  
Total
  
$
826,045
    
100.00
%
               
Source: FDIC DataBook

   
 
 
% of
 
Dorchester County, Maryland
Deposits
Total
 
 
 
(in thousands)
 
 
 
The National Bank of Cambridge
  
$
161,898
    
32.69
%
Bank of the Eastern Shore
    
146,050
    
29.49
  
Hebron Savings Bank
    
48,137
    
9.72
  
Provident State Bank of Preston, Maryland
    
31,529
    
6.37
  
Bank of America, National Association
    
29,154
    
5.89
  
Branch Banking & Trust
    
26,697
    
5.39
  
M&T
    
23,681
    
4.78
  
SunTrust Bank
    
14,665
    
2.96
  
The Talbot Bank of Easton, Maryland
    
13,371
    
2.71
  
Total
  
$
495,182
    
100.00
%
               
Source: FDIC DataBook

Kent County, Delaware
Deposits
Total
 
 
 
(in thousands)
 
 
  
Wilmington Trust
  
$
416,313
    
30.25
%
Citizens Bank
    
271,354
    
19.72
  
PNC Bank Delaware
    
230,623
    
16.76
  
First NB of Wyoming
    
181,573
    
13.19
  
Wachovia Bank of Delaware
    
111,679
    
8.12
  
Artisans Bank
    
56,970
    
4.14
  
The Felton Bank
    
53,280
    
3.87
  
County Bank
    
35,467
    
2.58
  
Wilmington Savings Fund Society
    
12,616
    
0.92
  
Fort Sill National Bank
    
6,275
    
0.45
  
Total
  
$
1,376,150
    
100.00
%
               
Source: FDIC DataBook

SUPERVISION AND REGULATION

The following discussion is a summary of the material regulations and policies applicable to the Company and its subsidiaries and is not intended to be a comprehensive discussion. Changes in applicable laws and regulations may have a material effect on the business of the Company.


6

General

The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the FRB.

Talbot Bank is a Maryland commercial bank subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year). Centreville National Bank is a national banking association subject to federal banking laws and regulations enforced and/or promulgated by the Office of the Comptroller of the Currency (the “OCC”), which is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the association has assets of $250 million or less and meets certain other conditions). Felton Bank is a Delaware commercial bank subject to the banking laws of Delaware and to regulation by the Delaware Office of the State Bank Commissioner, who is entitled by statute to make examinations of Felton Bank as and when deemed necessary or expedient. The primary federal regulator of both Talbot Bank and Felton Bank is the FDIC, which is also entitled to conduct regular examinations. The deposits of the Banks are insured by the FDIC, so certain laws and regulations administered by the FDIC also govern their deposit taking operations. In addition to the foregoing, the Banks are subject to numerous state and federal statutes and regulations that affect the business of banking generally.

Nonbank affiliates of the Company are subject to examination by the FRB, and, as affiliates of the Banks, may be subject to examination by the Banks’ regulators from time to time. In addition, the Insurance Subsidiaries are each subject to licensing and regulation by the insurance authorities of the states in which they do business. Retail sales of insurance products by the Insurance Subsidiaries to the Bank’s customers are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994, as amended, by the FDIC, the FRB, the OCC, and the Office of Thrift Supervision. Wye Financial Services, LLC is subject to the registration and examination requirements of federal and state laws governing investment advisers.

Regulation of Financial Holding Companies

In November 1999, the federal Gramm-Leach-Bliley Act (the “GLBA”) was signed into law. Effective in pertinent part on March 11, 2000, GLBA revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution. Under GLBA, a bank holding company can elect, subject to certain qualifications, to become a “financial holding company” and may thereafter engage in a full range of financial activities, including insurance and securities sales and underwriting activities, and real estate development, with new expedited notice procedures. A financial holding company’s expanded activities may be limited or prohibited unless each of the financial holding company’s depository institution subsidiaries, among other things, remains well capitalized and well managed after the election.

Under FRB policy, the Company is expected to act as a source of strength to its subsidiary banks, and the FRB may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its stockholders and obligations to other affiliates.

Banking Regulation

Federal and state banking regulators may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believes are unsafe or unsound banking practices. These banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.
 

 
7
 
The Company and its affiliates are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act. Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its nonbank affiliates by the Banks. Section 23B requires that transactions between any of the Banks and the Company and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.

The Banks are also subject to certain restrictions on extensions of credit to executive officers, directors, and principal stockholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as are available to third parties dealing with the Banks and not involve more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.

As part of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority. These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The Company, on behalf of the Banks, believes that the Banks meet substantially all standards that have been adopted. FDICIA also imposes new capital standards on insured depository institutions.

The Community Reinvestment Act (“CRA”) requires that, in connection with the examination of financial institutions within their jurisdictions, the federal banking regulators evaluate the record of the financial institution in meeting the credit needs of their communities including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, each of the Banks had a CRA rating of “Satisfactory.”

Capital Requirements

FDICIA established a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, federal banking regulators are required to rate supervised institutions on the basis of five capital categories: “well -capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized;” and to take certain mandatory actions, and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories. The severity of the actions will depend upon the category in which the institution is placed. A depository institution is “well capitalized” if it has a total risk based capital ratio of 10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any order, regulatory agreement, or written directive to meet and maintain a specific capital level for any capital measure. An “adequately capitalized” institution is defined as one that has a total risk based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMEL rating of 1).

FDICIA generally prohibits a depository institution from making any capital distribution, including the payment of cash dividends, or paying a management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee (subject to certain limitations) that the institution will comply with such capital restoration plan.

Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized depository institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically undercapitalized.

As of December 31, 2004, Talbot Bank and Centreville National Bank were each deemed to be “well capitalized.” Felton Bank was not deemed to be “well capitalized” due to its total risk based capital ratio falling below 10%. The Company has since made the necessary capital contributions to Felton Bank to increase its total risk based capital ratio. For further information about the capital condition of the Company and the Banks, see Note 17 of the Notes to Consolidated Financial Statements appearing in Item 8 of Part II of this report.
 
 
8

Deposit Insurance

As FDIC member institutions, the Banks’ deposits are insured to a maximum of $100,000 per depositor through the Bank Insurance Fund (“BIF”), administered by the FDIC, and each institution is required to pay semi-annual deposit insurance premium assessments to the FDIC. The FDIC is required to establish semi-annual assessments for BIF-insured depository institutions at a rate determined to be appropriate to maintain or increase the reserve ratio of the BIF at or above 1.25% of estimated insured deposits or at such higher percentage as the FDIC determines to be justified for that year by circumstances raising significant risk of substantial future losses to the fund. Assessments are made on a risk-based premium system with nine risk classifications based on certain capital and supervisory measures. Financial institutions with higher levels of capital and involving a low degree of supervisory concern are assessed lower premiums than financial institutions with lower levels of capital or involving a higher degree of supervisory concern. In addition, as a result of the April 1997 merger of Kent Savings and Loan Association, F.A. into Centreville National Bank, approximately $34.9 million of the Centreville National Bank’s deposits are insured through the Savings Association Insurance Fund (“SAIF”), also administered by the FDIC, which are determined quarterly. The federal Economic Growth and Regulatory Paperwork Reduction Act of 1996 included provisions that, among other things, recapitalized the SAIF through a special assessment on savings association deposits and bank deposits that had been acquired from savings associations.

USA PATRIOT Act

Congress adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response to the terrorist attacks that occurred on September 11, 2001. Under the Patriot Act, certain financial institutions, including banks, are required to maintain and prepare additional records and reports that are designed to assist the government’s efforts to combat terrorism. The Patriot Act includes sweeping anti-money laundering and financial transparency laws and required additional regulations, including, among other things, standards for verifying client identification when opening an account and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Federal Securities Laws

Shares of the Company’s common stock are registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are listed on the Nasdaq Small Cap Market. The Company is subject to information reporting, proxy solicitation, insider trading restrictions and other requirements of the Exchange Act and the listing standards of The Nasdaq Stock Market, Inc. The federal Sarbanes-Oxley Act of 2002 and the new regulations adopted in furtherance thereof made several changes to the Exchange Act and the listing standards of The Nasdaq Stock Market, Inc. These changes impose additional requirements and restrictions on the Company, including, among other things, restrictions on loans to and other transactions with insiders, additional disclosure requirements in the reports and other documents that the Company files with the SEC, new director independence requirements, certain Board of Director committee requirements, and other corporate governance requirements.

Governmental Monetary and Credit Policies and Economic Controls

The earnings and growth of the banking industry and ultimately of the Company and its subsidiaries are affected by the monetary and credit policies of governmental authorities, including the FRB. An important function of the FRB is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the FRB to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the FRB authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the FRB, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and its subsidiaries.


9

AVAILABLE INFORMATION

The Company maintains an Internet site at www.shbi.net on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC. In addition, stockholders may access these reports and documents on the SEC’s web site at www.sec.gov.

Item 2.    Properties.

The tables below identify the offices of the Company’s subsidiaries. The Company’s main office is the same as Talbot Bank’s main office. The Company owns real property at 28969 Information Lane in Easton, Maryland, which houses the Operations, Information Technology and Finance departments of the Company and its subsidiaries, and certain operations of The Avon Dixon Agency. A portion of the facility is leased to an unaffiliated third party.

The Talbot Bank of Easton, Maryland
Main Office
18 East Dover Street
Easton, Maryland 21601
Tred Avon Square Branch
210 Marlboro Road
Easton, Maryland 21601
St. Michaels Branch
1013 South Talbot Street
St. Michaels, Maryland 21663
     
Elliott Road Branch
8275 Elliott Road
Easton, Maryland 21601
Cambridge Branch
2745 Dorchester Square
Cambridge, Maryland 21613
Sunburst Branch
424 Dorchester Avenue
Cambridge, Maryland 21613
     
 
ATMs
  
Memorial Hospital at Easton
219 South Washington Street
Easton, Maryland 21601
Sailwinds Amoco
511 Maryland Avenue
Cambridge, Maryland 21613
Talbottown
218 North Washington Street
Easton, Maryland 21601

The Centreville National Bank of Maryland
Main Office
109 North Commerce Street
Centreville, Maryland 21617
Route 213 South Branch
2609 Centreville Road
Centreville, Maryland 21617
Stevensville Branch
408 Thompson Creek Road
Stevensville, Maryland 21666
     
Kent Branch
305 East High Street
Chestertown, Maryland 21620
Hillsboro Branch
21913 Shore Highway
Hillsboro, Maryland 21641
Denton Branch
850 South 5th Street
Denton, Maryland 21629
     
Chester Branch
300 Castle Marina Road
Chester, Maryland 21619
  
                      ATM
Queenstown Harbor Golf Links
Queenstown, Maryland 21658
 
The Felton Bank
Main Office
120 West Main Street
Felton, Delaware 19943
Milford Branch
648 North West Front Street
Routes 14 & 113
Milford, Delaware 19963
  
 
The Avon-Dixon Agency, LLC
Easton Office
106 North Harrison Street
Easton, Maryland 21601
Grasonville Office
301 Saddler Road
Grasonville, Maryland 21638
Centreville Office
195 Lawyers Row
Centreville, Maryland 21617
     
Elliott-Wilson Insurance, LLC
Mubell Finance, LLC
Wye Financial Services, LLC
106 North Harrison Street
Easton, Maryland 21601
106 North Harrison Street
Easton, Maryland 21601
17 East Dover Street, Suite 101
Easton, Maryland 21601

 
 
10
 
Talbot Bank owns the real property on which all of its offices are located, except that it operates under leases at its Saint Michaels Branch and its Cambridge Branch. Centreville National Bank owns the real property on which all of its offices are located. The Felton Bank owns the real property on which its main office is located and leases the property on which its Milford branch is located. The Insurance Subsidiaries do not own any real property, but operate under leases. Wye Financial Services, LLC occupies space in Talbot Bank’s main office. For information about rent expense for all leased premises, see Note 6 of the Notes to Consolidated Financial Statements appearing in Item 8 of Part II of this report.

Item 3.    Legal Proceedings

In the normal course of business, the Company may become involved in litigation arising from banking, financial, and other activities of the Company. Management, after consultation with legal counsel, does not anticipate that the future liability, if any, arising out of these matters will have a material effect on the Company’s financial condition, operating results, or liquidity.

Item 4.    Submission of Matters to a Vote of Security Holders.

None.
 
PART II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities.

MARKET PRICE, HOLDERS AND CASH DIVIDENDS

The shares of the Company’s common stock are listed on the Nasdaq Small Cap Market under the symbol “SHBI”. As of March 1, 2005, the Company had approximately 1,685 holders of record. The high and low sales prices as reported on the Nasdaq SmallCap Market for the shares of the Company’s common stock, as well as the cash dividends declared on those shares, for each quarterly period of 2004 and 2003 are set forth in the table below.

   
2004
  
2003
  
 
  
Price Range
  
Dividends
  
Price Range
  
Dividends
  
 
  
High
  
Low
  
Paid
  
High
  
Low
  
Paid
  
First Quarter
  
$
39.45
  
$
30.37
  
$
.18
  
$
35.74
  
$
23.60
  
$
.15
  
Second Quarter
    
32.72
    
25.15
    
.18
    
36.61
    
28.00
    
.17
  
Third Quarter
    
29.70
    
25.25
    
.18
    
40.59
    
29.50
    
.17
  
Fourth Quarter
    
37.01
    
29.05
    
.18
    
44.00
    
35.45
    
.17
  
               
$
.72
              
$
.66
  
                                       

Stockholders received cash dividends totaling $3,948,218 in 2004 and $3,548,410 in 2003. The ratio of dividends per share to net income per share was 38.71% in 2004, compared to 37.29% in 2003. Cash dividends are typically declared on a quarterly basis and are at the discretion of the Board of Directors, based upon such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return. The Company’s ability to pay dividends is limited by federal and Maryland law and is generally dependent on the ability of the Company’s subsidiaries, particularly the Banks, to declare dividends to the Company. For more information regarding these limitations, see the Risk Factors attached to this report as Exhibit 99.1 under the heading “The Company’s Ability to Pay Dividends is Limited”.
 
Stockholders received cash dividends totaling $3,948,218 in 2004 and $3,548,410 in 2003. The ratio of dividends per share to net income per share was 38.71% in 2004, compared to 37.29% in 2003. Cash dividends are typically declared on a quarterly basis and are at the discretion of the Board of Directors, based upon such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return. The Company’s ability to pay dividends is limited by federal and Maryland law and is generally dependent on the ability of the Company’s subsidiaries, particularly the Banks, to declare dividends to the Company. For more information regarding these limitations, see the Risk Factors attached to this report as Exhibit 99.1 under the heading “The Company’s Ability to Pay Dividends is Limited”.

The transfer agent for the Company’s common stock is:

Registrar & Transfer Company
10 Commerce Drive
Cranford, New Jersey 07016
Investor Relations: 1-800-368-5948
E-mail for investor inquiries: info@rtco.com.
 

11

EQUITY COMPENSATION PLAN INFORMATION

The Company has three equity compensation plans under which it may issue shares of its common stock to employees, officers, and/or directors of the Company and its subsidiaries. These plans are: (i) the Shore Bancshares, Inc. 1998 Stock Option Plan (the “1998 Stock Option Plan”); the (ii) the Shore Bancshares, Inc. 1998 Employee Stock Purchase Plan (the “1998 Stock Purchase Plan”); and (iii) the Talbot Bancshares, Inc. Employee Stock Option Plan (the “Talbot Plan”).

The 1998 Stock Option Plan and the 1998 Employee Stock Purchase Plan were approved by the Company’s Board of Directors and its stockholders. In connection with the merger of Talbot Bancshares, Inc. (“Talbot Bancshares”) into the Company in December 2000, the Company assumed options previously granted under, and subject to all terms of, the Talbot Plan. The Company subsequently registered the Talbot Plan with the SEC, and this plan authorizes the grant of options to purchase up to 114,000 shares of the Company’s common stock (subject to adjustment for capital adjustments, stock dividends, and similar changes in the common stock). The Talbot Plan was previously approved by both the Board of Directors and the stockholders of Talbot Bancshares, but was not approved by the stockholders of the combined companies. Thus, only non-qualified stock options may be granted under the Talbot Plan.

The Talbot Plan is administered by the Personnel Committee of the Company’s Board of Directors and will expire on April 9, 2007 unless sooner terminated. Generally, key management employees of the Company and its subsidiaries are eligible to receive option grants. An option granted under the plan vests according to the terms of the related stock option agreements and can generally be exercised for 10 years after grant, unless the Board provides otherwise. The option exercise price will generally be the fair market value of the shares on the date the option is granted. Upon exercise of options granted under the plan, the plan obligates the Company to pay the optionee a tax benefit payment in an amount of U.S. dollars equal to the number of shares as to which the option is being exercised, multiplied by (i) the “tax rate” and (ii) the difference between the per share fair market value at the time of exercise and the per share option price. The tax rate shall be a percentage designated by the Company to result in compensating the optionee for the federal, state and local income tax liability incurred by the optionee by virtue of his exercise of the option and the payment to him of the tax benefit payment. Options are not transferable other than by will or the laws of descent and distribution. All unexercised options will lapse upon termination of employment other than because of death, disability or approved retirement. If employment is terminated because of disability or approved retirement, the options will lapse one year or three months after termination, respectively. Upon a “change in control” as defined in the plan, all unexercised options will immediately vest and become exercisable. No options have been granted under the Talbot Plan since the merger with Talbot.

The following table contains information about these equity compensation plans as of December 31, 2004:

Plan Category
  
Number of securities to be issued upon exercise of outstanding options, warrants, and rights
(a)
  
Weighted-average exercise price of outstanding options, warrants, and rights
(b)
  
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in
column (a))
(c)
  
Equity compensation plans approved by security holders (1)(2)
    
85,225
 
$
14.05
    
74,156
 
Equity compensation plans not approved by security holders (3)
    
0
 
$
0
    
3,491
 
Total
    
85,225
 
$
14.05
    
77,647
 
 
(1) Includes information for the 1998 Stock Option Plan and the 1998 Employee Stock Purchase Plan.
(2) Columns (a) and (b) of this item also include options assumed by the Company under the Talbot Plan in the 2000 merger of Talbot Bancshares into the Company. As of December 31, 2004, outstanding options assumed in the merger represent 52,203 shares of the Company’s common stock, with a weighted-average exercise price of $8.62.
(3) This item covers options under the Talbot Plan other than those assumed by the Company in the 2000 merger of Talbot Bancshares into the Company.
 

 
12
 
Item 6.    Selected Financial Data.

The following table sets forth certain selected financial data for the five years ended December 31, 2004 and is qualified in its entirety by the detailed information and financial statements, including notes thereto, included elsewhere or incorporated by reference in this annual report. This data should be read in conjunction with the consolidated financial statements and related notes thereto appearing in Item 8 of Part II of this report and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 7 of Part II of this report.

   
Years Ended December 31,
  
(Dollars in thousands, except per shares data)
  
2004
2003
2002
2001
2000
  
                       
RESULTS OF OPERATIONS:
                      
Interest income
  
$
38,291
  
$
34,339
  
$
36,306
  
$
38,938
  
$
39,480
  
Interest expense
    
9,010
    
9,743
    
12,438
    
17,061
    
17,888
  
Net interest income
    
29,281
    
24,596
    
23,868
    
21,877
    
21,592
  
Provision for credit losses
    
931
    
335
    
356
    
226
    
437
  
Net interest income after provision for credit losses
    
28,350
    
24,261
    
23,512
    
21,651
    
21,155
  
Noninterest income
    
10,224
    
9,845
    
5,968
    
2,646
    
3,104
  
Noninterest expenses
    
22,535
    
19,344
    
15,960
    
12,026
    
11,904
  
Income before taxes
    
16,039
    
14,762
    
13,520
    
12,271
    
12,355
  
Income taxes
    
5,841
    
5,266
    
4,730
    
4,277
    
4,398
  
NET INCOME
  
$
10,198
  
$
9,496
  
$
8,790
  
$
7,994
  
$
7,957
  
                                 
PER SHARE DATA:
                                
Net income - basic
  
$
1.86
  
$
1.77
  
$
1.64
  
$
1.50
  
$
1.50
  
Net income - diluted
    
1.84
    
1.74
    
1.62
    
1.49
    
1.48
  
Dividends paid
    
.72
    
.66
    
.60
    
.60
    
.52
  
Book value (at year end)
    
16.86
    
15.47
    
14.52
    
13.31
    
12.21
  
Tangible book value (at year end) (1)
    
14.29
    
14.06
    
13.08
    
13.03
    
11.91
  
 
                                
FINANCIAL CONDITION (at year end):
                                
Assets
  
$
790,598
  
$
705,379
  
$
654,066
  
$
582,403
  
$
553,097
  
Deposits
    
658,672
    
592,409
    
545,192
    
487,470
    
464,485
  
Total loans, net of unearned income
                                
and allowance for credit losses
    
590,766
    
470,895
    
435,422
    
388,516
    
378,307
  
Stockholders’ equity
    
92,976
    
83,527
    
78,028
    
70,971
    
65,024
  
                                 
PERFORMANCE RATIOS (for the year):
                                
Return on average assets
    
1.32
%
  
1.40
%
  
1.42
%
  
1.42
%
  
1.52
%
Return on average stockholders’ equity
    
11.17
%
  
11.70
%
  
11.79
%
  
11.70
%
  
12.98
%
Net interest margin
    
4.10
%
  
3.91
%
  
4.12
%
  
4.15
%
  
4.40
%
Efficiency ratio(2)
    
57.04
%
  
56.17
%
  
53.49
%
  
49.04
%
  
48.20
%
Dividend payout ratio
    
38.71
%
  
37.29
%
  
36.59
%
  
40.00
%
  
34.66
%
Average stockholders’ equity to average total assets
    
11.79
%
  
11.96
%
  
12.00
%
  
12.16
%
  
11.68
%
                                 
 
(1)  
Total stockholders’ equity, net of goodwill and other intangible assets, divided by the number of shares of common stock outstanding at year-end.
(2)  
Noninterest expenses as a percentage of total revenue (net interest income plus total noninterest income). Lower ratios indicate improved productivity.


13

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operation.

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

The following discussion compares the financial condition of the Company at December 31, 2004 to the financial condition at December 31, 2003 and the results of operations for the years ended December 31, 2004, 2003, and 2002. This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto appearing in Item 8 of Part II of this report.

PERFORMANCE OVERVIEW

The Company recorded a 7.4% increase in net income for 2004 over 2003. Net income for the year ended December 31, 2004 was $10,198,000, compared to $9,496,000 and $8,790,000 for the years ended December 31, 2003 and 2002, respectively. Basic net income per share for 2004 was $1.86, an increase of 5.1% over 2003. Basic net income per share was $1.77 and $1.64 for 2003 and 2002, respectively. Diluted net income per share for 2004 was $1.84, an increase of 5.7% over 2003. Diluted net income per share was $1.74 and $1.62 for 2003 and 2002, respectively.

Return on average assets was 1.32% for 2004, compared to 1.40% for 2003 and 1.42% for 2002. Return on stockholders’ equity for 2004 was 11.17%, compared to 11.70% for 2003 and 11.79% for 2002. When compared to 2003, average assets increased 14.2% totaling $774,880,000, average loans increased 21.4% totaling $555,259,000, average deposits increased 14.1% totaling $648,145,000, and average stockholders’ equity increased 12.5% totaling $91,326,000 for the year ended December 31, 2004.

RECENT DEVELOPMENTS

On February 15, 2005, in furtherance of the Company’s acquisition of all of the assets of The Avon-Dixon Agency, Inc. on May 1, 2002, the Company made a $2.8 million deferred payment (earn-out) to The Avon-Dixon Agency, Inc. The deferred payment was required by the acquisition agreement and was based on the acquired business’ satisfaction of certain performance criteria through December 31, 2004. As a result of this payment, the Company recorded $2.8 million in Goodwill on December 31, 2004. For further information about acquisition-related Goodwill recognized during 2004, see Note 2 of the Notes to Consolidated Financial Statements.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

The most significant accounting policies followed by the Company are presented in Note 1 of the Notes to Consolidated Financial Statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for credit losses to be the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

14


The allowance for credit losses represents management’s estimate of probable credit losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheets. Note 1 of the Notes to Consolidated Financial Statements describes the methodology used to determine the allowance for credit losses and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in the Credit Risk Management section of this financial review.

RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS

Note 1 of the Notes to the Consolidated Financial Statements discusses new accounting policies adopted by the Company during 2004 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects the Company’s financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section(s) of this financial review and notes to the consolidated financial statements.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

Net interest income remains the most significant component of the Company’s earnings. It is the excess of interest and fees earned on loans, federal funds sold, and investment securities, over interest paid on deposits and borrowings. Tax equivalent net interest income for 2004 was $29,624,000, representing an 18.6% increase over 2003. Tax equivalent net interest income for 2003 was $24,987,000, a 3.3% increase over 2002. Increased interest income and a reduction in interest expense was the reason for the increased net interest income in 2004. Interest income declined in 2003, but a greater overall reduction of interest expense during that year resulted in an increase in net interest income over 2002. The tax equivalent yield on earning assets was 5.35% for 2004, compared to 5.44% and 6.24% for 2003 and 2002, respectively.

In June of 2004, the FRB began to increase short-term interest rates, but these increases were not enough to increase the overall yields on earning assets that resulted from previous rate reductions. Short-term rates were reduced by 25 basis points in 2003, 50 basis points in 2002, and a record setting eleven reductions totaling 475 basis points in 2001. The federal funds rate was 2.25% at December 31, 2004, compared to 1.0% and 1.25% at December 31, 2003 and 2002, respectively, and the New York Prime rate was 5.25% at December 31, 2004, compared to 4.0% and 4.25% at December 31, 2003 and 2002, respectively.

The rate paid for interest bearing liabilities declined 33 basis points in 2004, from 1.88% for the year ended December 31, 2003 to 1.55% for the year ended December 31, 2004. The average balance of earning assets increased during 2004 totaling $722,490,000, compared to $638,271,000 for 2003. On a tax equivalent basis, net interest income for 2004 was $29,624,000, compared to $24,987,000 for 2003 and $24,184,000 for 2002, representing an increase of 18.6% and 3.3% for 2004 and 2003, respectively.


15

The following table sets forth the major components of net interest income, on a tax equivalent basis, for the years ended December 31, 2004, 2003 and 2002.


   
(Dollars in thousands)
  
2004
2003
  
2002
  
   
Average
 
Interest
 
Yield/
 
Average
 
Interest
 
Yield/
 
Average
 
Interest
 
Yield/
 
Balance
(1)
Rate
Balance
(1)
Rate
Balance
(1)
Rate
 
                                       
Earning Assets:
                                      
Investment securities:
                                      
Taxable
  
$
126,835
  
$
4,359
    
3.44
%
$
118,104
  
$
4,332
    
3.67
%
  
115,012
  
$
5,641
    
4.91
%
Non-taxable
    
15,593
    
909
    
5.83
    
14,739
    
914
    
6.20
    
11,058
    
733
    
6.63
  
Loans (2)(3)
    
555,259
    
33,065
    
5.95
    
457,491
    
28,981
    
6.33
    
423,771
    
29,646
    
7.00
  
Interest bearing deposits
    
4,737
    
46
    
.98
    
19,602
    
202
    
1.03
    
9,849
    
149
    
1.52
  
Federal funds sold
    
20,066
    
255
    
1.27
    
28,335
    
301
    
1.06
    
27,410
    
453
    
1.65
  
Total earning assets
    
722,490
    
38,634
    
5.35
%
  
638,271
    
34,730
    
5.44
%
  
587,100
    
36,622
    
6.24
%
Cash and due from banks
    
23,190
                
18,436
                
16,757
              
Other assets
    
33,685
                
26,130
                
21,550
              
Allowance for credit losses
    
(4,485
)
              
(4,190
)
              
(4,266
)
            
Total assets
  
$
774,880
              
$
678,647
              
$
621,141
              
Interest bearing liabilities:
                                                        
Demand
  
$
110,614
  
$
409
    
.37
%
$
101,227
  
$
504
    
.50
%
  
91,939
  
$
762
    
.83
%
Savings
    
195,842
    
1,394
    
.71
    
153,721
    
1,388
    
.90
    
126,947
    
1,809
    
1.43
  
Certificates of deposit $100,000 or more
    
86,450
    
2,346
    
2.71
    
91,194
    
2,503
    
2.74
    
87,761
    
3,032
    
3.45
  
Other time
    
159,612
    
4,393
    
2.75
    
145,035
    
4,918
    
3.39
    
145,539
    
6,340
    
4.36
  
Interest bearing deposits
    
552,518
    
8,542
    
1.55
    
491,177
    
9,313
    
1.90
    
452,186
    
11,943
    
2.64
  
Short-term borrowings
    
25,590
    
215
    
0.84
    
23,071
    
178
    
0.77
    
20,986
    
243
    
1.16
  
Long-term debt
    
5,000
    
253
    
5.05
    
5,000
    
252
    
5.04
    
5,000
    
252
    
5.04
  
Total interest bearing liabilities
    
583,108
    
9,010
    
1.55
%
  
519,248
    
9,743
    
1.88
%
  
478,172
    
12,438
    
2.60
%
Noninterest bearing deposits
    
95,627
                
73,910
                
65,067
              
Other liabilities
    
4,819
                
4,308
                
3,357
              
Stockholders’ equity
    
91,326
                
81,181
                
74,545
              
Total liabilities and stockholders’ equity
  
$
774,880
              
$
678,647
              
$
621,141
              
Net interest spread
        
$
29,624
    
3.80
%
      
$
24,987
    
3.56
%
      
$
24,184
    
3.64
%
Net interest margin
                
4.10
%
              
3.91
%
              
4.12
%
                                                         
 
(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 35% exclusive of the alternative minimum tax rate and nondeductible interest expense. The taxable equivalent adjustment amounts utilized in the above table to compute yields aggregated $343 in 2004, $392 in 2003, and $316 in 2002.
(2) Average loan balances include nonaccrual loans.
(3) Interest income on loans includes amortized loan fees, net of costs, for each category and yields are stated to include all.

The Company’s tax equivalent yield on loans continued to decline in 2004 as new loans and loans refinanced with the Company were recorded at lower rates than the year before. An increased volume of loans during 2004 resulted in an increase in interest income for the year when compared to 2003, when the effect of declining rates was much greater than the impact of loan volume on the resultant interest income. In 2004, the increased volume of loans generated $5,866,000 in additional interest income, which was offset by a $1,782,000 decline in interest income due to the reduced yields. Tax equivalent interest income totaled $38,634,000 for 2004, compared to $34,730,000 for 2003 and $36,622,000 for 2002. The primary reason for a $1,892,000 decline in total interest income in 2003 was lower overall yields on loans and other earning assets, which caused interest income declines of $1,421,000 and $2,785,000 for taxable investment securities and loans, respectively, when compared to 2002. 

Growth in the average balance of earning assets was $84,219,000 or 13.2% for the year ended December 31, 2004. Average loans increased $33,720,000, or 8.0%, totaling $457,491,000 at December 31, 2004, compared to an increase of $37,610,000, or 9.7%, during 2002. For the year ended December 31, 2004, the average balance of investment securities increased $9,585,000 and federal funds sold and interest bearing deposits in other banks declined $23,134,000 when compared to 2003. In 2003, the average balance of earning assets increased $51,171,000, or 8.7%, when compared to 2002, driven primarily by growth in interest bearing deposits and federal funds sold, with lower overall yields than other earning assets. As a percentage of total average earning assets, loans and investment securities totaled 76.9% and 19.7%, respectively, for 2004, compared to 71.7% and 20.8%, respectively, for 2003.
 

 
16
 
The following Rate/Volume Variance Analysis identifies the portion of the changes in tax equivalent net interest income, which are attributable to changes in volume of average balances or to changes in the yield on earning assets and rates paid on interest bearing liabilities.

   
2004 over (under) 2003
 
2003 over (under) 2002
  
   
Total
 
Caused By
 
Total
 
Caused By
 
(Dollars in thousands)
Variance
 
Rate
 
Volume
Variance
Rate
Volume
  
                           
Interest income from earning assets:
                          
Interest Bearing Deposits
  
$
(156
)
$
(15
)
$
(141
)
$
53
  
$
(95
)
$
148
  
Federal funds sold
    
(46
)
  
63
    
(109
)
  
(152
)
  
(161
)
  
9
  
Taxable investment securities
    
27
    
(281
)
  
308
    
(1,309
)
  
(1,421
)
  
112
  
Non-taxable investment securities
    
(5
)
  
(55
)
  
50
    
181
    
(52
)
  
233
  
Loans
    
4,084
    
(1,782
)
  
5,866
    
(665
)
  
(2,785
)
  
2,120
  
Total interest income
    
3,904
    
(2,070
)
  
5,974
    
(1,892
)
  
(4,514
)
  
2,622
  
                                       
Interest expense on deposits
                                     
and borrowed funds:
                                      
Interest bearing demand
    
(95
)
  
(131
)
  
36
    
(258
)
  
(307
)
  
49
  
Savings deposits
    
6
    
(321
)
  
327
    
(421
)
  
(697
)
  
276
  
Time deposits
    
(682
)
  
(962
)
  
280
    
(1,951
)
  
(2,030
)
  
79
  
Short-term borrowings
    
37
    
14
    
23
    
(65
)
  
(88
)
  
23
  
Long term debt
    
1
    
-
    
1
    
-
    
-
    
-
  
Total interest expense
    
(733
)
  
(1,400
)
  
667
    
(2,695
)
  
(3,122
)
  
427
  
Net interest income
  
$
4,637
  
$
(670
)
$
5,307
  
$
803
  
$
(1,392
)
$
2,195
  
                                       
The rate and volume variance for each category has been allocated on a consistent basis between rate and volume variances, based on a percentage of rate, or volume, variance to the sum of the absolute two variances.

The Company’s net interest margin (its tax equivalent net interest income divided by average earning assets) represents the net yield on earning assets. The net interest margin is managed through loan and deposit pricing and assets/liability strategies. The Company’s net interest margin increased 19 basis points for 2004 to 4.10%, from 3.91% for 2003, compared to a 21 basis point decline for 2003. The Company’s net interest spread, which is the difference between the average yield on earning assets and the rate paid for interest bearing liabilities, increased from 3.56% for 2003 to 3.80% for 2004.

Interest expense for 2004 decreased $733,000 when compared to 2003. Lower rates accounted for a $1,400,000 reduction in interest expense, while the increased volume of deposits and other interest bearing liabilities generated additional interest expense of $667,000 for 2004. The average rate paid for certificates of deposit of $100,000 or more remained substantially unchanged, however the rate paid for all other time deposits decreased by 64 basis points. Average interest bearing demand deposits increased $9,387,000 during the year, and the rate paid for those deposits decreased 13 basis points to .37%, compared to .50% for 2003 and ..83% for 2002. The rate paid for short-term borrowings, which consist primarily of securities sold under agreements to repurchase, increased to .84% in 2004 from .77% in 2003.

Noninterest Income

Noninterest income increased $379,000 or 3.8% in 2004, compared to an increase of $3,877,000 or 65% in 2003. Service charges on deposits increased $541,000 during 2004. This increase resulted primarily from new and enhanced overdraft products offered to customers, which generated approximately $330,000 of the increase, and operations of the Felton Bank, which contributed $139,000 toward the increase. Service charges on deposit accounts increased $14,000 and $38,000 for 2003 and 2002, respectively. Other service charges and fees increased $522,000 in 2004 as a result of increased letter of credit fees ($94,000), increases in interchange income relating to bank debit and ATM cards ($232,000), an agency management fee received by one of the Company’s insurance subsidiaries ($67,000) and fee income generated by the Felton Bank ($79,000). In 2003, other service charges and fees increased $66,000 or 11.3% when compared to 2002. The Insurance Subsidiaries generated income of $6,383,000, an increase of $346,000 over 2003 (the first full year of operations since being acquired in April 2002). Insurance commission income for the eight months ended December 31, 2002 was $2,872,000. The Company recognized $41,000 in gains on sales of securities in 2004, compared to $448,000 in 2003. These gains were offset by other-than temporary impairment adjustments of $657,500 and $131,000 in 2004 and 2003, respectively. Other-than-temporary impairment adjustments related to certain Freddie Mac preferred stocks and a U.S. Government bond fund owned by the Company in 2004 and 2003, respectively. Other noninterest income decreased $87,000 in 2004, compared to an increase of $345,000 or 64.7% in 2003. The 2003 increase resulted primarily from income generated from the sale of loans on the secondary market totaling $465,000. Mortgage loans that are to be sold in the secondary market are not generally funded by the Company, but the Company receives a commission upon settlement.

17
 
The following table summarizes noninterest income of the Company for the years ended December 31:

   
Years Ended
 
Change from Prior Year
 
 
 
 
 
 
 
 
 
2004/03
 
2003/02
 
(Dollars in thousands)
2004
2003
2002
Amount
 
Percent
Amount
Percent
 
                               
Service charges on deposit accounts
  
$
2,470
  
$
1,929
  
$
1,915
  
$
541
    
28.1
%
$
14
    
0.7
%
Other service charges and fees
    
1,170
    
648
    
582
    
522
    
80.4
    
66
    
11.3
  
Gain on sale of securities
    
41
    
448
    
26
    
(407
)
  
(90.8
)
  
422
    
1,623.1
  
Other than temporary impairment of securities
    
(657
)
  
(132
)
  
-
    
(525
)
  
398.1
    
(132
)
  
(100.0
)
Earnings from unconsolidated subsidiaries
    
26
    
37
    
40
    
(11
)
  
(29.2
)
  
(3
)
  
7.5
  
Insurance agency commissions
    
6,383
    
6,037
    
2,872
    
346
    
5.7
    
3,165
    
110.2
  
Other noninterest income
    
791
    
878
    
533
    
(87
)
  
(9.9
)
  
345
    
64.7
  
Total
  
$
10,224
  
$
9,845
  
$
5,968
  
$
379
    
3.8
%
$
3,877
    
65.0
%

Noninterest Expense

Total noninterest expense increased $3,190,000 or 16.5% in 2004, compared to an increase of $3,384,000 or 21.2% in 2003. A significant portion of the overall increase is attributable to the Felton Bank, which was acquired in 2004. Expenses relating to the Felton Bank were: $805,000 in salaries and employee benefits; $171,000 in occupancy and equipment; $85,000 in data processing; $6,000 in directors’ fees; $91,000 in amortization of intangibles; and $270,000 in other noninterest expense. As in 2003, new bank branches were opened in 2004 and the Company experienced increases in all categories of noninterest expense resulting from overall growth. In 2003, the increase in noninterest expense was primarily attributable to the operation of the Insurance Subsidiaries. Expenses related to the operation of the Insurance Subsidiaries in 2003 were: $3,737,000 in salaries and employee benefits; $443,000 in occupancy and equipment expenses; $829,000 in other noninterest expense. For the eight-month period of 2002 during which the Insurance Subsidiaries were operational, noninterest expenses were: $1,949,000 in salaries and employee benefits; $249,000 in occupancy and equipment expense; and $457,000 in other noninterest expense. Salaries attributable to the Insurance Subsidiaries are based in large part on insurance commissions, and, accordingly, these salaries fluctuate with premium revenue fluctuations. Amortization of other intangible assets relate to the Felton Bank and the operation of the Insurance Subsidiaries. See Note 8 of the Notes to Consolidated Financial Statements for further information regarding the impact of goodwill and other intangible assets on the financial statements. The Company had 268 full-time equivalent employees at December 31, 2004, compared to 231 and 222 at December 31, 2003 and 2002, respectively.

The following table summarizes noninterest expense of the Company for the years ended December 31:

   
Years Ended
  
Change from Prior Year
  
 
      
 
  
 
  
2004/03
  
2003/02
  
(Dollars in thousands)
  
2004
  
2003
  
2002
  
Amount
  
Percent
  
Amount
  
Percent
  
                               
Salaries and employee benefits
  
$
13,760
  
$
12,243
  
$
9,573
  
$
1,517
    
12.4
%
$
2,670
    
27.9
%
Occupancy and equipment
    
2,427
    
2,034
    
1,758
    
393
    
19.3
    
276
    
15.7
  
Data processing
    
1,310
    
955
    
889
    
355
    
37.1
    
66
    
7.4
  
Directors’ fees
    
553
    
569
    
472
    
(16
)
  
(2.8
)
  
97
    
20.6
  
Amortization of other intangible assets
    
306
    
216
    
129
    
90
    
42.1
    
87
    
67.4
  
Other operating expenses
    
4,178
    
3,327
    
3,139
    
851
    
25.6
    
188
    
6.0
  
Total
  
$
22,534
  
$
19,344
  
$
15,960
  
$
3,190
    
16.5
%
$
3,384
    
21.2
%
                                             
Income Taxes

Income tax expense was $5,841,000 for 2004, compared to $5,266,000 for 2003 and $4,730,000 for 2002. The effective tax rates on earnings during these three years were 36.4%, 35.7% and 35.0%, respectively.

18

REVIEW OF FINANCIAL CONDITION

Asset and liability composition, asset quality, capital resources, liquidity, market risk and interest sensitivity are all factors that affect the Company’s financial condition.

Assets

Total assets increased 12.1% to $790,598,000 at December 31, 2004, compared to an increase of 7.8% for 2003. Average total assets at December 31, 2004 were $774,880,000, an increase of 14.2% over 2003. Average total assets increased 9.3% in 2003, totaling $678,647,000 for the year. The loan portfolio represents 76.9% of average earning assets and is the primary source of income for the Company.

Funding for loans is provided primarily by core deposits and short-term borrowings. Total deposits increased 11.2% to $658,672,000 at December 31, 2004, compared to an 8.7% increase for 2003.

The following table sets forth the average balance of the components of average earning assets as a percentage of total average earning assets as of December 31.

   
2004
 
2003
 
2002
 
2001
 
2000
  
Investment securities
    
19.71
%
  
20.81
%
  
21.47
%
  
21.42
%
  
24.25
%
Loans
    
76.85
    
71.68
    
72.18
    
72.28
    
73.66
  
Interest bearing deposits with other banks
    
.66
    
3.07
    
1.68
    
2.00
    
--
  
Federal funds sold
    
2.78
    
4.44
    
4.67
    
4.30
    
2.09
  
     
100.00
%
  
100.00
%
  
100.00
%
  
100.00
%
  
100.00
%
                                 
Interest Bearing Deposits With Other Banks and Federal Funds Sold

The Company invests excess cash balances in interest bearing accounts and federal funds sold offered by its correspondent banks. These liquid investments are maintained at a level necessary to meet the immediate liquidity needs of the Company. The average balance of interest bearing deposits with other banks and federal funds sold declined $23,134,000 to $24,803,000 during 2004 with the proceeds used to fund loan growth during the year. In 2003, the average balance increased $10,678,000 to $47,937,000.

Investment Securities

The investment portfolio is structured to provide liquidity for the Company and also plays an important role in the overall management of interest rate risk. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. The Company intends and has current ability to hold such securities until maturity. Investment securities available for sale are stated at estimated fair value based on quoted market prices. They represent securities which may be sold as part of the Company’s asset/liability strategy or which may be sold in response to changing interest rates. Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders’ equity. During 2003 and again in 2004, the Company recognized losses on securities in the amount of $657,500 and $131,394, respectively, due to declines that were determined to be other than temporary. At December 31, 2004, the Company had classified 87% of the portfolio as available for sale and 13% as held to maturity, compared to 90% and 10%, respectively, at December 31, 2003. The percentage of securities designated as available for sale reflects the amount needed to support the anticipated growth and liquidity needs of the Company. With the exception of municipal securities, it is the general practice of the Company to classify all newly purchased securities as available for sale.

At December 31, 2004, investment securities available for sale were $103,434,000, compared to $144,368,000 at December 31, 2003, which represents a decrease of $40,934,000 or 28.4%. The decline was primarily the result of a $29,795,000 decrease in investments in U.S. Government Agency bonds, which totaled $74,469,000 or 72% of the total available for sale portfolio. At December 31, 2003, U.S. Government Agency securities totaled $104,264,000 or 72.2% of the available for sale portfolio. Mortgage-backed securities at December 31, 2004 and 2003 totaled $24,413,000 and $30,595,000, respectively, or 23.6% and 21.2% of the available for sale portfolio at December 31, 2004 and 2003, respectively. During 2004, proceeds from matured or called bond, which were not used as a funding source for loan growth, were typically reinvested in U.S. Government Agency bonds with maturities less than 5 years. Earnings on certain U.S. Government Agency Bonds are exempt from state income tax, producing higher effective returns without affecting the overall credit risk and liquidity of the portfolio. Investment securities held to maturity, consisting primarily of tax-exempt municipal bonds, totaled $15,313,000 at December 31, 2004, compared to $13,124,000 at December 31, 2003. The Company does not typically invest in structured notes or other derivative securities.

19
 
The following table sets forth the maturities and weighted average yields of the investment portfolio as of December 31, 2004.

   
1 Year or Less
 
1-5 Years
 
5-10 Years
 
Over 10 Years
 
 
 
Carrying
 
Average
 
Carrying
 
Average
 
Carrying
 
Average
 
Carrying
 
Average
 
(Dollars in thousand)
Amount
Yield
Amount
Yield
Amount
Yield
Amount
Yield
 
                                   
Held to Maturity:
                                  
Obligations of states and
                                 
political subdivisions (1)
  
$
1,010
    
4.29
%
$
4,566
    
3.64
%
$
7,130
    
3.97
%
$
2,952
    
3.60
%
Mortgage backed securities
    
4
    
8.81
%
  
-
    
-
    
-
    
-
    
-
    
-
  
Total Held to Maturity
  
$
1,014
    
4.29
%
$
4,566
    
3.64
%
$
7,130
    
3.97
%
$
2,952
    
3.60
%
 
Available for Sale:
                                  
U.S. government agencies
  
$
7,491
    
2.26
%
$
63,968
    
3.14
%
$
3,010
    
4.10
%
$
-
    
-
%
Mortgage backed securities
    
656
    
4.57
    
15,037
    
3.67
    
2,050
    
4.55
    
6,670
    
4.37
  
Equity securities
    
-
    
-
    
- -
    
-
    
-
    
4,552
    
3.20
        
Total Available for Sale
  
$
8,147
    
2.27
%
$
79,005
    
3.42
%
$
5,060
    
4.23
%
$
11,222
    
3.51
%
 
(1) Yields adjusted to reflect a tax equivalent basis assuming a federal tax rate of 35%.

Loans

The Company continued to experience strong growth trends in the real estate lending market. Loans increased 25.4% in 2004, compared to 8.1% in 2003 and 11.9% in 2002. Most of the growth in 2004 was concentrated in loans secured by real estate, both construction and other mortgages, which increased $60,381,000 or 164.8% and $49,172,000 or 13.8%, respectively. Commercial, financial and agricultural loans increased $9,338,000 or 14.5% in 2004, compared to an increase of $2,457,000 or 4.0% in 2003. A healthy local real estate market and low interest rates were the driving force behind the growth. The market in which the Company operates has experienced a significant amount of construction and land development activity over the last year, which has also contributed significantly to loan growth. Consumer loans remain a small percentage of the overall loan portfolio and increased $1,612,000 or 9.5% in 2004 when compared to 2003. Loans, net of unearned income, totaled $595,458,000 at December 31, 2004, an increase of $120,503,000 when compared to 2003. The Felton Bank, which was acquired in April 2004, represented approximately $50,364,000 of this growth. Loans, net of unearned income, totaled $474,955,000 at December 31, 2003, an increase of $35,416,000 or 8.1% when compared to 2002. Since 2002, the Company has brokered long-term fixed rate residential mortgage loans for sale on the secondary market.

The table below sets forth trends in the composition of the loan portfolio over the past five years (including net deferred loan fees/costs).
 
   
December 31,
 
(Dollars in thousands)
2004
2003
2002
2001
2000
  
Commercial, financial and agricultural
  
$
73,757
  
$
64,419
  
$
61,962
  
$
58,953
  
$
54,642
  
Real estate - construction
    
97,021
    
36,640
    
25,354
    
20,255
    
18,587
  
Real estate - mortgage
    
406,053
    
356,881
    
335,037
    
293,921
    
291,136
  
Consumer
    
18,627
    
17,015
    
17,186
    
19,577
    
18,141
  
Total Loans
  
$
595,458
  
$
474,955
  
$
439,539
  
$
392,706
  
$
382,506
  
                                 


20

The table below sets forth the maturities and interest rate sensitivity of the loan portfolio at December 31, 2004.

   
 
 
Maturing
 
 
 
 
 
 
 
Maturing
 
After one
 
Maturing
 
 
 
 
 
Within
 
But Within
 
After Five
 
 
 
 
 
One Year
 
Five Years
 
Years
 
Total
 
 
                  
Commercial, financial and agricultural
  
$
68,461
  
$
92,637
  
$
14,786
  
$
175,884
  
Real estate - construction
    
49,858
    
46,403
    
760
    
97,021
  
Real estate - mortgage
    
63,248
    
131,813
    
108,862
    
303,923
  
Consumer
    
8,693
    
7,835
    
2,102
    
18,630
  
Total
  
$
190,260
  
$
278,688
  
$
126,510
  
$
595,458
  
                           
Rate Terms:
                          
Fixed-Interest Rate Loans
  
$
63,529
  
$
152,217
  
$
46,531
  
$
262,277
  
Adjustable-Interest Rate Loans
    
126,731
    
126,471
    
79,979
    
333,181
  
Total
  
$
190,260
  
$
278,688
  
$
126,510
  
$
595,458
  
                           
Deposits

The Company primarily utilizes core deposits to fund its earning assets. At both December 31, 2004 and 2003, deposits provided funding for approximately 89% of average earning assets. Average deposits increased 14.7% in 2004, compared to a 9.2% increase in 2003. The most significant growth occurred in the average balance of money management account and other savings accounts, which increased $42,121,000 or 27.4%. Low interest rates kept depositors from utilizing long-term deposit products for much of the year, but the Company began to offer higher rates paid for time deposits during the third and fourth quarters of 2004 due to increased competition. Certificates of deposit over $100,000 declined on average as a result of a municipal depositor who sought competitive bids and moved money to other financial institutions. The average balance of other time deposits increased $14,577,000 or 10.1% during 2004. In 2003, the average balance of certificates of deposit increased only $2,929,000 or 1.2%. The average balance of noninterest bearing demand deposits increased $21,717,000 or 29.4% in 2004, compared to an increase of $8,843,000 or 13.5% in 2003. NOW and SuperNOW accounts increased $9,387,000 or 9.3% in 2004 and $9,289,000 or 10.1% in 2003.

The Company has not historically relied on brokered deposits or purchased deposits as funding sources for loans.

The following table sets forth the average balances of deposits and the percentage of each category to total deposits for the years ended December 31.

(Dollars in thousands)
  
Average Balances
 
2004
2003
2002
 
Noninterest-bearing demand
  
$
95,627
    
14.75
%
$
73,910
    
13.08
%
$
65,067
    
12.58
%
Interest bearing deposits
                                      
NOW and Super NOW
    
110,614
    
17.07
    
101,227
    
17.91
    
91,938
    
17.77
  
Savings
    
48,875
    
7.54
    
40,726
    
7.21
    
35,885
    
6.93
  
Money management
    
146,967
    
22.68
    
112,995
    
20.00
    
91,063
    
17.61
  
Certificates of Deposit and other
                                      
time deposits less than $100,000
    
159,612
    
24.62
    
145,035
    
25.66
    
145,539
    
28.14
  
Certificates of Deposit $100,000 or more
    
86,450
    
13.34
    
91,194
    
16.14
    
87,761
    
16.97
  
   
$
648,145
    
100.00
%
$
565,087
    
100.00
%
$
517,253
    
100.00
%
                                       


21

The following table sets forth the maturity ranges of certificates of deposit with balances of $100,000 or more on December 31, 2004 (in thousands).

Three months or less
  
$
10,532
  
Over three through twelve month
    
41,734
  
Over twelve months
    
39,049
  
   
$
91,315
  
         
Short-Term Borrowings

Short-term borrowings consist primarily of securities sold under agreement to repurchase. These short-term obligations are issued in conjunction with cash management services for deposit customers. The Company occasionally borrows from a correspondent bank under a federal funds line of credit arrangement to meet short-term liquidity needs.

The average balance of short-term borrowings increased $2,519,000 or 10.9% in 2004, compared to an increase of $2,085,000 or 9.9% in 2003.

The following table sets forth the Company’s position with respect to short-term borrowings.

(Dollars in thousands)
2004
2003
2002
 
 
 
 
Interest
 
 
 
Interest
 
 
 
Interest
 
 
 
Balance
 
Rate
 
Balance
 
Rate
 
Balance
 
Rate
 
Federal funds purchased and securities sold
                          
under agreements to repurchase:
                          
Average outstanding for the year
  
$
25,590
    
0.84
%
$
23,071
    
0.77
%
$
20,986
    
1.15
%
Outstanding at year end
    
27,106
    
0.80
%
  
20,957
    
0.63
%
  
22,008
    
0.90
  
Maximum outstanding at any month end
    
30,845
    
-
    
29,781
    
-
    
28,585
    
-
 
                                       
Capital Management

The Company continues to maintain capital at levels in excess of the minimum risk based capital requirements adopted by the federal banking agencies. Total stockholders’ equity was $92,976,000 at December 31, 2004, 11.3% higher than the previous year. Stockholders’ equity was $83,527,000 at December 31, 2003, an increase of 7.0% over December 31, 2002. The increase in stockholders’ equity in 2004 resulted primarily from the Company’s earnings for the year of $10,198,000, reduced by dividends paid on common stock of $3,948,000. An additional $3,208,000 in stockholder’s equity resulted from the issuance of common stock in conjunction with the acquisition of Felton Bank in 2004.

The Company records unrealized holding gains (losses), net of tax, on investment securities available for sale as accumulated other comprehensive income (loss), a separate component of stockholder’s equity. As of December 31, 2004, the portion of the Banks’ investment portfolio designated as “available for sale” had net unrealized holding losses, net of tax, of $278,000, compared to unrealized holding gains, net of tax, of $310,000 at December 31, 2003.


22

The following table compares the Company’s capital ratios as of December 31 to the regulatory requirements.

   
 
 
 
 
Regulatory
 
(Dollars in thousands)
 
2004
2003
Requirements
  
Tier 1 capital
  
$
82,385
  
$
75,421
        
Tier 2 capital
    
4,844
    
4,170
          
Total capital, less deductions
  
$
87,229
  
$
79,591
        
Risk-adjusted assets
  
$
629,225
  
$
492,326
        
Risk-based capital ratios:
                    
Tier 1
    
13.04
%
  
15.32
%
  
4.0
%
Total capital
    
13.86
%
  
16.17
%
  
8.0
%
                     
Total Capital
  
$
82,385
  
$
75,421
        
Total adjusted assets
  
$
772,140
  
$
703,223
        
Leverage capital ratio
    
10.67
%
  
10.73
%
  
4.0
%
                     
 
Management knows of no trends or demands, commitments, events or uncertainties that are likely to have a material adverse impact on capital. See Note 17 of the Notes to Consolidated Financial Statements for further information about the regulatory capital positions of the Company and the Banks.

Provision for Credit Losses and Risk Management

Originating loans involves a degree of risk that credit losses will occur in varying amounts according to, among other factors, the types of loans being made, the credit-worthiness of the borrowers over the term of the loans, the quality of the collateral for the loan, if any, as well as general economic conditions. The Company’s Board of Directors demands accountability of management, keeping the interests of stockholders’ in focus. Through its Asset/Liability and Audit Committees, the Board actively reviews critical risk positions, including market, credit, liquidity and operational risk. The Company’s goal in managing risk is to reduce earnings volatility, control exposure to unnecessary risk, and ensure appropriate returns for risk assumed. Senior members of management actively manage risk at the product level, supplemented with corporate level oversight through the Asset/Liability Committee and internal audit function. The risk management structure is designed to identify risk issues through a systematic process, enabling timely and appropriate action to avoid and mitigate risk.

Credit Risk Management

The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is mitigated through portfolio diversification, limiting exposure to any single industry or customer, collateral protection and standard lending policies and underwriting criteria. The following discussion provides information and statistics on the overall quality of the Company’s loan portfolio. Note 1 to Consolidated Financial Statements describes the accounting policies related to nonperforming loans and charge-offs and describes the methodologies used to develop the allowance for credit losses, including both the specific and nonspecific components. Management believes the policies governing nonperforming loans and charge-offs are consistent with regulatory standards. The amount of the allowance for credit losses and the resulting provision are reviewed monthly by senior members of management and approved quarterly by the Board of Directors.

The allowance is increased by provisions for credit losses charged to expense and recoveries of loans previously charged-off. It is decreased by loans charged-off in the current period. Provisions for credit losses are made to bring the allowance for credit losses within the range of balances that are considered appropriate based upon the allowance methodology and to reflect losses within the loan portfolio as of the balance sheet date.

The adequacy of the allowance for credit losses is determined based upon management’s estimate of the inherent risks associated with lending activities, estimated fair value of collateral, past experience and present indicators such as loan delinquency trends, nonaccrual loans and current market conditions. Management believes the allowance is adequate; however, future changes in the composition of the loan portfolio and financial condition of borrowers may result in additions to the allowance. Examination of the portfolio and allowance by various regulatory agencies and consultants engaged by the Company may result in the need for additional provisions based upon information available at the time of the examination.

Each of the Banks maintains a separate allowance for credit losses, which is only available to absorb losses from their respective loan portfolios. Each Banks’ allowance is subject to regulatory examination and determination as to its adequacy.

23
 
The allowance for credit losses is comprised of two parts: the specific allowance and the formula allowance. The specific allowance is the portion of the allowance that results from management’s evaluation of specific loss allocations for identified problem loans and pooled reserves based on historical loss experience for each loan category. The formula allowance is determined based on management’s assessment of industry trends and economic factors in the markets in which the Company operates. The determination of the formula allowance involves a higher risk of uncertainty and considers current risk factors that may not have yet manifested themselves in the Company’s historical loss factors.

The specific allowance is based on each Banks’ quarterly analysis of its loan portfolio and is determined based upon the analysis of collateral values, cash flows and guarantor’s financial capacity, whichever are applicable. In addition, allowance factors are applied to internally classified loans for which specific allowances have not been determined and historical loss factors are applied to homogenous pools of unclassified loans. Historical loss factors may be adjusted by management in situations where no historical losses have occurred or where current conditions are not reflective of the specific history of the Company.

The formula allowance is based upon management’s evaluation of external conditions, the effects of which are not directly measured in the determination of the specific allowance. The conditions evaluated in connection with the formula allowance include: general economic and business conditions affecting the Company’s primary lending area; credit quality trends; collateral values; loan values; loan volumes and concentrations; seasoning of the loan portfolio; specific industry conditions within the portfolio segments; recent loss experience; duration of the current business cycle; bank regulatory examination results; and findings of internal loan review personnel. Management reviews the conditions which impact the formula allowance quarterly and to the extent any of these conditions relate to specifically identifiable loans may reflect the adjustment in the specific allowance. Where any of these conditions is not related to a specific loan or loan category, management’s evaluation of the probable loss related to the condition is reflected in the formula allowance.

While the local economy does not appear to show signs of weakness or the effects of the recent recession exhibited elsewhere in the nation, management is aware that the effects of continued weakness in the national economy and/or a weakness in the local economy could result in future higher loss levels for the Company.

The ratio of net charge-offs to average loans was .13% in 2004, compared to .09% in 2003. At December 31, 2004, the allowance for credit losses was $4,692,000, or .85% of average outstanding loans, and 319% of total nonaccrual loans. This compares to an allowance of $4,060,000, or .89% of average outstanding loans and 406% of nonaccrual loans, at December 31, 2003, and an allowance for credit losses of $4,117,000, or .97% of outstanding loans and 534% of nonaccrual loans, at December 31, 2002.

Management’s decision regarding the amount of the provision is influenced in part by growth in commercial and real estate loan balances. The Company experienced higher levels of charge-offs during 2004 than it had experienced during the prior five years. Charge-offs were $887,000 in 2004, compared to $530,000 in 2003 and $538,000 in 2002. Charge-offs were $335,000 and $378,000 in 2001 and 2000, respectively.


24

The following table sets forth a summary of the Company’s loan loss experience for the years ended December 31.

(Dollars in thousands)
  
2004
2003
2002
2001
2000
 
                       
Balance, beginning of year
  
$
4,060
  
$
4,117
  
$
4,189
  
$
4,199
  
$
3,991
  
                                 
Loans charged off:
                                
Real estate loans
    
(131
)
  
(7
)
  
(86
)
  
(5
)
  
(61
)
Installment loans
    
(94
)
  
(114
)
  
(170
)
  
(155
)
  
(73
)
Commercial and other
    
(662
)
  
(409
)
  
(282
)
  
(175
)
  
(244
)
     
(887
)
  
(530
)
  
(538
)
  
(335
)
  
(378
)
Recoveries:
                                
Real estate loans
    
20
    
35
    
16
    
2
    
18
  
Installment loans
    
63
    
56
    
76
    
60
    
50
  
Commercial and other
    
79
    
47
    
18
    
37
    
81
  
     
162
    
138
    
110
    
99
    
149
  
Net losses charged off
    
(725
)
  
(392
)
  
(428
)
  
(236
)
  
(229
)
Allowance of acquired institution
    
426
    
-
    
-
    
-
    
-
  
Provision for credit losses
    
931
    
335
    
356
    
226
    
437
  
Balance, end of year
  
$
4,692
  
$
4,060
  
$
4,117
  
$
4,189
  
$
4,199
  
                                 
Average loans outstanding
  
$
555,259
  
$
457,491
  
$
423,771
  
$
386,161
  
$
367,075
  
                                 
Percentage of net charge-offs to average
                                
loans outstanding during the year
    
.13
%
  
.09
%
  
.10
%
  
.06
%
  
.06
%
Percentage of allowance for loan losses
                                
at year-end to average loans
    
0.85
%
  
0.89
%
  
0.97
%
  
1.08
%
  
1.14
%
                                 
 
Total non-accrual loans of the Company increased in 2004, representing .25% of total loans, net of unearned income at December 31, 2004, compared to .21% one year earlier. Specific valuation allowances totaling $442,000 have been established for these nonaccrual loans. Loans 90 days past due increased from $1,128,000 for 2003 to $2,969,000 for 2004, but $2,881,000 or 97% of those loans were real estate secured and present limited loss exposure to the Company.

The following table summarizes the past due and non-performing assets of the Company as of December 31.

(Dollars in thousands)
  
2004
2003
2002
2001
2000
  
                       
Non-performing assets:
                      
Non-accrual loans
  
$
1,469
  
$
1,002
  
$
771
  
$
943
  
$
623
  
Other real estate and other assets owned
    
391
    
-
    
54
    
56
    
14
  
Total non-performing assets
    
1,860
    
1,002
    
825
    
999
    
637
  
Loans 90 days past due
    
2,969
    
1,128
    
374
    
1,532
    
1,333
  
Total non-performing assets and past due loans
  
$
4,829
  
$
2,130
  
$
1,199
  
$
2,531
  
$
1,970
  
                                 
Non-accrual loans to total loans at period end
    
.25
%
  
.21
%
  
.18
%
  
.24
%
  
.16
%
Non-accrual loans and past due loans,
                                
to total loans at period end
    
.75
%
  
.45
%
  
.26
%
  
.64
%
  
.51
%

During 2004, there was no change in the methods or assumptions affecting the allowance methodology. The provision for credit losses was $931,000 for the year, compared to $335,000 for 2003. The amount of the provision is determined based upon management’s analysis of the portfolio, growth and changes in the condition of credits and their resultant specific loss allocations. Historically, the Company has experienced the majority of its losses in the commercial loan portfolio, which are typically not secured by real estate. Because the majority of loan growth is in loans secured by real estate, which have experienced minimal losses over the past five years, the required allowance for those type of loans is minimal compared to the amount required for non real estate secured commercial loans.

Net charge-offs during 2004 were $725,000, compared to $392,000 during 2003 and 2002. The increase relates primarily to losses identified in December 2004 attributable to a single commercial loan relationship. The allowance increased $632,000, or 15.6%, of which $426,000 is due to the acquisition of Felton Bank. During 2003, the allowance decreased $57,000, or 1.4%, totaling $4,060,000 or ..89% of total loans at December 31, 2003.
 
 
25
 
The overall quality of the loan portfolio was strong at December 31, 2004, with nonaccrual loans and delinquencies within acceptable levels for the industry. There was no unallocated portion of the allowance at December 31, 2004, compared to 1.3% of the total allowance at December 31, 2003. The allowance pertaining to commercial, financial and agricultural loans represented 39.7% of the total allowance at December 31, 2004, compared to 33.5% at December 31, 2003. The decline is attributable in part to the improved condition of several large commercial customers, the recognition of previously identified losses, and improved underwriting practices. The amount of the reserve allocated to real estate mortgage loans decreased from 55% at December 31, 2003 to 48.2% at December 31, 2004. Growth in the allowance in 2004 is concentrated in the commercial and construction loan categories as these types of loans have more risk than consumer and commercial real estate secured loans. The Company’s loans are primarily made in Kent, Queen Anne’s, Talbot, Caroline and Dorchester Counties in Maryland and in Kent County, Delaware.

Real estate mortgage loans represented 68.3% of the portfolio at December 31, 2004, compared to 75.2% at December 31, 2003. The Company has experienced relatively low historical losses with respect to these loans as a result of underlying collateral values, its substantial experience in the markets it serves, and its conservative lending practices. Real estate secured construction and land development loans increased to 16.3% of the total loan portfolio at December 31, 2004, compared to 7.7% one year ago.

The following table sets forth the allocation of the allowance for credit losses and the percentage of loans in each category to total loans for the years ended December 31,

   
2004
  
2003
  
2002
  
2001
  
2000
  
(Dollars in thousands)
  
Amount
 
%
 
Amount
  
%
  
Amount
  
%
  
Amount
  
%
  
Amount
  
%
 
                                         
Commercial, Financial and Agricultural
  
$
1,863
    
12.3
%
$
1,362
    
13.6
%
$
1,869
    
14.1
%
$
1,563
    
15.0
%
$
1,694
    
14.3
%
Real Estate-Construction
    
429
    
16.3
    
253
    
7.7
    
172
    
5.8
    
135
    
5.2
    
126
    
4.9
  
Real Estate-Mortgage
    
2,262
    
68.3
    
2,231
    
75.2
    
1,825
    
76.2
    
1,918
    
74.8
    
1,807
    
76.1
  
Consumer
    
138
    
3.1
    
160
    
3.5
    
169
    
3.9
    
387
    
5.0
    
412
    
4.7
  
Unallocated
    
-
    
-
    
54
    
-
    
82
    
-
    
186
    
-
    
160
    
-
  
   
$
4,692
    
100
%
$
4,060
    
100
%
$
4,117
    
100
%
$
4,189
    
100
%
$
4,199
    
100
%
                                                               
Market Risk Management

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates or equity pricing. The Company’s principal market risk is interest rate risk that arises from its lending, investing and deposit taking activities. The Company’s profitability is dependent on the Banks’ net interest income. Interest rate risk can significantly affect net interest income to the degree that interest bearing liabilities mature or reprice at different intervals than interest earning assets. The Banks’ Asset/Liability Committees oversee the management of interest rate risk. The primary purpose of these committees is to manage the exposure of net interest margins to unexpected changes due to interest rate fluctuations. These efforts affect the loan pricing and deposit rate policies of the Company as well as the asset mix, volume guidelines, and liquidity and capital planning.
 
The Company does not utilize derivative financial or commodity instruments or hedging strategies in its management of interest rate risk. Since the Company is not exposed to market risk from trading activities and does not utilize hedging strategies or off-balance sheet management strategies, the Asset/Liability Committees of the Banks rely on “gap” analysis as its primary tool in managing interest rate risk. Gap analysis summarizes the amount of interest sensitive assets and liabilities, which will reprice over various time intervals. The difference between the volume of assets and liabilities repricing in each interval is the interest sensitivity “gap”. “Positive gap” occurs when more assets reprice in a given time interval, while “negative gap” occurs when more liabilities reprice. As of December 31, 2004, the Company had a negative gap position within the one-year repricing interval because the interest sensitive liabilities exceeded the interest sensitive assets within the one-year repricing interval by $41.8 million, or 5.3% of total assets. Rates paid for interest bearing liabilities reached their theoretical floors during 2004, but currently offered rates for time deposits began to increase during the second half of the year. As of December 31, 2003, the Company likewise had a negative gap position within the one-year repricing interval because the interest sensitive liabilities exceeded the interest sensitive assets within the one-year repricing interval by $52.1 million, or 7.4% of total assets.
 
26
 
The following table summarizes the Company’s interest sensitivity at December 31, 2004. Loans, federal funds sold, time deposits and short-term borrowings are classified based upon contractual maturities if fixed-rate or earliest repricing date if variable rate. Investment securities are classified by contractual maturities or, if they have call provisions, by the most likely repricing date.
 
   
 
3 Months
 
1 Year
 
 
 
Non-
 
 
 
 
 
Within
 
through
 
through
 
After
 
Sensitive
 
 
 
December 31, 2004
3 Months
12 Months
5 Years
5 Years
Funds
Total
  
(Dollars in Thousands)
                          
ASSETS:
                          
Loans
  
$
316,924
  
$
56,115
  
$
181,350
  
$
41,068
  
$
(4,691
)
$
590,766
  
Investment securities
    
575
    
7,271
    
72,736
    
37,447
    
1,067
    
119,096
  
Interest bearing deposits with other banks
    
961
    
-
    
-
    
-
    
-
    
961
  
Federal funds sold
    
20,539
    
-
    
-
    
-
    
-
    
20,539
  
Other assets
    
-
    
-
    
-
    
-
    
59,236
    
59,236
  
Total Assets
  
$
338,999
  
$
63,386
  
$
254,086
  
$
78,515
  
$
55,612
  
$
790,598
  
LIABILITIES:
                                      
Certificates of deposit $100,000 and over
  
$
10,532
  
$
41,734
  
$
39,049
  
$
-
  
$
-
  
$
91,315
  
Other time deposits
    
19,715
    
36,057
    
99,835
    
-
    
-
    
155,607
  
Savings and money market
    
196,752
    
-
    
-
    
-
    
-
    
196,752
  
NOW and SuperNOW
    
112,327
    
-
    
-
    
-
    
-
    
112,327
  
Noninterest bearing demand
    
-
    
-
    
-
    
-
    
102,672
    
102,672
  
Short-term borrowings
    
27,106
    
-
    
-
    
-
    
-
    
27,106
  
Long-term debt
    
-
    
-
    
5,000
    
-
    
-
    
5,000
  
Other liabilities
    
-
    
-
    
-
    
-
    
6,843
    
6,843
  
STOCKHOLDERS’ EQUITY
    
-
    
-
    
-
    
-
    
92,976
    
92,976
  
Total Liabilities and Stockholders’ Equity
  
$
366,432
  
$
77,791
  
$
143,884
  
$
-
  
$
202,491
  
$
790,598
  
Excess
  
$
(27,433
)
$
(14,405
)
$
110,202
  
$
78,515
  
$
(146,879
)
$
-
  
Cumulative Excess
  
$
(27,433
)
$
(41,838
)
$
68,364
  
$
146,879
  
$
-
  
$
-
  
Cumulative Excess as percent of total assets
    
(3.47
)%
  
(5.29
)%
  
8.76
%
  
18.58
%
  
-
    
-
  
                                       

In addition to gap analysis, the Banks utilize simulation models to quantify the effect a hypothetical immediate plus or minus 200 basis point change in rates would have on net interest income and the fair value of capital. The model takes into consideration the effect of call features of investments as well as prepayments of loans in periods of declining rates. When actual changes in interest rates occur, the changes in interest earning assets and interest bearing liabilities may differ from the assumptions used in the model. As of December 31, 2004 and 2003, the models produced similar sensitivity profiles for net interest income and the fair value of capital, which are provided below.
 
   
Immediate Change in Rates
 
 
 
+200
 
+100
 
-100
 
-200
 
Policy
 
  
Basis Points
Basis Points
Basis Points
Basis Points
Limit
 
2004
                      
% Change in Net Interest Income
    
8.90
%
  
5.19
%
  
(6.41
)%
  
(14.09
)%
  
+ 25
%
% Change in Fair Value of Capital
    
2.49
%
  
1.90
%
  
(4.08
)%
  
(10.31
)%
  
+15
%
                                 
2003
                                
% Change in Net Interest Income
    
8.20
%
  
5.07
%
  
(7.39
)%
  
(14.57
)%
  
+ 25
%
% Change in Fair Value of Capital
    
3.42
%
  
2.44
%
  
(5.22
)%
  
(11.17
)%
  
+15
%
                                 
The slight change in the Company’s interest rate sensitivity profile from 2003 to 2004 resulted from a decline in the Company’s excess liabilities repricing within one year from $52.1 million at December 31, 2003 to $41.8 at December 31, 2004.

Off-Balance Sheet Arrangements

In the normal course of business, to meet the financing needs of its customers, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. The Company’s exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company generally requires collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. The Company evaluates each customer’s creditworthiness on a case-by-case basis.
 
27
 
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Further information about these arrangements is provided in Note 20 to Consolidated Financial Statements.

Management does not believe that any of the foregoing arrangements have or are reasonably likely to have a current or future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Liquidity Management

Liquidity describes the ability of the Company to meet financial obligations that arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of customers and to fund current and planned expenditures. Liquidity is derived through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets. The Company has arrangements with correspondent banks whereby it has $19,500,000 available in federal funds lines of credit and a reverse repurchase agreement available to meet any short-term needs which may not otherwise be funded by its portfolio of readily marketable investments that can be converted to cash. The Talbot Bank and Centreville National Bank are also members of the Federal Home Loan Bank of Atlanta, which provides another source of liquidity. At December 31, 2004 the Federal Home Loan Bank had issued a letter of credit in the amount of $20,000,000 on behalf of the Talbot Bank to a local government entity as collateral for its deposits.

At December 31, 2004, the Company’s loan to deposit ratio was 90%, which is approximately 10% higher than one year ago. Investment securities available for sale totaling $103,434,000 were available for the management of liquidity and interest rate risk. Cash and cash equivalents were $43,551,000 at December 31, 2004, which is $3,180,000 less than one year ago. Management is not aware of any demands, commitments, events or uncertainties that will materially affect the Company’s ability to maintain liquidity at satisfactory levels.

The Company has various financial obligations, including contractual obligations and commitments that may require future cash payments.

The following table presents, as of December 31, 2004, significant fixed and determinable contractual obligations to third parties by payment date.

   
Within
  
One to
  
Three to
  
Over five
  
(Dollars in Thousands)
  
one year
  
three years
  
five years
  
years
  
Deposits without a stated maturity(a)
  
$
411,751
  
$
-
  
$
-
  
$
-
  
Certificates of Deposit(a)
    
108,037
   
87,305
   
51,580
   
-
 
Short-term borrowings
    
27,106
   
-
   
-
   
-
 
Long-term debt
    
-
   
5,000
   
-
   
-
 
Operating Leases
    
243
   
170
   
-
   
-
 
Purchase obligations
    
4,796
   
-
   
-
   
-
 
Contingent earn-out payments
    
2,913
   
-
   
-
   
-
 
   
$
555,476
  
$
92,475
  
$
51,580
  
$
-
  

(a) Includes accrued interest payable

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

The information required by this item may be found in Item 7 of Part II of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Market Risk Management”, which is incorporated herein by reference.

28
Item 8.    Financial Statements and Supplementary Data.
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

   
Report of Independent Registered Public Accounting Firm
30
Consolidated Balance Sheets
31
Consolidated Statements of Income
32
Consolidated Statements of Stockholders’ Equity
33
Consolidated Statements of Cash Flows
34
Notes to Consolidated Financial Statements
36


29

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 
The Board of Directors and Stockholders
Shore Bancshares, Inc.
 
We have audited the accompanying consolidated balance sheets of Shore Bancshares, Inc. (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Shore Bancshares, Inc. as of December 31, 2004 and 2003, and the results of its operations and cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 11, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.


/s/ Stegman and Company
Baltimore, Maryland
March 11, 2005 


30

CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003
 
   
2004
2003
  
           
ASSETS
          
Cash and due from banks
  
$
22,050,846
  
$
19,391,392
  
Interest bearing deposits with other banks
    
960,812
    
9,897,025
  
Federal funds sold
    
20,539,412
    
17,442,889
  
Investment securities:
             
Available for sale - at fair value
    
103,433,819
    
144,368,198
  
             
Held to maturity - at amortized cost - fair value of (2004) $15,802,385 and (2003) $15,584,968
    
15,662,077
    
15,313,009
  
Loans, less allowance for credit losses (2004) $4,692,202 and (2003) $4,059,964
    
590,765,937
    
470,894,601
  
Insurance premiums receivable
    
385,923
    
844,576
  
Premises and equipment, net
    
13,069,835
    
11,301,549
  
Accrued interest receivable on loans and investment securities
    
3,275,042
    
3,041,981
  
Investment in unconsolidated subsidiary
    
859,133
    
1,202,786
  
Goodwill
    
11,938,714
    
5,990,132
  
Other intangible assets
    
2,242,367
    
1,580,902
  
Deferred income taxes
    
1,542,544
    
855,640
  
Other real estate
    
390,825
    
-
  
Other assets
    
3,480,229
    
3,254,315
  
Total assets
  
$
790,597,515
  
$
705,378,995
  
               
LIABILITIES
              
Deposits:
              
Noninterest bearing demand
  
$
102,671,672
  
$
91,669,053
  
NOW and Super NOW
    
112,326,736
    
103,415,076
  
Certificates of deposit, $100,000 or more
    
91,315,421
    
71,385,479
  
Other time and savings
    
352,358,525
    
325,939,805
  
     
658,672,354
    
592,409,413
  
               
Accrued interest payable
    
630,062
    
415,185
  
Short-term borrowings
    
27,106,241
    
20,957,294
  
Long term debt
    
5,000,000
    
5,000,000
  
Contingent earn-out payments payable
    
3,312,500
    
-
  
Other liabilities
    
2,900,705
    
3,069,623
  
Total liabilities
    
697,621,862
    
621,851,515
  
               
STOCKHOLDERS’ EQUITY
             
             
Common stock, par value $.01, authorized 35,000,000 shares; issued and outstanding
             
(2004) 5,515,198 shares; (2003) 5,400,793 shares
    
55,152
    
54,008
  
Additional paid in capital
    
28,016,571
    
24,231,213
  
Retained earnings
    
65,182,004
    
58,932,021
  
Accumulated other comprehensive (loss) income
    
(278,074
)
  
310,238
  
Total stockholders’ equity
    
92,975,653
    
83,527,480
  
Total liabilities and stockholders’ equity
  
$
790,597,515
  
$
705,378,995
  
               

The notes to consolidated financial statements are an integral part of these statements.

31

CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended December 31, 2004, 2003 and 2002
 
   
2004
2003
2002
  
               
INTEREST INCOME
              
Loans, including fees
  
$
33,034,103
  
$
28,916,967
  
$
29,604,305
  
Interest and dividends on investment securities:
                    
Taxable
    
4,353,701
    
4,314,727
    
5,615,608
  
Tax-exempt
    
601,803
    
603,421
    
483,731
  
Federal funds sold
    
254,618
    
301,316
    
453,458
  
Other interest
    
46,568
    
202,025
    
149,300
  
Total interest income
    
38,290,793
    
34,338,456
    
36,306,402
  
                     
INTEREST EXPENSE
                    
NOW and Super NOW accounts
    
409,441
    
503,993
    
753,898
  
Certificates of deposit, $100,000 or more
    
2,345,737
    
2,503,373
    
3,031,783
  
Other time and savings
    
5,787,514
    
6,305,204
    
8,157,742
  
Interest on short-term borrowings
    
214,504
    
178,052
    
243,001
  
Interest on long term debt
    
252,642
    
251,951
    
251,952
  
Total interest expense
    
9,009,838
    
9,742,573
    
12,438,376
  
                     
NET INTEREST INCOME
    
29,280,955
    
24,595,883
    
23,868,026
  
                     
PROVISION FOR CREDIT LOSSES
    
931,345
    
335,000
    
356,066
  
                     
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
    
28,349,610
    
24,260,883
    
23,511,960
  
 
                    
NONINTEREST INCOME
                    
Service charges on deposit accounts
    
2,470,350
    
1,928,521
    
1,915,103
  
Other service charges and fees
    
1,169,648
    
648,251
    
582,329
  
Gain on sale of securities
    
41,440
    
447,713
    
26,126
  
Recognized loss on impairment of securities
    
(657,500
)
  
(131,394
)
  
-
  
Insurance agency commissions
    
6,383,212
    
6,036,792
    
2,871,620
 
Other operating income
    
816,450
    
914,839
    
573,311
  
     
10,223,600
    
9,844,722
    
5,968,489
  
NONINTEREST EXPENSE
                    
Salaries and wages
    
10,658,637
    
9,372,409
    
7,386,228
  
Employee benefits
    
3,101,617
    
2,871,206
    
2,187,051
  
Occupancy expense
    
1,448,320
    
1,225,476
    
1,019,380
  
Furniture and equipment expense
    
978,635
    
808,143
    
738,362
  
Data processing
    
1,309,746
    
955,108
    
889,329
  
Directors’ fees
    
553,249
    
569,039
    
471,618
  
Amortization of other intangible assets
    
306,533
    
215,786
    
129,484
  
Other operating expenses
    
4,177,648
    
3,327,042
    
3,139,012
  
     
22,534,385
    
19,344,209
    
15,960,464
  
                     
INCOME BEFORE INCOME TAXES
    
16,038,825
    
14,761,396
    
13,519,985
  
Federal and state income taxes
    
5,840,624
    
5,265,701
    
4,729,841
  
                     
NET INCOME
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
                     
Basic earnings per common share
  
$
1.86
  
$
1.77
  
$
1.64
  
                     
Diluted earnings per common share
  
$
1.84
  
$
1.74
  
$
1.62
  
                     
Cash dividends paid per common share
  
$
.72
  
$
.66
  
$
.60
  
                     
The notes to consolidated financial statements are an integral part of these statements.
 

 
32
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Years Ended December 31, 2004, 2003 and 2002

   
 
 
 
 
 
Accumulated
 
 
 
 
 
 
Additional
 
 
 
Other
 
Total
 
 
 
Common
 
Paid in
 
Retained
 
Comprehensive
 
Stockholders’
 
 
 
Stock
 
Capital
 
Earnings
 
Income (Loss)
 
Equity
 
Balances, January 1, 2002
  
$
53,330
  
$
23,039,084
  
$
47,411,873
  
$
466,346
  
$
70,970,633
  
Comprehensive income:
                                
Net income
    
-
    
-
    
8,790,144
    
-
    
8,790,144
  
Other comprehensive income, net of tax:
                                
Unrealized gain on available for
                                
sale securities, net of reclassification
                                
adjustment of $(416)
    
-
    
-
    
-
    
685,490
    
685,490
  
                                 
Total comprehensive income
    
9,475,634
                          
                                 
Shares repurchased and retired
    
(12
)
  
(20,832
)
  
-
    
-
    
(20,844
)
Shares issued in purchase accounting acquisitions
    
390
    
799,610
    
-
    
-
    
800,000
  
Shares issued for employee stock
                                
based awards and related tax effects
    
13
    
19,746
    
-
    
-
    
19,759
  
Cash dividends paid $.60 per share
    
-
    
-
    
(3,217,282
)
  
-
    
(3,217,282
)
                                 
Balances, December 31, 2002
    
53,721
    
23,837,608
    
52,984,735
    
1,151,836
    
78,027,900
  
Comprehensive income:
                                
Net income
    
-
    
-
    
9,495,695
    
-
    
9,495,695
  
Other comprehensive income, net of tax:
                                
Unrealized loss on available for
                                
sale securities, net of reclassification adjustment
                               
of $(104,509)
    
-
    
-
    
-
    
(841,598
)
  
(841,598
)
Total comprehensive income
                            
8,654,097
  
                                 
Shares issued for employee stock
                                
based awards and related tax effects
    
287
    
393,605
    
-
    
-
    
393,892
  
Cash dividends paid $.66 per share
    
-
    
-
    
(3,548,409
)
  
-
    
(3,548,409
)
                                 
Balances, December 31, 2003
    
54,008
    
24,231,213
    
58,932,021
    
310,238
    
83,527,480
  
Comprehensive income:
                                
Net income
    
-
    
-
    
10,198,201
    
-
    
10,198,201
  
Other comprehensive income, net of tax:
                                
Unrealized loss on available for
                                
sale securities, net of reclassification
                                
adjustment of $225,865
    
-
    
-
    
-
    
(588,312
)
  
(588,312
)
Total comprehensive income
    
-
    
-
    
-
    
-
    
9,609,889
  
Shares issued for employee stock
                                
based awards and related tax effects
    
316
    
577,805
    
-
    
-
    
578,121
  
Shares issued for purchase accounting acquisition
    
828
    
3,207,553
    
-
    
-
    
3,208,381
  
Cash dividends paid $.72 per share
    
-
    
-
    
(3,948,218
)
  
-
    
(3,948,218
)
Balances, December 31, 2004
  
$
55,152
  
$
28,016,571
  
$
65,182,004
  
$
(278,074
)
$
92,975,653
  
                                 

The notes to consolidated financial statements are an integral part of these statements.
 
 
33

CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2004, 2003 and 2002


   
2004
2003
2002
  
CASH FLOWS FROM OPERATING ACTIVITIES:
              
Net income
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
Adjustments to reconcile net income to net cash provided
                    
by operating activities:
                    
Depreciation and amortization
    
1,474,954
    
1,521,160
    
1,266,580
  
Discount accretion on debt securities
    
(116,838
)
  
(60,236
)
  
(110,316
)
Gain on sale of securities
    
(41,440
)
  
(579,107
)
  
(26,126
)
Recognized loss on impairment of securities
    
657,500
    
131,394
    
-
  
Provision for credit losses, net
    
931,345
    
335,000
    
356,000
  
Deferred income taxes
    
(273,569
)
  
75,412
    
(19,996
)
Loss (gain) on disposal of premises and equipment
    
37,789
    
-
    
(1,125
)
Loss on other real estate owned
    
-
    
2,143
    
4,000
  
Net changes in:
                    
Insurance premiums receivable
    
458,653
    
774,582
    
(1,619,158
)
Accrued interest receivable
    
(877
)
  
(83,542
)
  
362,484
  
Other assets
    
75,538
    
(387,710
)
  
(300,028
)
Accrued interest payable
    
46,269
    
(221,558
)
  
(148,251
)
Other liabilities
    
(314,669
)
  
(132,195
)
  
2,077,457
  
                     
Net cash provided by operating activities
    
13,132,856
    
10,871,038
    
10,631,665
  
                     
CASH FLOWS FROM INVESTING ACTIVITIES:
                    
Proceeds from sales of securities available for sale
    
16,955,388
    
8,770,500
    
3,017,109
  
Proceeds from maturities and principal payments
                    
of securities available for sale
    
63,612,769
    
112,185,011
    
79,132,663
  
Purchases of securities available for sale
    
(31,222,203
)
  
( 156,031,628
)
  
(77,385,015
)
Proceeds from maturities and principal payments
                    
of securities held to maturity
    
2,155,368
    
2,836,613
    
3,991,642
  
Purchases of securities held to maturity
    
(2,533,504
)
  
(5,051,827
)
  
(6,223,062
)
Net increase in loans
    
(83,345,923
)
  
(35,807,512
)
  
(47,306,853
)
Purchase of premises and equipment
    
(1,827,159
)
  
(3,469,743
)
  
(1,599,409
)
Proceeds from sale of other real estate owned
    
-
    
51,973
    
43,000
  
Proceed from sale of investment in unconsolidated subsidiary
    
379,490
    
-
    
-
  
Proceeds from sale of premises and equipment
    
-
    
-
    
22,000
  
Acquisition, net of stock issued and cash acquired
    
(234,845
)
  
-
    
(5,949,073
)
                     
Net cash used in investing activities
    
(36,060,619
)
  
(76,516,613
)
  
(52,256,998
)
                     
CASH FLOWS FROM FINANCING ACTIVITIES:
                    
Net increase in demand, NOW,
                    
money market, and savings deposits
    
6,901,851
    
76,290,829
    
36,418,059
  
Net increase (decrease) in certificates of deposit
    
10,365,672
    
(29,073,330
)
  
21,304,227
  
Net increase (decrease) in short-term borrowings
    
6,148,947
    
(1,050,823
)
  
4,954,253
  
Proceeds from issuance of common stock
    
279,275
    
290,308
    
17,031
  
Repurchase of common stock
    
-
    
-
    
(20,844
)
Dividends paid
    
(3,948,218
)
  
(3,548,410
)
  
(3,217,282
)
                     
Net cash provided by financing activities
    
19,747,527
    
42,908,574
    
59,455,444
  
                     

34
 
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
For the Years Ended December 31, 2004, 2003 and 2002

   
2004
2003
2002
  
               
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
    
(3,180,236
)
  
(22,737,001
)
  
17,830,111
  
                     
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR
    
46,731,306
    
69,468,307
    
51,638,196
  
                     
CASH AND CASH EQUIVALENTS AT END OF YEAR
  
$
43,551,070
  
$
46,731,306
  
$
69,468,307
  
                     
Supplemental cash flows information:
                    
                     
Interest paid
  
$
8,794,961
  
$
9,964,131
  
$
12,586,627
  
                     
Income taxes paid
  
$
5,832,108
  
$
5,559,256
  
$
4,680,382
  
                     
Transfers from loans to other real estate
  
$
390,825
  
$
-
  
$
45,000
  
                     
Details of acquisitions:
                    
Fair value of assets acquired
  
$
49,538,073
  
$
-
  
$
307,611
  
Fair value of liabilities acquired
    
( 49,309,778
)
  
-
    
-
  
Stock issued for acquisition
    
( 3,208,381
)
  
-
    
(800,000
)
Purchase price in excess of net assets acquired
    
3,214,931
    
-
    
6,441,462
 
Net cash paid for acquisition
  
$
234,845
  
$
-
  
$
5,949,073
  
                     
                     
The notes to consolidated financial statements are an integral part of these statements.

35

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2004, 2003 and 2002

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The consolidated financial statements include the accounts of Shore Bancshares, Inc. and its subsidiaries (collectively referred to in these Notes as the “Company”), with all significant intercompany transactions eliminated. The investments in subsidiaries are recorded on the Company’s books (Parent only) on the basis of its equity in the net assets of the subsidiaries. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to prevailing practices within the industries in which it operates. For purposes of comparability, certain reclassifications have been made to amounts previously reported to conform with the current period presentation.

Nature of Operations
The Company provides commercial banking services from its locations in the Maryland Counties of Talbot, Queen Anne’s, Kent, Caroline, and Dorchester and Kent County in Delaware. Its primary source of revenue is from providing commercial, real estate and consumer loans to customers located on the Delmarva Peninsula. A full range of insurance and investment services are offered through the Company’s nonbank subsidiaries.

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 that 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.

The allowance for credit losses is a material estimate that is particularly susceptible to significant changes in the near-term. Management believes that the allowance for credit losses is sufficient to address the probable losses in the current portfolio. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review the Company’s allowance for credit losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

Investment Securities Available for Sale 
Investment securities available for sale are stated at estimated fair value based on quoted market prices. They represent those securities which management may sell as part of its asset/liability strategy or which may be sold in response to changing interest rates, changes in prepayment risk or other similar factors. The cost of securities sold is determined by the specific identification method. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Net unrealized holding gains and losses on these securities are reported as accumulated other comprehensive income, a separate component of stockholders’ equity, net of related income taxes. Declines in the fair value of individual available-for-sale securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value and are reflected in earnings as realized losses. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by a rating agency, a significant deterioration in the financial condition of the issuer, or that management would not have the intent and ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value.

Investment Securities Held to Maturity
Investment securities held to maturity are stated at cost adjusted for amortization of premiums and accretion of discounts. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. The Company intends and has the ability to hold such securities until maturity. Declines in the fair value of individual held-to-maturity securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by the rating agency, a significant deterioration in the financial condition of the issuer, or that management would not have the ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value.


36

Loans
Loans are stated at their principal amount outstanding net of any deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Any unpaid interest previously accrued on those loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Loans are considered impaired when it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Income on impaired loans is recognized on a cash basis, and payments are first applied against the principal balance outstanding. Impaired loans do not include groups of smaller balance homogeneous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based upon historical loss ratios and are included in the allowance for credit losses.

Allowance for Credit Losses
The allowance for credit losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio as of the balance sheet date and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans and actual loss experience, current economic events in specific industries and geographical areas, including unemployment levels, and other pertinent factors, including regulatory guidance and general economic conditions and other observable data. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows or collateral value of impaired loans, estimated losses on pools of homogeneous loans that are based on historical loss experience, and consideration of current economic trends, all of which may be susceptible to significant change. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for credit losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary.

The Company’s systematic methodology for assessing the appropriateness of the allowance includes the two following components: (1) the formula allowance component reflecting historical losses, as adjusted, by credit category and (2) the specific allowance component for risk rated credits on an individual or portfolio basis. The components of the allowance for credit losses represent an estimation done pursuant to either Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” or SFAS No. 114 “Accounting by Creditors for Impairment of a Loan.” The specific component of the allowance for credit losses reflects expected losses resulting from analysis developed through credit allocations for individual loans and historical loss experience for each loan category. The specific credit allocations are based on a regular analysis of all loans over a fixed-dollar amount where the internal credit rating is at or below a predetermined classification. The historical loan loss element is determined statistically using a loss migration analysis that examines loss experience and the related internal grading of loans charged off. The loss migration analysis is performed quarterly and loss factors are updated regularly based on actual experience. The specific component of the allowance for credit losses also includes consideration of concentrations and changes in portfolio mix and volume.

The formula portion of the allowance reflects management’s estimate of probable inherent but undetected losses within the portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower’s financial condition, the difficulty in identifying triggering events that correlate perfectly to subsequent loss rates, and risk factors that have not yet manifested themselves in loss allocation factors. In addition, the formula allowance includes a component that explicitly accounts for the inherent imprecision in loan loss migration models. Historical loss experience data used to establish allocation estimates may not precisely correspond to the current portfolio. The uncertainty surrounding the strength and timing of economic cycles, including management’s concerns over the effects of the prolonged economic downturn in the current cycle, also affects the allocation model’s estimates of loss. The historical losses used in the migration analysis may not be representative of actual losses inherent in the portfolio that have not yet been realized.
 
 
37
 
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. Useful lives range from three to ten years for furniture, fixtures and equipment; three to five years for computer hardware and data handling equipment; and ten to forty years for buildings and building improvements. Land improvements are amortized over a period of fifteen years; and leasehold improvements are amortized over the term of the respective lease. Maintenance and repairs are charged to expense as incurred, while improvements which extend the useful life of an asset are capitalized and depreciated over the estimated remaining life of the asset.
 
Long-lived assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, the Company recognizes a loss for the difference between the carrying amount and the estimated fair value of the asset.

Goodwill and Other Intangible Assets
Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Under the provisions of SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Intangible assets that have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. All of the Company’s other intangible assets have finite lives and are amortized on a straight-line basis over varying periods not exceeding fifteen years. Prior to adoption of SFAS No. 142, the Company’s goodwill was amortized on a straight-line basis over fifteen years. Note 8 includes a summary of the Company’s goodwill and other intangible assets as well as further detail about the effect of the adoption of SFAS No. 142.

Other Real Estate
Other real estate represents assets acquired in satisfaction of loans either by foreclosure or deeds taken in lieu of foreclosure. Properties acquired are recorded at the lower of cost or fair value less estimated selling costs at the time of acquisition with any deficiency charged to the allowance for credit losses. Thereafter, costs incurred to operate or carry the properties as well as reductions in value as determined by periodic appraisals are charged to operating expense. Gains and losses resulting from the final disposition of the properties are included in noninterest expense.

Short-Term Borrowings
Short-term borrowing are comprised primarily of repurchase agreements which are securities sold to the Company’s customers, at the customers’ request, under a continuing “roll-over” contract that matures in one business day. The underlying securities sold are U.S. Treasury notes or Government Agency bonds, which are segregated from the Company’s other investment securities by its safekeeping agents.

Income Taxes
The Company and its subsidiaries file a consolidated federal income tax return. Income tax expense is based on the results of operations, adjusted for permanent differences between items of income or expense reported in the financial statements and those reported for income tax purposes.

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.

Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
 

38

Statement of Cash Flows
Cash and demand balances due from banks, interest bearing deposits with other banks and federal funds sold are considered “cash and cash equivalents” for financial reporting purposes.

Stock-Based Compensation
The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure”, but applies APB Opinion No. 25 and related interpretations in accounting for its plans. No compensation expense related to the plans was recorded during the years ended December 31, 2004, 2003, and 2002. If the Company had elected to recognize compensation cost based on fair value of the award on date of grant and recognized cost based upon the vesting dates under the plans consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts as follows for the years ended December 31:

   
2004
 
2003
 
2002
  
Net income:
              
As reported
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
Less pro forma stock-based compensation expense determined under the fair
                   
value method, net of related tax effects
    
(49,407
)
  
(32,328
)
  
(29,700
)
Pro forma net income
  
$
10,148,794
  
$
9,463,367
  
$
8,760,444
  
                     
Basic net income per share:
                    
As reported
  
$
1.86
  
$
1.77
  
$
1.64
  
Pro forma
    
1.85
    
1.76
    
1.64
  
                     
Diluted earnings per share
                    
As reported
  
$
1.84
  
$
1.74
  
$
1.62
  
Pro forma
    
1.83
    
1.74
    
1.62
  

The pro forma amounts are not representative of the effects on reported net income for future years. 

Advertising Costs
Advertising costs are generally expensed as incurred. The Company incurred advertising costs of approximately $217,000, $169,000, and $179,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” This statement amends the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges of nonmonetary assets that do not have commercial substance. This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard is not expected to have a material impact on financial condition, results of operations, or liquidity.

In December 2004, FASB issued SFAS No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock Issued for Employees.” SFAS No. 123R requires that all share-based payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period. SFAS No. 123R is effective for the Company on July 1, 2005. The Company will transition to SFAS No. 123R using the “modified prospective application.” Under the “modified prospective application,” compensation costs will be recognized in the financial statements for all new share-based payments granted after July 1, 2005. Additionally, the Company will recognize compensation costs for the portion of previously granted awards for which the requisite service has not been rendered (“nonvested awards”) that are outstanding as of July 1, 2005 over the remaining requisite service period of the awards. The compensation expense to be recognized for the nonvested awards will be based on the fair value of the awards. The Company does not expect the impact of utilizing the “modified prospective application” to adopt SFAS No. 123R to be materially different from the pro forma information shown above in this Note 1 under “Stock-Based Compensation.”
 
 
39
 
In March 2004,FASB Emerging Issues Task Force (EITF) released Issue 03-01, “Meaning of Other Than Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance for determining whether impairment for certain debt and equity investments is other-than-temporary and the measurement of the impaired loss. Certain disclosure requirements of EITF 03-1 were adopted in 2003 and the Company complied with the new disclosure requirements in its consolidated financial statements. The recognition and measurement requirements of EITF 03-01 were initially effective for periods beginning after June 15, 2004. In September 2004, however, the FASB staff issued FASB Staff Position (“FSP”) EITF 03-1-1, which delayed the effective date for certain measurement and recognition guidance contained in Issue 03-1. The FSP requires the application of pre-existing other-than-temporary guidance during the period of delay until a final consensus is reached. Management does not anticipate the issuance of the final consensus will have a material impact on financial condition, the results of operations, or liquidity. During 2004, the Company recorded a $657,500 write-down relating to its investment in FHLMC preferred stock whose decline in value was determined to be other-than-temporary.

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer”. SOP 03-3 requires acquired loans, including debt securities, to be recorded at the amount of the purchase’s initial investment and prohibits carrying over valuation allowances from the seller for those-individually-evaluated loans that have evidence of deterioration in credit quality since origination, and it is probable all contractual cash flows on the loan will be unable to be collected. SOP 03-3 also requires the excess of all undiscounted cash flows expected to be collected at acquisition over the purchase’s initial investment to be recognized as interest income on a level-yield basis over the life of the loan. Subsequent increases in cash flows expected to be collected are recognized prospectively through an adjustment of the loan’s yield over its remaining life, while subsequent decreases are recognized as impairment. Loans carried at fair value, loans held for sale, and loans to borrowers in good standing under revolving credit agreements are excluded from the scope of SOP 03-3. The guidance is effective for loans acquired in fiscal years beginning after December 15, 2004 and is not expected to have a material impact on the Company’s financial condition, result of operations, or liquidity.

Reclassifications
Certain amounts in the prior year statements have been reclassified to conform to the current year’s presentation.

NOTE 2. ACQUISITIONS

On April 1, 2004, the Company completed its merger with Midstate Bancorp, Inc., a Delaware bank holding company (“Midstate Bancorp”). Pursuant to the merger agreement, each outstanding share of common stock of Midstate Bancorp was converted into the right to receive (i) $31.00 in cash, plus (ii) 0.8732 shares of the common stock of the Company, with cash being paid in lieu of fractional shares at the rate of $33.83 per share. The Company paid $2,953,710 in cash and issued 82,786 shares of common stock to stockholders of Midstate Bancorp in connection with the merger. The Company recorded approximately $2,636,000 of Goodwill and $968,000 of other intangible assets as a result of the acquisition.

On May 1, 2002, the Company acquired certain assets of The Avon-Dixon Agency, Inc., a full service insurance agency, and its subsidiaries, all located in Easton, Maryland. The acquisition agreement called for a deferred payment (earn-out) to be made on or before February 15, 2005, the exact amount of which would depend upon the acquired business meeting certain performance criteria through December 31, 2004. The Company recorded a deferred payment of $2,800,000 on December 31, 2004 as additional Goodwill. On November 1, 2002, The Avon-Dixon Agency, LLC acquired certain assets of W. M. Freestate & Son, Inc., a full service insurance agency located in Centreville, Maryland. The acquisition agreement called for a deferred payment (earn-out) to be made on or before December 16, 2005, the exact amount of which would depend upon the acquired business meeting certain performance criteria through December 31, 2004. The Company has not yet made this payment but recorded a deferred payment of $512,500 on December 31, 2004 as additional Goodwill.

NOTE 3. CASH AND DUE FROM BANKS

The Board of Governors of the Federal Reserve System (the “FRB”) requires banks to maintain certain minimum cash balances consisting of vault cash and deposits in the Federal Reserve Bank or in other commercial banks. Such balances averaged approximately $11,877,000 and $9,276,000 during 2004 and 2003, respectively.
 

40

NOTE 4. INVESTMENT SECURITIES

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

   
Gross
 
Gross
 
Estimated
 
 
 
 
 
Amortized
 
Unrealized
 
Unrealized
 
Fair
 
Available for sale securities:
 
Cost
 
Gains
 
Losses
 
Value
  
December 31, 2004:
                  
Obligations of U.S. Government agencies and corporations
  
$
74,961,442
  
$
46,913
  
$
539,525
  
$
74,468,830
  
Other securities:
                          
Mortgage backed securities
    
24,379,611
    
199,610
    
165,979
    
24,413,242
 
Federal Home Loan Bank stock
    
1,614,100
    
-
    
-
    
1,614,100
  
Federal Reserve Bank stock
    
302,250
    
-
    
-
    
302,250
  
Federal Home Loan Mortgage Corporation
                          
Cumulative preferred stock
    
2,342,500
    
-
    
-
    
2,342,500
  
Equity securities
    
284,180
    
8,717
    
-
    
292,897
 
   
$
103,884,083
  
$
255,240
  
$
705,504
  
$
103,433,819
  
December 31, 2003:
                          
Obligations of U.S. Government agencies and corporations
  
$
103,936,791
  
$
542,450
  
$
215,488
  
$
104,263,753
  
Other securities:
                          
Mortgage backed securities
    
30,195,164
    
553,683
    
153,979
    
30,594,868
 
Federal Home Loan Bank stock
    
2,469,400
    
-
    
-
    
2,469,400
  
Federal Reserve Bank stock
    
302,250
    
-
    
-
    
302,250
  
Federal Home Loan Mortgage Corporation
                          
Cumulative preferred stock
    
5,972,500
    
32,500
    
247,500
    
5,757,500
  
Equity securities
    
978,641
    
1,786
    
-
    
980,427
 
   
$
143,854,746
  
$
1,130,419
  
$
616,967
  
$
144,368,198
  

Held to Maturity securities:
                  
December 31, 2004
                  
Obligations of states and political subdivisions
  
$
15,658,414
  
$
219,019
  
$
79,047
  
$
15,798,386
  
Mortgage backed securities
    
3,663
    
336
    
-
    
3,999
  
   
$
15,662,077
  
$
219,355
  
$
79,047
  
$
15,802,385
  
December 31, 2003
                          
Obligations of states and political subdivisions
  
$
15,307,658
  
$
323,029
  
$
51,600
  
$
15,579,087
  
Mortgage backed securities
    
5,351
    
530
    
-
    
5,881
  
   
$
15,313,009
  
$
323,559
  
$
51,600
  
$
15,584,968
  
                           

Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position at December 31, 2004 are as follows:

   
Continuous unrealized losses existing for:
 
 
 
 
Less than 12
 
12 Months
 
Total Unrealized
 
Available for sale securities:
 
Fair Value
 
Months
 
or More
 
Losses
 
Obligations of U.S. Government
                  
Agencies and Corporations
  
$
56,061,108
  
$
420,979
  
$
118,546
  
$
539,525
  
Mortgage-backed securities
    
13,138,768
    
63,857
    
102,122
    
165,979
  
   
$
69,199,876
  
$
484,836
  
$
220,668
  
$
705,504
  
                           
The available-for-sale investment portfolio has a fair value of approximately $103 million, of which approximately $69 million have unrealized losses from their purchase price. Of these securities, $56 million or 81% are government agency bonds, and $13 million or 19% are mortgage-backed securities. The securities representing the unrealized losses in the available-for-sale portfolio all have modest duration risk, low credit risk, and minimal loss (approximately 1.02%) when compared to book value. The unrealized losses that exist are the result of market changes in interest rates since the original purchase. These factors coupled with the fact the Company has both the intent and ability to hold these investments for a period of time sufficient to allow for any anticipated recovery in fair value substantiates that the unrealized losses in the available-for-sale portfolio are temporary. During 2004, the Company recorded impairment losses in the amount of $657,500 for losses on Freddie Mac Preferred Stock investments that were determined to be other than temporary.
 
 
41
 
Gross unrealized losses and fair value by length of time that the individual held-to-maturity securities have been in a continuous unrealized loss position at December 31, 2004 are as follows:
 
   
Continuous unrealized losses existing for:
 
 
 
 
Less than 12
 
12 Months
 
Total Unrealized
 
Held-to-Maturity:
 
Fair Value
 
Months
 
or More
 
Losses
 
 
                  
Obligations of states and political subdivisions
  
$
5,770,037
  
$
31,906
  
$
47,141
  
$
79,047
  
                           
The held-to-maturity investment portfolio has a fair value of approximately $16 million, of which approximately $6 million have some unrealized losses from their purchase price. The securities representing the unrealized losses in the held-to-maturity portfolio are all municipal securities with modest duration risk, low credit risk, and minimal losses (approximately .50%) when compared to book value. The unrealized losses that exist are the result of market changes in interest rates since the original purchase. These factors coupled with the Company’s intent and ability to hold these investments for a period of time sufficient to allow for any anticipated recovery in fair value substantiates that the unrealized losses in the held-to-maturity portfolio are temporary.

The amortized cost and estimated fair values of investment securities by maturity date at December 31, 2004 are as follows:

   
Available for Sale
 
Held to Maturity
 
 
 
Amortized
 
Estimated
 
Amortized
 
Estimated
 
 
 
Cost
 
Fair Value
 
Cost
 
Fair Value
 
Due in one year or less
  
$
8,176,846
  
$
8,147,033
  
$
1,013,541
  
$
1,023,037
  
Due after one year through five years
    
79,323,330
    
79,004,649
    
4,566,629
    
4,630,620
  
Due after five years through ten years
    
5,112,415
    
5,060,055
    
7,130,397
    
7,137,173
  
Due after ten years
    
6,728,462
    
6,670,335
    
2,951,510
    
3,011,555
  
     
99,341,053
    
98,882,072
    
15,662,077
    
15,802,385
  
Equity securities
    
4,543,030
    
4,551,747
    
-
    
-
  
   
$
103,884,083
  
$
103,433,819
  
$
15,662,077
  
$
15,802,385
  
                           
The maturity date for mortgage-backed securities is determined by its expected maturity. The maturity date for the remaining debt securities is determined using its contractual maturity date.


42

The following table sets forth the amortized cost and estimated fair values of securities which have been pledged as collateral for obligations to federal, state and local government agencies, and other purposes as required or permitted by law, or sold under agreements to repurchase. All pledged securities are held in the available for sale investment portfolio.

   
December 31, 2004
 
December 31,2003
 
 
 
Amortized
 
Estimated
 
Amortized
 
Estimated
 
 
 
Cost
 
Fair Value
 
Cost
 
Fair Value
 
                   
Available for sale
  
$
77,185,632
  
$
76,863,198
  
$
68,483,332
  
$
68,881,748
  
                           
 
There were no obligations of states or political subdivisions whose carrying value, as to any issuer, exceeded 10% of stockholders’ equity at December 31, 2004 or 2003.

Proceeds from sales of investment securities were $16,955,000, $8,771,000, and $3,017,000 for the years ended December 31, 2004, 2003, and 2002, respectively. Gross gains from sales of investment securities were $129,000, $449,000, and $26,000 for the years ended December 31, 2004, 2003, and 2002, respectively. Gross losses were $88,000 and $1,000 for the years ended December 31, 2004 and 2003, respectively. There were no gross losses in 2002.

NOTE 5. LOANS AND ALLOWANCE FOR CREDIT LOSSES

The Company grants residential mortgage, consumer and commercial loans to customers primarily in the Maryland counties of Talbot, Queen Anne’s, Kent, Caroline and Dorchester and in Kent County, Delaware. The principal categories of the loan portfolio at December 31 are summarized as follows:

   
2004
 
2003
  
Real estate loans:
          
Construction and land development
  
$
97,010,075
  
$
36,639,173
  
Secured by farmland
    
18,740,634
    
14,401,354
  
Secured by residential properties
    
240,594,157
    
221,309,705
  
Secured by non-farm, nonresidential properties
    
147,207,463
    
121,338,281
  
Loans to farmers (loans to finance agricultural production and other loans)
    
4,495,116
    
3,518,341
  
Commercial and industrial loans
    
68,163,985
    
60,153,828
  
Loans to individuals for household, family, and other personal expenditures
    
18,485,816
    
16,498,761
  
Obligations of states and political subdivisions in the United States, tax-exempt
    
1,082,824
    
1,060,363
  
All other loans
    
133,156
    
159,063
  
     
595,913,226
    
475,078,869
  
Net deferred loan fees/costs
    
(455,087
)
  
(124,304
)
     
595,458,139
    
474,954,565
  
Allowance for credit losses
    
(4,692,202
)
  
(4,059,964
)
   
$
590,765,937
  
$
470,894,601
  
               
In the normal course of banking business, loans are made to officers and directors and their affiliated interests. These loans are made on substantially the same terms and conditions as those prevailing at the time for comparable transactions with outsiders and are not considered to involve more than the normal risk of collectibility. As of December 31, 2004 and 2003, such loans outstanding, both direct and indirect (including guarantees), to directors, their associates and policy-making officers, totaled approximately $16,384,000, and $12,014,000, respectively. During 2004 and 2003, loan additions were approximately $10,031,000 and $3,149,000, and loan repayments were approximately $5,661,000 and $3,307,000, respectively.


43

Activity in the allowance for credit losses is summarized as follows:

   
2004
 
2003
 
2002
  
               
Balance, beginning of year
  
$
4,059,964
  
$
4,116,598
  
$
4,189,368
  
                     
Loans charged off:
                    
Real estate loans
    
(130,624
)
  
(7,369
)
  
(86,623
)
Installment loans
    
(94,052
)
  
(113,717
)
  
(170,187
)
Commercial and other
    
(662,246
)
  
(409,329
)
  
(282,081
)
     
(886,922
)
  
(530,415
)
  
(538,891
)
Recoveries:
                    
Real estate loans
    
19,681
    
35,060
    
15,541
  
Installment loans
    
62,896
    
56,592
    
76,177
  
Commercial and other
    
79,093
    
47,129
    
18,337
  
     
161,670
    
138,781
    
110,055
  
                     
Net loans charged off
    
(725,252
)
  
(391,634
)
  
(428,836
)
Allowance of acquired institution
    
426,145
    
-
    
-
  
Provision
    
931,345
    
335,000
    
356,066
  
                     
Balance, end of year
  
$
4,692,202
  
$
4,059,964
  
$
4,116,598
  
                     
 Information with respect to impaired loans and the related valuation allowance as of December 31 is as follows:
 
     
2004
 
 
2003
 
 
2002
  
Impaired loans with valuation allowance
  
$
1,245,881
  
$
729,340
  
$
433,091
  
Impaired loans with no valuation allowance
    
222,784
    
272,348
    
379,355
  
                     
Total impaired loans
  
$
1,468,665
  
$
1,001,688
  
$
812,446
  
                     
Allowance for loan losses related to impaired loans
  
$
441,930
  
$
349,268
  
$
116,024
  
Allowance for loan losses related to other than impaired loans
    
4,250,272
    
3,710,696
    
4,000,574
  
                     
Total allowance for loan losses
  
$
4,692,202
  
$
4,059,964
  
$
4,116,598
  
                     
Interest income on impaired loans recorded on the cash basis
  
$
11,177
  
$
26,464
  
$
78,312
  
                     
Average recorded investment in impaired loans for the year
  
$
1,174,632
  
$
826,098
  
$
676,565
  


NOTE 6. PREMISES AND EQUIPMENT

A summary of premises and equipment at December 31 is as follows:

   
2004
 
2003
  
Land
  
$
3,313,344
  
$
2,928,862
  
Buildings and land improvements
    
10,628,881
    
9,279,151
  
Furniture and equipment
    
6,013,936
    
5,403,013
  
     
19,956,161
    
17,611,026
  
Accumulated depreciation
    
(6,886,326
)
  
(6,309,477
)
   
$
13,069,835
  
$
11,301,549
  
               
Depreciation expense totaled $846,359, $702,042 and $576,390 for the years ended December 31, 2004, 2003 and 2002, respectively.


44

The Company leases facilities under operating leases. Rental expense for the years ended December 31, 2004, 2003 and 2002 was $314,015, $330,927 and $267,418, respectively. Future minimum annual rental payments are approximately as follows:

2005
  
$
243,280
  
2006
    
139,690
  
2007
    
29,867
  
2008 and thereafter
    
-
  
Total minimum lease payments
  
$
412,837
  
         

NOTE 7. INVESTMENT IN UNCONSOLIDATED SUBSIDIARY

At December 31, 2004, the Company owned, through The Centreville National Bank of Maryland (“Centreville National Bank”), 20.00% of the outstanding common stock of the Delmarva Data Bank Processing Center, Inc. (“Delmarva Data”). During 2004, Centreville National Bank sold shares of Delmarva Data to another institution. The investment is carried at cost, adjusted for the Company’s equity in Delmarva Data’s undistributed income.

   
December 31
 
   
2004
 
2003
 
2002
  
               
Balance, beginning of year
  
$
1,202,786
  
$
1,165,567
  
$
1,125,567
  
Sale of stock
    
(379,490
)
  
-
    
-
  
Equity in net income
    
35,837
    
37,219
    
40,000
  
                     
Balance, end of year
  
$
859,133
  
$
1,202,786
  
$
1,165,567
  
                     

Data processing and other expenses paid to Delmarva Data totaled approximately $1,554,000, $1,277,000, and $1,063,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

NOTE 8. GOODWILL AND OTHER INTANGIBLE ASSETS

Effective January 1, 2002, goodwill is no longer being amortized but rather tested for impairment under the provisions of SFAS No. 142. The acquired intangible assets apart from goodwill will continue to be amortized over their remaining estimated lives.

The significant components of goodwill and acquired intangible assets are as follows:

   
2004
 
2003
 
 
 
 
 
 
 
 
Weighted
 
 
 
 
 
 
 
Weighted
 
 
 
Gross
 
 
 
Net
 
Average
 
Gross
 
 
Net
 
Average
 
 
 
Carrying
 
Accumulated
 
Carrying
 
Remaining
 
Carrying
 
Accumulated
 
Carrying
 
Remaining
 
 
 
Amount
 
Amortization
 
Amount
 
Life
 
Amount
 
Amortization
 
Amount
 
Life
 
                                   
Goodwill
  
$
12,605,832
  
$
667,118
  
$
11,938,714
  
-
  
$
6,657,250
  
$
667,118
  
$
5,990,132
    
-
  
Core Deposit Intangible
    
968,000
    
90,748
    
877,252
  
7.3
    
-
    
-
    
-
        
Unidentifiable intangible
                                                
resulting from branch acquisitions
    
104,144
  
89,685
    
14,459
  
2.1
    
104,144
    
82,742
    
21,402
    
3.1
  
Insurance expirations
    
1,270,000
  
216,778
    
1,053,222
12.4
    
1,270,000
    
132,111
    
1,137,889
    
13.4
  
Other identifiable intangibles
    
620,883
  
323,449
    
297,434
2.4
    
620,883
    
199,272
    
421,611
    
3.4
  
Total
  
$
15,568,859
  
$
1,387,778
  
$
14,181,081
    
$
8,652,277
  
$
1,081,243
  
$
7,571,034
        


Future annual estimated annual amortization expense is as follows:

2005
  
$
336,786
  
2006
    
336,786
  
2007
    
247,632
  
2008
    
205,667
  
2009
    
205,667
  


Under the provisions of SFAS No. 142, goodwill was subjected to an annual assessment for impairment during 2004. As a result of annual assessment reviews, the Company determined that there was no impairment of goodwill. The Company will continue to review goodwill on an annual basis for impairment and as events occur or circumstances change.
 

 
45
 
NOTE 9. DEPOSITS

The approximate amount of certificates of deposit of $100,000 or more at December 31, 2004 and 2003 was $91,315,000 and $71,385,000, respectively.

The approximate maturities of time deposits at December 31, 2004 are as follows:

Due in one year or less
  
$
108,037,000
  
Due in one to three years
    
87,305,000
  
Due in three to five years
    
51,580,000
  
   
$
246,922,000
  
         

NOTE 10. SHORT-TERM BORROWINGS

Short-term borrowings at December 31, 2004 and 2003 consisted of securities sold under agreements to repurchase. These short-term obligations represent securities sold to customers, at the customers’ request, under a “roll-over” contract that matures in one business day. The underlying securities sold are U.S. Treasury Notes or Government agency securities, which are segregated in the Company’s custodial accounts from other investment securities. The Company may periodically borrow from a correspondent federal funds line of credit arrangement or a secured reverse repurchase agreement to meet short-term liquidity needs. The following table summarizes certain information for short-term borrowings:

   
2004
 
2003
  
           
Average amount outstanding during the year
  
$
25,590,183
  
$
23,071,327
  
Weighted average interest rate during the year
    
.84
%
  
.77
%
Amount outstanding at year end
  
$
27,106,241
  
$
20,957,294
  
Weighted average rate at year end
    
.80
%
  
.63
%
Maximum amount at any month end
  
$
30,845,388
  
$
29,780,959
  
               

NOTE 11. LONG-TERM DEBT

As of December 31, 2004 and 2003, the Company had a convertible advance from the Federal Home Loan Bank of Atlanta in the amount of $5,000,000 at an interest rate of 4.97%, due March 29, 2006. The Company has pledged its wholly owned residential real estate mortgage loan portfolio under a blanket floating lien as collateral for this advance.

NOTE 12. BENEFIT PLANS

401(k) and Profit Sharing Plan
The Company has a 401(k) and profit sharing plan covering substantially all full-time employees. The plan calls for matching contributions by the Company, and the Company makes discretionary contributions based on profits. Company contributions to this plan included in expense totaled $750,260 (2004), $728,812 (2003), and $592,413 (2002).

The Felton Bank has a 401(k) plan covering substantially all full-time employees. The plan calls for matching contributions by the Felton Bank. During 2004, matching contributions totaled $10,244.
 
NOTE 13. STOCK OPTION PLANS

The Company has two stock option plans whereby incentive and nonqualified stock options may be granted periodically to directors, executive officers, and key employees at the discretion of the Company’s Compensation Committee. The plans provide for both immediate and graduated vesting schedules and originally reserved 194,000 shares of common stock for grant. At December 31, 2004, a total of 53,966 shares remained available for grant under the plans. The plans were adopted in 1998 and 1995 and the options granted have a life not to exceed ten years.

The Company also has an Employee Stock Purchase Plan that was adopted in 1998 and amended in 2003 that allows employees to receive options to purchase common stock at an amount equivalent to 85% of the fair market value of the common stock. As amended, the plan reserved 45,000 shares of common stock for issuance under the plan. There were 23,681 shares available for grant under the plan at December 31, 2004.

46
 
Following is a summary of changes in shares under option for all plans for the years indicated:

   
Year Ended December 31,
 
 
 
2004
 
2003
 
 
 
Number
 
Weighted Average
 
Number
 
Weighted Average
 
 
 
of Shares
Exercise Price
of Shares
Exercise Price
 
Outstanding at beginning of year
    
113,084
  
$
12.25
    
139,534
  
$
11.52
  
Granted
    
5,979
    
24.98
    
5,401
    
24.03
  
Exercised
    
(32,826
)
  
9.64
    
(29,309
)
  
10.03
  
Expired/Cancelled
    
(1,012
)
  
20.49
    
(2,542
)
  
22.95
  
Outstanding at end of year
    
85,225
  
$
14.05
    
113,084
  
$
12.25
  
                           
Weighted average fair value of options granted during the year
  
 
 
   $
8.26
  
 
   $
7.12
  
                           

The following summarizes information about options outstanding at December 31, 2004:

     
Options Outstanding and Exercisable
  
Options Outstanding
      
Weighted Average
  
 
          
Remaining
 
Exercise Price
 
Number
 
Number
  
Contract Life
  
$  6.85  
    
4,323
    
4,323
    
.61
  
   8.78 
   
47,880
    
47,880
    
1.95
  
32.00
    
4,000
    
4,000
    
4.05
  
21.00
    
3,570
    
2,676
    
5.05
  
19.75
    
16,935
    
5,265
    
7.42
  
24.03
    
3,196
    
3,196
    
.26
  
24.98
    
5,321
    
5,321
    
1.68
  
     
85,225
    
72,661
        

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for options that vest during the years ended December 31, 2004.

   
2004 
  
2003 
  
Dividend yield
    
2.29
%
  
1.70
%
Expected volatility
    
27.60
%
  
20.00
%
Risk free interest
    
4.0
%
  
4.23
%
Expected lives (in years)
    
2.25
    
2.17
  
               

NOTE 14. DEFERRED COMPENSATION

The Company has a supplemental deferred compensation plan to provide retirement benefits to its President and Chief Executive Officer. The plan calls for fixed annual payments of $20,000 to be credited to the participant’s account. The participant is 100% vested in amounts credited to his account. Contributions to the plan were $20,000 in 2004, 2003, and 2002.

Centreville National Bank has agreements with certain of its directors under which they have deferred part of their fees and compensation. The amounts deferred are invested in insurance policies, owned by Centreville National Bank, on the lives of the respective individuals. Amounts available under the policies are to be paid to the individuals as retirement benefits over future years. Cash surrender values and the accrued benefit obligation included in other assets and other liabilities at December 31 are as follows:

 
  
2004
 
2003
  
Cash surrender value
  
$
2,046,706
  
$
1,970,630
  
Accrued benefit obligations
    
820,719
    
697,633
  

 
47
 
NOTE 15. INCOME TAXES

Income taxes included in the balance sheets as of December 31 are as follows:
 
   
2004
 
2003
  
Federal income taxes currently (receivable) payable
  
$
263,652
  
$
(25,038
)
State income taxes currently payable
    
86,100
    
42,666
  
Deferred income tax benefits
    
1,542,544
    
855,640
  

Components of income tax expense for each of the three years ended December 31 are as follows:

 
 
2004
 
2003
 
2002
  
Currently payable:
              
Federal
  
$
4,913,929
  
$
4,500,099
  
$
4,091,475
  
State
    
918,988
    
826,384
    
670,478
  
     
5,832,917
    
5,326,483
    
4,761,953
  
Deferred income tax expense (benefits):
                    
Federal
    
5,399
    
(50,635
)
  
(27,431
)
State
    
2,308
    
(10,147
)
  
(4,681
)
     
7,707
    
(60,782
)
  
(32,112
)
   
$
5,840,624
  
$
5,265,701
  
$
4,729,841
  
                     

A reconciliation of tax computed at the statutory federal tax rates of 35% to the actual tax expense for the three years ended December 31 follows:

 
 
2004
 
2003
 
2002
  
Tax at federal statutory rate
    
35.0
%
  
35.0
%
  
35.0
%
Tax effect of:
                    
Tax-exempt income
    
(1.5
)
  
(2.0
)
  
(2.0
)
Non-deductible expenses
    
.2
    
.1
    
.1
  
State income taxes, net of federal benefit
    
3.7
    
3.6
    
3.2
  
Other
    
(1.0
)
  
(1.0
)
  
(1.3
)
Income tax expense
    
36.4
%
  
35.7
%
  
35.0
%
                     

Significant components of the Company’s deferred tax assets and liabilities as of December 31 are as follows:

   
2004
 
2003
  
Deferred tax assets:
          
Allowance for credit losses
  
$
1,735,196
  
$
1,435,285
  
Provision for off balance sheet commitments
    
57,850
    
42,566
 
Net operating loss carryforward
    
303,137
    
-
  
Unrealized losses on available for sale securities
    
172,169
    
-
  
Recognized loss on impaired securities
    
304,671
    
50,744
  
Loan fees
    
75,182
    
24,570
  
Deferred compensation
    
313,528
    
269,455
  
Total deferred tax assets
    
2,961,733
    
1,822,620
  
Deferred tax liabilities:
              
Depreciation
    
363,979
    
373,039
  
Purchase accounting adjustments
    
635,149
    
-
  
Federal Home Loan Bank stock dividend
    
27,613
    
27,613
  
Undistributed income of unconsolidated subsidiary
    
69,345
    
66,577
  
Loan origination fees and costs
    
288,934
    
258,500
  
Unrealized gains on available for sale securities
    
-
    
195,201
 
Other
    
34,169
    
46,050
  
Total deferred tax liabilities
    
1,419,189
    
966,980
  
Net deferred tax assets
  
$
1,542,544
  
$
855,640
  
               
The Company had unused net operating loss carryforward of approximately $816,000 at December 31, 2004 that resulted from the acquisition of the Felton Bank in 2004. In accordance with current tax laws, the Company is allowed to utilize the loss carryforward over a 20-year period beginning in 2004. The Company expects to utilize the entire loss carryforward.

48
 
NOTE 16. EARNINGS PER COMMON SHARE

Basic earnings per share is derived by dividing net income available to common stockholders by the weighted-average number of common shares outstanding and does not include the effect of any potentially dilutive common stock equivalents. Diluted earnings per share is derived by dividing net income by the weighted-average number of shares outstanding, adjusted for the dilutive effect of outstanding stock options and warrants. For the years ended December 31, 2004 and 2002 options to purchase 4,000 and 5,500 shares of common stock, respectively, were excluded from computing diluted earnings per share because their effects were antidilutive.

   
2004
 
2003
 
2002
 
Basic:
              
Net income (applicable to common stock)
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
Average common shares outstanding
    
5,482,928
    
5,376,618
    
5,358,969
  
Basic earnings per share
  
$
1.86
  
$
1.77
  
$
1.64
  
                     
Diluted:
                    
Net income (applicable to common stock)
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
Average common shares outstanding
    
5,482,928
    
5,376,618
    
5,358,969
  
Diluted effect of stock options
    
47,230
    
72,303
    
69,609
  
Average common shares outstanding - diluted
    
5,530,158
    
5,448,921
    
5,428,578
  
Diluted earnings per share
  
$
1.84
  
$
1.74
  
$
1.62
  
                     

NOTE 17. REGULATORY CAPITAL REQUIREMENTS

The Company and each of The Talbot Bank of Easton, Maryland (“Talbot Bank”), Centreville National Bank, and The Felton Bank (“Felton Bank” and together with Talbot Bank and Centreville National Bank, the “Banks”) are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators, that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Banks must meet specific capital guidelines that involve quantitative measures of the Banks’ assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Banks’ capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Banks to maintain amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets. Management believes as of December 31, 2004 that the Company and the Banks met all capital adequacy requirements to which they are subject.

As of December 31, 2004, the most recent notification from the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency categorized Talbot Bank and Centreville National Bank, respectively, as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Banks must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. At December 31, 2004, Felton Bank did not meet the minimum total risk-based ratio to be categorized as well capitalized under the framework for prompt corrective action. The Company has since made additional capital contributions to the Felton Bank to achieve the minimum required total risk based capital ratio. Management knows of no trends or demands, commitments, events or uncertainties that are likely to have a material adverse impact on the ability of the Company or any of the Banks to remain in the well capitalized category.
49

Capital levels and ratios for the Company, Talbot Bank, Centreville National Bank and Felton Bank as of December 31, 2004 and 2003, compared with the minimum requirements, are presented below:

   
 
 
 
 
 
 
 
To Be Well
 
 
 
 
 
 
 
 
 
 
Capitalized Under
 
 
 
 
 
For Capital
 
Prompt Corrective
 
 
 
Actual
 
Adequacy Purposes
 
Action Provisions
 
 
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
As of December 31, 2004:
                          
Total Capital (to Risk Weighted Assets):
                          
Company
  
$
87,229,000
    
13.86
%
$
50,338,000
    
8.00
%
$
62,922,500
    
10.00
%
Talbot Bank
  
$
49,620,000
    
12.65
%
$
31,383,040
    
8.00
%
$
39,228,800
    
10.00
%
Centreville National Bank
  
$
27,691,000
    
14.69
%
$
15,085,280
    
8.00
%
$
18,856,600
    
10.00
%
Felton Bank
  
$
4,478,000
    
9.68
%
$
3,700,240
    
8.00
%
$
4,625,300
    
10.00
%
Tier 1 Capital (to Risk Weighted Assets):
                                      
Company
  
$
82,385,000
    
13.04
%
$
25,169,000
    
4.00
%
            
Talbot Bank
  
$
46,857,000
    
11.94
%
$
15,691,520
    
4.00
%
$
23,537,280
    
6.00
%
Centreville National Bank
  
$
26,121,000
    
13.85
%
$
7,542,640
    
4.00
%
$
11,313,960
    
6.00
%
Felton Bank
  
$
3,967,000
    
8.09
%
$
1,850,000
    
4.00
%
$
2,775,180
    
6.00
%
Tier 1 Capital (to Average Assets):
                                      
Company
  
$
82,385,000
    
10.67
%
$
30,885,600
    
4.00
%
            
Talbot Bank
  
$
46,857,000
    
10.76
%
$
17,411,920
    
4.00
%
$
21,764,900
    
5.00
%
Centreville National Bank
  
$
26,121,000
    
9.61
%
$
10,871,480
    
4.00
%
$
13,589,350
    
5.00
%
Felton Bank
  
$
3,967,000
    
6.58
%
$
2,410,200
    
4.00
%
$
3,012,750
    
5.00
%
                                       
As of December 31, 2003:
                                      
Total Capital (to Risk Weighted Assets):
                                      
Company
  
$
79,591,000
    
16.17
%
$
39,386,080
    
8.00
%
$
32,967,500
    
10.00
%
Talbot Bank
  
$
48,500,000
    
14.71
%
$
26,374,000
    
8.00
%
$
32,967,500
    
10.00
%
Centreville National Bank
  
$
26,335,000
    
16.66
%
$
12,648,960
    
8.00
%
$
15,811,200
    
10.00
%
Tier 1 Capital (to Risk Weighted Assets):
                                      
Company
  
$
75,421,000
    
15.32
%
$
19,693,040
    
4.00
%
            
Talbot Bank
  
$
45,688,000
    
13.86
%
$
13,187,040
    
4.00
%
$
21,857,420
    
6.00
%
Centreville National Bank
  
$
24,977,000
    
15.80
%
$
6,324,480
    
4.00
%
$
13,068,160
    
6.00
%
Tier 1 Capital (to Average Assets):
                                      
Company
  
$
75,421,000
    
10.73
%
$
28,128,920
    
4.00
%
            
Talbot Bank
  
$
45,688,000
    
10.45
%
$
17,485,800
    
4.00
%
$
21,857,250
    
5.00
%
Centreville National Bank
  
$
24,977,000
    
9.56
%
$
10,454,480
    
4.00
%
$
13,068,100
    
5.00
%
                                       
Bank and holding company regulations, as well as Maryland and Delaware law, impose certain restrictions on dividend payments by the Banks, as well as restricting extensions of credit and transfers of assets between the Banks and the Company. At December 31, 2004, the Banks could have paid dividends to the parent company of approximately $7,899,000 without the prior consent and approval of the regulatory agencies. The Company had no outstanding receivables from subsidiaries at year-end December 31, 2004 and 2003.

NOTE 18. LINES OF CREDIT

The Banks had $19,500,000 in unsecured federal funds lines of credit and a reverse repurchase agreement available on a short-term basis from correspondent banks. In addition, the Banks have credit availability of approximately $98,494,000 from the Federal Home Loan Bank of Atlanta. The Banks have pledged as collateral, under blanket lien, all qualifying residential loans under borrowing agreements with the Federal Home Loan Bank. At December 31, 2004 and 2003, the Federal Home Loan Bank had issued a letter of credit in the amounts of $20,000,000 on behalf of the Talbot Bank to a local government entity as collateral for its deposits.
50

NOTE 19.  DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents
For short-term instruments, the carrying amount is a reasonable estimate of fair value.

Investment Securities
For all investments in debt securities, fair values are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loan Receivables
The fair value of categories of fixed rate loans, such as commercial loans, residential mortgage, and other consumer loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Other loans, including variable rates loans, are adjusted for differences in loan characteristics.

Financial Liabilities
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates do not take into consideration the value of core deposit intangibles. The fair value of securities sold under agreements to repurchase and long-term debt is estimated using the rates offered for similar borrowings.

Commitments to Extend Credit and Standby Letters of Credit
The majority of the Company’s commitments to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. Because commitments to extend credit and letters of credit are generally unassignable by the Company or the borrower, they only have value to the Company and the borrower and therefore it is impractical to assign any value to these commitments.

The estimated fair values of the Company’s financial instruments, excluding goodwill, as of December 31 are as follows:

   
2004
   2003  
   
Estimated
  
Estimated
         
   
Carrying
  
Fair
  
Carrying
  
Fair
 
   
Amount
  
Value
  
Amount
  
Value
  
Financial assets:
                  
Cash and cash equivalents
  
$
43,551,070
  
$
43,551,000
  
$
46,731,306
  
$
46,731,000
  
Investment securities
    
119,095,896
    
119,236,000
    
159,681,207
    
159,953,000
  
Loans
    
594,458,139
    
599,331,000
    
474,954,565
    
476,470,000
  
Less: allowance for loan losses
    
(4,692,202
)
  
(4,692,000
)
  
(4,059,964
)
  
(4,060,000
)
   
$
752,412,903
  
$
757,426,000
  
$
677,307,114
  
$
679,094,000
  
                           
Financial liabilities:
                          
Deposits
  
$
658,672,354
  
$
653,693,000
  
$
592,409,413
  
$
595,767,000
  
Short-term borrowings
    
27,106,241
    
27,106,000
    
20,957,294
    
20,957,000
  
Long-term debt
    
5,000,000
    
5,114,000
    
5,000,000
    
5,284,000
  
   
$
690,778,595
  
$
685,913,000
  
$
618,366,707
  
$
622,008,000
  
Unrecognized financial instruments:
                          
Commitments to extend credit
  
$
181,067,000
  
$
-
  
$
142,813,000
  
$
-
  
Standby letters of credit
    
22,021,000
    
-
    
9,453,000
    
-
  
   
$
203,088,000
  
$
-
  
$
152,266,000
  
$
-
  



51

NOTE 20. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

In the normal course of business, to meet the financing needs of its customers, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. The Company’s exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company generally requires collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. The Company evaluates each customer’s creditworthiness on a case-by-case basis.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.

Commitments outstanding as of December 31 are as follows:

   
2004
 
2003
  
           
Commitments to extend credit
  
$
181,067,000
  
$
142,813,000
  
Letters of credit
    
22,021,000
    
9,453,000
  
   
$
203,088,000
  
$
152,266,000
  
               

NOTE 21. CONTINGENCIES

In the normal course of business, the Company may become involved in litigation arising from banking, financial, and other activities. Management, after consultation with legal counsel, does not anticipate that the future liability, if any, arising out of these matters will have a material effect on the Company’s financial condition, operating results, or liquidity.
 

52

NOTE 22. PARENT COMPANY FINANCIAL INFORMATION

Condensed financial information for Shore Bancshares, Inc. (Parent Company Only) is as follows:

Condensed Balance Sheets
December 31, 2004 and 2003
 
   
2004
 
2003
  
Assets:
          
Cash
  
$
790,710
  
$
733,612
  
Investment in subsidiaries
    
91,967,166
    
79,782,185
  
Investment in equity securities
    
-
    
100,035
  
Income taxes receivable
    
451,254
    
248,001
  
Premises and equipment, net
    
2,882,676
    
2,842,827
  
Other assets
    
83,865
    
108,359
  
Total assets
  
$
96,175,671
  
$
83,815,019
  
               
Liabilities:
              
Accounts payable
  
$
112,883
  
$
124,251
  
Deferred tax liability
    
287,135
    
163,288
  
Earn-out payment payable
    
2,800,000
    
-
  
     
3,200,018
    
287,539
 
Stockholders’ equity:
              
Common stock
    
55,152
    
54,008
  
Additional paid in capital
    
28,016,571
    
24,231,213
  
Retained earnings
    
65,182,004
    
58,932,021
  
Accumulated other comprehensive (loss) income
    
(278,074
)
  
310,238
  
Total stockholders’ equity
    
92,975,653
    
83,527,480
  
Total liabilities and stockholders’ equity
  
$
96,175,671
  
$
83,815,019
  
               

Condensed Statements of Income
For the years ended December 31, 2004, 2003 and 2002

   
2004
  
2003
  
2002
  
Dividends from subsidiaries
  
$
7,665,535
  
$
6,773,560
  
$
9,096,080
  
Management and other fees from subsidiaries
    
2,174,187
    
1,315,960
    
-
  
Gain on sales of securities
    
-
    
80,000
    
-
  
Rental Income
    
97,771
    
33,333
    
-
  
Other investment income
    
-
    
11,000
    
11,000
 
Interest income
    
5,754
    
3,033
    
608
  
     
9,943,247
    
8,216,886
    
9,107,688
  
                     
Salaries and employee benefits
    
1,572,973
    
770,933
    
-
  
Occupancy expense
    
202,256
    
143,164
    
-
  
Other operating expenses
    
513,232
    
403,089
    
182,591
  
     
2,288,461
    
1,317,186
    
182,591
  
Income before income tax benefit and
                    
equity in undistributed income of subsidiary
    
7,654,786
    
6,899,700
    
8,925,097
  
                     
Income tax expense(benefit)
    
396,717
    
489,819
    
(49,134
)
Income before equity in undistributed income of subsidiary
    
7,258,069
    
6,409,881
    
8,974,231
  
                     
Equity in undistributed income (loss) of subsidiary
    
2,940,132
    
3,085,814
    
(184,087
)
Net income
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
                     

 
53

Condensed Statements of Cash Flows
For the years ended December 31, 2004, 2003 and 2002
 
   
2004
 
2003
 
2002
  
Cash flows from operating activities:
              
Net income
  
$
10,198,201
  
$
9,495,695
  
$
8,790,144
  
Adjustments to reconcile net income to cash provided by operating activities:
                    
Equity in undistributed (income)\loss of subsidiaries
    
(2,940,132
)
  
(3,085,815
)
  
184,087
  
Gain on sale of investment securities
    
-
    
(80,000
)
  
-
  
Depreciation
    
75,098
    
34,716
    
-
  
Net (increase) decrease in other assets
    
155,059
    
(30,231
)
  
(55,979
)
Net increase (decrease) in other liabilities
    
112,479
    
180,871
    
(20,369
)
Net cash provided by operating activities
    
7,600,705
    
6,515,236
    
8,897,883
  
                     
Cash flows from investing activities:
                    
Proceeds from sale of investment securities
    
-
    
360,000
    
-
  
Acquisition, net of stock issued
    
(3,724,645
)
  
-
    
(5,105,497
)
Purchases premises and equipment
    
(150,019
)
  
(2,877,543
)
  
-
  
Investment in subsidiaries
    
-
    
(53,711
)
  
(550,000
)
Net cash used by investing activities
    
(3,874,664
)
  
(2,571,254
)
  
(5,655,497
)
                     
Cash flows from financing activities:
                    
Proceeds from issuance of common stock
    
279,275
    
290,308
    
17,031
 
Repurchase of common stock
    
-
    
-
    
(20,844
)
Dividends paid
    
(3,948,218
)
  
(3,548,410
)
  
(3,217,282
)
Net cash used by financing activities
    
(3,668,943
)
  
(3,258,102
)
  
(3,221,095
)
                     
Net increase in cash and cash equivalents
    
57,098
    
685,880
    
21,291
  
Cash and cash equivalents at beginning of year
    
733,612
    
47,732
    
26,441
  
Cash and cash equivalents at end of year
  
$
790,710
  
$
733,612
  
$
47,732
  

 
54

NOTE 23. QUARTERLY FINANCIAL RESULTS (unaudited)

A summary of selected consolidated quarterly financial data for the two years ended December 31, 2004 is reported as follows:

   
First
 
Second
 
Third
 
Fourth
 
(In thousands, except per share data)
Quarter
Quarter
Quarter
Quarter
  
                   
2004
                  
Interest income
  
$
8,550
  
$
9,345
  
$
9,981
  
$
10,415
  
Net interest income
    
6,422
    
7,087
    
7,704
    
8,068
  
Provision for credit losses
    
105
    
100
    
165
    
561
  
Income before income taxes
    
3,982
    
4,053
    
4,569
    
3,435
  
Net Income
    
2,516
    
2,600
    
2,935
    
2,147
  
                           
Basic earnings per common share
  
$
0.47
  
$
0.47
  
$
0.53
  
$
0.39
  
Diluted earnings per common share
  
$
0.46
  
$
0.47
  
$
0.53
  
$
0.39
  
                           
                           
2003
                          
Interest income
  
$
8,628
  
$
8,642
  
$
8,339
  
$
8,729
  
Net interest income
    
5,972
    
6,114
    
5,988
    
6,522
  
Provision for credit losses
    
90
    
70
    
75
    
100
  
Income before income taxes
    
3,999
    
3,794
    
3,442
    
3,526
  
Net Income
    
2,521
    
2,456
    
2,195
    
2,324
  
                           
Basic earnings per common share
  
$
0.47
  
$
0.46
  
$
0.40
  
$
0.43
  
Diluted earnings per common share
  
$
0.46
  
$
0.45
  
$
0.40
  
$
0.43
  

Earnings per share are based upon quarterly results and may not be additive to the annual earnings per share amounts.

NOTE 24. LINE OF BUSINESS RESULTS

The Company operates two primary businesses: Community Banking and Insurance Products and Services. The Community Banking business provides services to consumers and small businesses on the Eastern Shore of Maryland through its fifteen branch network. Community banking activities include small business services, retail brokerage, and consumer banking products and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable financing arrangements, and merchant card services.

A full range of insurance products and services are available to businesses and consumers in the Company’s market. Products include property and casualty, life, marine, individual health and long term care insurance. Pension and profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.


55

Selected financial information by line of business is included in the following table:

 
 
 
 
Community
 
Insurance products
 
Parent
 
Intercompany
 
Consolidated
 
(In thousands)
 
banking
 
and services
 
Company
 
Transactions
 
Total
 
         
2004
                      
Net Interest income
  
$
29,275
  
$
-
  
$
5
  
$
-
  
$
29,280
  
Provision for credit losses
    
931
    
-
    
-
    
-
    
931
  
Net interest income after provision
    
28,344
    
-
    
5
    
-
    
28,349
  
                                 
Noninterest income
    
3,586
    
6,617
    
2,272
    
(2,251
)
  
10,224
  
Noninterest expense
    
16,875
    
5,622
    
2,288
    
(2,251
)
  
22,534
  
Income before taxes
    
15,055
    
995
    
(11
)
  
-
    
16,039
  
Income tax expense(benefit)
    
5,452
    
393
    
(4
)
  
-
    
5,841
  
Net income
  
$
9,603
  
$
602
  
$
(7
)
$
-
  
$
10,198
  
                                 
Average assets
  
$
764,000
  
$
7,610
  
$
3,270
  
$
-
  
$
774,880
  
                                 
2003
                                
Net Interest income
  
$
24,610
  
$
(14
)
$
-
  
$
-
  
$
24,596
  
Provision for credit losses
    
335
    
-
    
-
    
-
    
335
  
Net interest income after provision
    
24,275
    
(14
)
  
-
    
-
    
24,261
  
                                 
Noninterest income
    
3,695
    
6,037
    
1,430
    
(1,317
)
  
9,845
  
Noninterest expense
    
14,324
    
5,020
    
1,317
    
(1,317
)
  
19,344
  
Income before taxes
    
13,646
    
1,003
    
113
    
-
    
14,762
  
Income tax expense
    
4,868
    
358
    
40
    
-
    
5,266
  
Net income
  
$
8,778
  
$
645
  
$
73
    
-
  
$
9,496
  
                                 
Average assets
  
$
670,022
  
$
7,324
  
$
1,301
    
-
  
$
678,647
  





56

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

Item 9A.    Controls and Procedures.

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Exchange Act with the SEC, such as this annual report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to the Company’s management, including the President and Chief Executive Officer (“CEO”) and the Principal Accounting Officer (“PAO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

An evaluation of the effectiveness of these disclosure controls as of December 31, 2004 was carried out under the supervision and with the participation of the Company’s management, including the CEO and the PAO. Based on that evaluation, the Company’s management, including the CEO and the PAO, has concluded that the Company’s disclosure controls and procedures are effective.

During the fourth quarter of 2004, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

As required by Section 404 of the Sarbanes-Oxley Act of 2002, management has performed an evaluation and testing of the Company’s internal control over financial reporting as of December 31, 2004. Management’s report on the Company’s internal control over financial reporting and the related attestation report of the Company’s registered public accounting firm are included on the following pages.
 

57

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Company’s management is responsible for the preparation, integrity and fair presentation of the consolidated financial statements included in this annual report. The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, as such, include some amounts that are based on the best estimates and judgments of management.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. This internal control system is designed to provide reasonable assurance to management and the Board of Directors regarding the reliability of the Company’s financial reporting and the preparation and presentation of financial statements for external reporting purposes in conformity with accounting principles generally accepted in the United States of America, as well as to safeguard assets from unauthorized use or disposition. The system of internal control over financial reporting is evaluated for effectiveness by management and tested for reliability through a program of internal audit with actions taken to correct potential deficiencies as they are identified. Because of inherent limitations in any internal control system, no matter how well designed, misstatement due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 based upon criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrity Framework. In performing this assessment, management excluded Felton Bank’s internal control over financial reporting associated with total assets of $63,213,000 and total revenues of $2,777,000 included in the Company’s consolidated financial statements as of and for the year ended December 31, 2004. Felton Bank was acquired in April 2004 and the excluded assets and revenues constitute 8% of the Company’s consolidated assets at December 31, 2004 and 5.7% of its revenues for the year ended December 31, 2004.

Based on this assessment and on the foregoing criteria, management has concluded that, as of December 31, 2004, the Company’s internal control over financial reporting is effective. Stegman and Company, the Company’s independent registered public accounting firm that audited the financial statements included in this annual report, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting, as stated in their report, which is included herein on page 59.

March 11, 2005      
       
/s/ W. Moorhead Vermilye     /s/ Susan E. Leaverton
    
W. Moorhead Vermilye
President and Chief Executive Officer		     Susan E. Leaverton
Principal Accounting Officer


58

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


The Board of Directors and Stockholders
Shore Bancshares, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Shore Bancshares, Inc. (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

The Company acquired The Felton Bank during 2004, and management excluded from its assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. The Felton Bank’s internal control over financial reporting associated with total assets of $63,213,000 and total revenues of $2,777,000 included in the consolidated financial statements of the Company as of and for the year ended December 31, 2004. Our audit of internal control over financial reporting of the Company also excluded an evaluation of the internal control over financial reporting of The Felton Bank.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s consolidated balance sheets as of December 31, 2004 and 2003 and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004, and our report dated March 11, 2005 expressed an unqualified opinion on those consolidated financial statements.

/s/ Stegman and Company
Baltimore, Maryland
March 11, 2005
 
59
 
Item 9B.    Other Information
 
The Company intends to offer trust services to customers beginning in the second quarter of 2005. These services will be offered through Centreville National Bank, which must first apply for and receive authority from the OCC to exercise fiduciary powers. Although the Company believes that the OCC will approve Centreville National Bank’s request, there can be no assurance that the OCC will do so.

PART III

Item 10.    Directors and Executive Officers of the Registrant.

The Company has adopted a Code of Ethics that applies to all of its directors, officers, and employees, including its principal executive officer, principal financial officer, principal accounting officer, or controller, or persons performing similar functions. A written copy of the Company’s Code of Ethics will be provided to stockholders, free of charge, upon request to: Carol I. Brownawell, Secretary, Shore Bancshares, Inc., 18 E. Dover Street, Easton, Maryland 21601 or (410) 822-1400.

All other information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2005 Annual Meeting of Stockholders.

Item 11.    Executive Compensation.

The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2005 Annual Meeting of Stockholders.

Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters.

The information provided in Item 5 of Part II of this report under the heading “EQUITY COMPENSATION PLAN INFORMATION” is incorporated herein by reference. All other information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2005 Annual Meeting of Stockholders.

Item 13.    Certain Relationships and Related Transactions.

The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2005 Annual Meeting of Stockholders.

Item 14. Principal Accountant Fees and Services.

The information required by this item is incorporated herein by reference to the Company’s definitive proxy statement to be filed in connection with the 2005 Annual Meeting of Stockholders.

PART IV

Item 15.    Exhibits and Financial Statement Schedules.

(a)(1),(2) Financial statements and schedules:

Reports of Independent Registered Public Accounting Firm

Consolidated Balance Sheets at December 31, 2004 and 2003

Consolidated Statements of Income -- Years Ended December 31, 2004, 2003, and 2002

Consolidated Statements of Stockholders’ Equity -- Years Ended December 31, 2004, 2003 and 2002

Consolidated Statements of Cash Flows -- Years Ended December 31, 2004, 2003 and 2002

Notes to Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002
 

 
60
 
(3)  Exhibits required to be filed by Item 601 of Regulation S-K:
3.1
Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed on December 14, 2000).
3.2
Amended and Restated By-Laws (incorporated by reference to Exhibit 3.2 of the Company’s Form 8-K filed on December 14, 2000).
10.1
Form of Employment Agreement with W. Moorhead Vermilye (incorporated by reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed on July 31, 2000).
10.2
Form of Employment Agreement with Daniel T. Cannon (incorporated by reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed on July 31, 2000).
10.3
Form of Employment Agreement between The Avon-Dixon Agency, LLC and Kevin P. LaTulip (incorporated by reference to Exhibit 10.3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).
10.4
Form of Executive Supplemental Retirement Plan Agreement between The Centreville National Bank of Maryland and Daniel T. Cannon (incorporated by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003).
10.5
Form of Life Insurance Endorsement Method Split Dollar Plan Agreement between The Centreville National Bank of Maryland and Daniel T. Cannon (incorporated by reference to Exhibit 10.5 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003).
10.6
Employment Agreement between The Avon-Dixon Agency, LLC and Steven Fulwood (incorporated by reference to Exhibit 10.6 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004).
10.7
Employment Agreement between The Felton Bank and Thomas H. Evans (filed herewith).
10.8
1998 Employee Stock Purchase Plan, as amended (incorporated by reference to Appendix A of the Company’s definitive Proxy Statement on Schedule 14A for the 2003 Annual Meeting of Stockholders filed on March 31, 2003).
10.9
1998 Stock Option Plan (incorporated by reference to Exhibit 10 of the Company’s Registration Statement on Form S-8 filed with the SEC on September 25, 1998 (Registration No. 333-64319)).
10.10
Talbot Bancshares, Inc. Employee Stock Option Plan (incorporated by reference to Exhibit 10 of the Company’s Registration Statement on Form S-8 filed May 4, 2001 (Registration No. 333-60214)).
21
Subsidiaries of the Company (filed herewith).
23
Consent of Stegman & Company (filed herewith).
31.1
Certifications of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).
31.2
Certifications of the PAO pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).
32.1
Certification of the CEO pursuant to 18 U.S.C. § 1350 (furnished herewith).
32.2
Certification of the PAO pursuant to 18 U.S.C. § 1350 (furnished herewith).
99.1
Risk Factors (filed herewith).

 

61

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
     
  SHORE BANCSHARES, INC.
 
 		  
 		  
 
Date: March 16, 2005 By:   /s/ W. Moorhead Vermilye
 
  W. Moorhead Vermilye
President and CEO 
   
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
 
         
/s/ Herbert L. Andrew, III
  
Director
  
March 16, 2005
Herbert L. Andrew, III
        
         
/s/ Blenda W. Armistead
  
Director
  
March 16, 2005
Blenda W. Armistead
        
         
/s/ Lloyd L. Beatty, Jr.
  
Director
  
March 16, 2005
Lloyd L. Beatty, Jr.
        
         
/s/ Paul M. Bowman
  
Director
  
March 16, 2005
Paul M. Bowman
        
         
/s/ David C. Bryan
  
Director
  
March 16, 2005
David C. Bryan
 
      
         
/s/ Daniel T. Cannon
  
Director
  
March 16, 2005
Daniel T. Cannon
        
         
/s/ Thomas H. Evans
  
Director
  
March 16, 2005
Thomas H. Evans
        
         
 
  
Director
  
March 16, 2005
Steven F. Fulwood
        
         
/s/ Richard C. Granville
  
Director
  
March 16, 2005
Richard C. Granville
        
         
/s/ W. Edwin Kee, Jr.
 
Director
  
March 16, 2005
W. Edwin Kee
        
         
/s/ Neil R. LeCompte
  
Director
  
March 16, 2005
Neil R. Le Compte
        
         
/s/ Jerry F. Pierson
  
Director
  
March 16, 2005
Jerry F. Pierson
        
         
/s/ Christopher F. Spurry
  
Director
  
March 16, 2005
Christopher F. Spurry
        
 
/s/ W. Moorhead Vermilye
  
Director
  
March 16, 2005
W. Moorhead Vermilye
  
President/CEO
    
         
/s/ Susan E. Leaverton
  
Treasurer/
  
March 16, 2005
Susan E. Leaverton
  
Principal Accounting Officer
    
         
         

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EXHIBIT LIST


Exhibit No.
  
Description
     
Exhibit 3.1
  
Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 of the Company’s Form 8-K filed on December 14, 2000).
     
Exhibit 3.2
  
Amended and Restated By-Laws (incorporated by reference to Exhibit 3.2 of the Company’s Form 8-K filed on December 14, 2000).
     
Exhibit 10.1
  
Form of Employment Agreement with W. Moorhead Vermilye (incorporated by reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed on July 31, 2000).
     
Exhibit 10.2
  
Form of Employment Agreement with Daniel T. Cannon (incorporated by reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed on July 31, 2000).
     
Exhibit 10.3
  
Form of Employment Agreement between The Avon-Dixon Agency, LLC and Kevin P. LaTulip (incorporated by reference to Exhibit 10.3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).
     
Exhibit 10.4
  
Form of Executive Supplemental Retirement Plan Agreement between The Centreville National Bank of Maryland and Daniel T. Cannon (incorporated by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003).
     
Exhibit 10.5
  
Form of Life Insurance Endorsement Method Split Dollar Plan Agreement between The Centreville National Bank of Maryland and Daniel T. Cannon (incorporated by reference to Exhibit 10.5 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003).
     
Exhibit 10.6
  
Employment Agreement between The Avon-Dixon Agency, LLC and Steven Fulwood (incorporated by reference to Exhibit 10.6 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2004).
     
Exhibit 10.7
  
Employment Agreement between The Felton Bank and Thomas H. Evans (filed herewith).
     
Exhibit 10.8
  
1998 Employee Stock Purchase Plan, as amended (incorporated by reference to Appendix A of the Company’s definitive Proxy Statement on Schedule 14A for the 2003 Annual Meeting of Stockholders filed on March 31, 2003).
     
Exhibit 10.9
  
1998 Stock Option Plan (incorporated by reference to Exhibit 10 of the Company’s Registration Statement on Form S-8 filed with the SEC on September 25, 1998 (Registration No. 333-64319)).
     
Exhibit 10.10
  
Talbot Bancshares, Inc. Employee Stock Option Plan (incorporated by reference to Exhibit 10 of the Company’s Registration Statement on Form S-8 filed May 4, 2001 (Registration No. 333-60214)).
     
Exhibit 21
  
Subsidiaries of the Company (filed herewith).
     
Exhibit 23
  
Consent of Stegman & Company (filed herewith).
     
Exhibit 31.1
  
Certifications of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).
     
Exhibit 31.2
  
Certifications of the PAO pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).
     
Exhibit 32.1
  
Certification of the CEO pursuant to 18 U.S.C. § 1350 (furnished herewith).
     
Exhibit 32.2
  
Certification of the PAO pursuant to 18 U.S.C. § 1350 (furnished herewith).
     
Exhibit 99.1
  
Risk Factors (filed herewith).
     

       
       
63