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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 FISCAL YEAR ENDED DECEMBER 31, 2004
COMMISSION FILE NUMBER: 0-23971
CITIZENS SOUTH BANKING CORPORATION
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(Exact name of Registrant as specified in its Charter)
Delaware 54-2069979
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(State of Incorporation) (I.R.S. Employer Identification No.)
519 South New Hope Road, Gastonia, North Carolina 28054-4040
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(Address of principal executive office)
(704) 868-5200
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(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, $0.01 par value
(Title of Class)
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 twelve months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
requirements for the past 90 days. YES [X] NO [ ]
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 registrant's knowledge, in the definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendments to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Exchange Act Rule 12b-2) YES [X] NO [ ]
As of March 3, 2005, 7,313,044 shares of common stock, $0.01 par value,
were outstanding. As of March 3, 2005, the aggregate market value of the voting
stock held by non-affiliates was $80.6 million.
Documents Incorporated by Reference
PART III: Portions of the Definitive Proxy Statement dated April 4,
2005, as filed pursuant to Section 14 of the Securities Exchange Act of 1934 in
connection with the 2004 Annual Meeting of Shareholders.
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CITIZENS SOUTH BANKING CORPORATION
AND SUBSIDIARIES
FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
TABLE OF CONTENTS
PAGE
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Part I
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Item 1. Business...................................................................................... 1
Item 2. Properties.................................................................................... 8
Item 3. Legal Proceedings............................................................................. 9
Item 4. Submission of Matters to a Vote of Security Holders........................................... 9
Part II
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Item 5. Market for Registrant's Common Stock and Related Shareholder Matters.......................... 10
Item 6. Selected Financial Data....................................................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations......... 12
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................... 36
Item 8. Financial Statements and Supplementary Data................................................... 37
Independent Auditors' Report.................................................................. 37
Consolidated Statements of Financial Condition................................................ 38
Consolidated Statements of Operations......................................................... 39
Consolidated Statements of Comprehensive Income............................................... 40
Consolidated Statements of Changes in Stockholders Equity..................................... 41
Consolidated Statements of Cash Flows......................................................... 42
Notes to Consolidated Financial Statements.................................................... 43
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.......... 68
Item 9A. Controls and Procedures....................................................................... 68
Management's Annual Report on Internal Control over Financial Reporting....................... 68
Report of Independent Registered Public Accounting Firm....................................... 69
Item 9B. Other Information............................................................................. 70
Part III
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Item 10. Directors and Executive Officers of the Registrant............................................ 70
Item 11. Executive Compensation........................................................................ 70
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters.......................................................................... 70
Item 13. Certain Relationships and Related Transactions................................................ 70
Item 14. Principal Accountant Fees and Services........................................................ 70
Item 15. Exhibits, Financial Statement Schedules, and Reports on Forms 8-K............................. 71
Signatures
PART I
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ITEM 1. BUSINESS
CITIZENS SOUTH BANKING CORPORATION
Citizens South Banking Corporation (also referred to as the "Company",
the "Registrant", "We", "Us", or "Our") is a Delaware corporation that owns all
of the outstanding shares of common stock of Citizens South Bank (the "Bank").
The common stock of the Company trades on the Nasdaq National Market under the
ticker symbol "CSBC." The Company became the holding company for the Bank on
September 30, 2002, in connection with the mutual-to-stock conversion of
Citizens South Holdings, MHC, the mutual holding company (the "Mutual Holding
Company") of Citizens South Banking Corporation, a federal corporation
("Citizens Federal"), formerly named Gaston Federal Bancorp, Inc. As a result of
the mutual-to-stock conversion, the Company succeeded to all of the rights of
Citizens Federal. As part of the mutual-to-stock conversion, the Company sold
5,259,945 shares of common stock at $10.00 per share in a stock offering. The
shares sold represented the Mutual Holding Company's ownership interest in
Citizens Federal. Shares owned by stockholders of Citizens federal other than
the Mutual Holding Company received new shares of the Company. The net proceeds
of the stock offering were $45.5 million.
Management has been utilizing a number of strategies to leverage the
Company's excess capital and enhance shareholder value. These strategies are
discussed throughout this report and include: 1) constructing new full-service
offices in growth markets; 2) expanding into other financial-related business
fields; 3) pursuing the acquisition of existing branch offices; 4) growing the
retail and commercial banking segments of our business; and 5) patiently
pursuing the acquisition of other financial institutions or related businesses.
Also, as a part of the Company's capital management strategy, the Board has
authorized a stock repurchase program that is currently being executed by
management, and has approved the payment of cash dividends to the Company's
shareholders. These strategies are constantly being evaluated and modified as
necessary.
The Company's principal business activities are overseeing and directing
the business of the Bank and investing the net stock offering proceeds retained
by the Company. The Company's assets consist primarily of the outstanding
capital stock of the Bank, deposits held at the Bank, and investment securities.
The Company's executive office is located at 519 South New Hope Road, P.O. Box
2249, North Carolina 28053-2249. Its telephone number at this address is (704)
868-5200. The Company also maintains a website at www.citizenssouth.com that
includes important information on our Company, including a list of our products
and services, branch locations, current financial information, and links to the
Company's 1934 Securities Exchange Act filings with the SEC.
CITIZENS SOUTH BANK
Citizens South Bank is a federally chartered savings bank headquartered
in Gastonia, North Carolina. The Bank's principal business activity is offering
deposit accounts to local customers through its 11 branch offices and investing
those deposits, together with funds generated from operations and borrowings, in
residential and nonresidential real estate loans, construction loans, commercial
business loans, consumer loans, investment securities, and mortgage-backed
securities. The Bank also acts as a broker in both the origination of loans
secured by one-to-four family dwellings and in the sale of uninsured financial
products. The Bank's results of operations are heavily dependent on net interest
income, which is the difference between the interest earned on loans and
securities and the interest paid on deposits and borrowings. Results of
operations are also materially affected by the Bank's provision for loan losses,
gains or losses from the sales of assets, fee income generated from deposit and
loan accounts, commissions earned from the sale of uninsured investment
products, and noninterest expenses. The Bank's noninterest expense primarily
consists of compensation and employee benefits, occupancy expense, professional
services, advertising, and other noninterest expenses. Results of operations are
also significantly affected by general economic and competitive conditions,
changes in interest rates, and actions of regulatory and governmental
authorities.
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Citizens South Bank is the successor entity to Gaston Federal Bank,
which was established on December 31, 1904, as Gastonia Mutual Building and Loan
Association ("Gastonia Mutual") under a charter from the State of North
Carolina. Gastonia Mutual converted to a Federal charter and became Gaston
Federal Savings and Loan Association ("Gaston Federal") on June 10, 1981. On
April 30, 1982, Mount Holly Federal Savings and Loan Association merged into
Gaston Federal and on April 9, 1998, Gaston Federal reorganized and sold stock
and became Gaston Federal Bank, a wholly-owned subsidiary of Gaston Federal
Bancorp, Inc.
Citizens South Bank has 11 full-service branch offices in the North
Carolina Counties of Gaston, Rowan, and Iredell. The Bank's executive office is
located at 519 South New Hope Road, P.O. Box 2249, Gastonia, North Carolina
28053-2249. Its telephone number at this address is (704) 868-5200.
MARKET AREA AND COMPETITION
We consider our primary market area to be the North Carolina Counties of
Gaston, Rowan, Iredell, Mecklenburg, Cabarrus, Lincoln, and Cleveland, and the
South Carolina County of York. Our market area predominately centers in the
suburbs surrounding the metropolitan area of Charlotte, North Carolina. The
metropolitan area of Charlotte has a diverse economic base that includes
business sectors in banking and finance, insurance, manufacturing, textiles,
apparel, fabricated metals, construction, health care, transportation, retail
trade, telecommunications, government services, and education. The Bank's
corporate headquarters is located in Gastonia, North Carolina, which is located
in the I-85 corridor, approximately 20 miles west of Charlotte.
The Bank's corporate headquarters and six of its branch offices are
located in Gaston County, North Carolina. These offices are located in the
cities of Gastonia (four offices), Dallas, Mount Holly, and Stanley. According
to data provided by the FDIC as of June 30, 2004, there were 12 banks and
thrifts operating in Gaston County with $1.7 billion in deposits. As of June 30,
2004, the Bank had $186.1 million in deposits in Gaston County, or 10.7% of the
total County deposits. This represents the third highest market share in Gaston
County.
We also operate two branch offices in Rowan County, North Carolina,
which is approximately 60 miles northeast of the corporate headquarters. These
offices are located in the cities of Salisbury and Rockwell. According to data
provided by the FDIC as of June 30, 2004, there were 11 banks and thrifts
operating in Rowan County with $1.2 billion in deposits. As of June 30, 2004,
the Bank had $117.7 million in deposits in Rowan County, or 9.8% of the total
County deposits. This represents the fourth highest market share in the County.
We also have two branch offices in Iredell County, North Carolina, in
the cities of Statesville and Mooresville. These offices are approximately 60
miles north of the corporate office. According to data provided by the FDIC as
of June 30, 2004, there were 15 banks and thrifts operating in Iredell County
with $1.6 billion in deposits. As of June 30, 2004, the Bank had $70.0 million
in deposits in Iredell County, or 4.5% of the total County deposits. This
represents the eighth highest market share in the County.
EMPLOYEES
As of December 31, 2004, the Company had 104 full-time and nine
part-time employees, none of whom is represented by a collective bargaining
unit. The Company provides employee benefit programs, including an Employee
Stock Ownership Plan, matching contributions to a 401(k) retirement/savings
plan, group life, heath, and dental insurance, and paid vacation and sick leave.
Management believes its relationship with its employees is good.
SUPERVISION AND REGULATION
Citizens South Banking Corporation is a unitary savings and loan holding
company, subject to regulation and supervision by the Office of Thrift
Supervision ("OTS"). The OTS has enforcement authority over Citizens South
Banking Corporation and its non-savings institution subsidiaries. This authority
permits the OTS to restrict or prohibit activities that are determined to be a
risk to Citizens South Bank. Federal law prohibits a savings and loan holding
company from acquiring control of another savings institution or holding company
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thereof, without prior written approval of the OTS. It also prohibits the
acquisition or retention of, with specified exceptions, more than 5% of the
equity securities of a company engaged in activities that are not closely
related to banking or financial in nature or acquiring or retaining control of
an institution that is not federally insured. In evaluating applications by
holding companies to acquire savings institutions, the OTS must consider the
financial and managerial resources, future prospects of the savings institution
involved, the effect of the acquisition on the risk to the insurance fund, the
convenience and needs of the community and competitive factors.
Citizens South Bank is a federal savings bank and derives its lending
and investment powers from the Home Owners' Loan Act, as amended, and the
regulations of the OTS. Under these laws and regulations, Citizens South Bank
may invest in mortgage loans secured by residential and commercial real estate,
commercial business and consumer loans, certain types of debt securities and
certain other assets. Citizens South Bank also may establish subsidiaries that
may engage in activities not otherwise permissible for Citizens South Bank,
including real estate investment and securities and insurance brokerage.
Citizens South Bank is a federally chartered SAIF-insured stock savings bank,
subject to examination, supervision, and regulation by the OTS, as its primary
federal regulator, and the Federal Deposit Insurance Corporation ("FDIC"), as
the deposit insurer. Citizens South Bank is also a member of and owns stock in
the Federal Home Loan Bank of Atlanta, which is a part of the Federal Home Loan
Bank System. The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition in addition to obtaining regulatory approvals
prior to entering into certain transactions such as mergers or acquisitions.
This regulation and supervision establishes a comprehensive framework of
activities in which an institution may engage and is intended primarily for the
protection of the insurance fund and depositors. Under this system of federal
regulation, financial institutions are periodically examined to ensure that they
satisfy applicable standards with respect to their capital adequacy, assets,
management, earnings, liquidity and sensitivity to market interest rates.
Citizens South Bank is also regulated to a lesser extent by the Board of
Governors of the Federal Reserve System, governing reserves to be maintained
against deposits and other matters. Citizens South Bank's relationship with its
depositors and borrowers also is regulated to a great extent by both federal and
state laws, especially in matters concerning the ownership of deposit accounts
and the form and content of Citizens South Bank's loan documents.
The following discussion summarizes certain material elements of the
regulatory framework applicable to Citizens South Banking Corporation and its
subsidiaries. These summaries of statutes and regulations are not intended to be
complete and such summaries are qualified in their entirety by reference to such
statutes and regulations. A change in the statutes, regulations, or regulatory
policies applicable to the Company, or its subsidiaries, could have a material
effect on the business of the Company.
Standards for Safety and Soundness. Federal law requires each federal
banking agency to prescribe certain standards for all insured depository
institutions. These standards relate to, among other things, internal controls,
information systems and audit systems, loan documentation, credit underwriting,
interest rate risk exposure, asset growth, compensation, and other operational
and managerial standards as the agency deems appropriate. If the appropriate
federal banking agency determines that an institution fails to meet any standard
prescribed by the guidelines, the agency may require the institution to submit
to the agency an acceptable plan to achieve compliance with the standard. If an
institution fails to meet these standards, the appropriate federal banking
agency may require the institution to submit a compliance plan. The OTS has
primary enforcement responsibility over federal savings institutions and has the
authority to bring enforcement action against all "institution-affiliated
parties," including stockholders, and attorneys, appraisers and accountants who
knowingly or recklessly participate in wrongful action likely to have an adverse
effect on an insured institution. Formal enforcement action may range from the
issuance of a capital directive, a cease and desist order, removal of officers
and/or directors of the institution, receivership, conservatorship, civil
penalties, or the termination of deposit insurance. The FDIC also has the
authority to recommend to the Director of the OTS that enforcement action be
taken with respect to a particular savings institution. If action is not taken
by the Director, the FDIC has authority to take action under specified
circumstances.
OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2004, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings
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bank is placed in one of the following five categories based on the bank's
capital: 1) well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based
capital and 10% total risk-based capital); 2) adequately capitalized (at least
4% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based
capital); 3) undercapitalized (less than 8% total risk-based capital, 4% tier 1
risk-based capital or 3% leverage capital); 4) significantly undercapitalized
(less than 6% total risk-based capital, 3% tier 1 risk-based capital or 3%
leverage capital); and 5) critically undercapitalized (less than 2% tangible
capital). At December 31, 2004, Citizens South Bank met the criteria for being
considered "well-capitalized."
OTS regulations govern capital distributions by a federal savings bank,
which include cash dividends, stock repurchases and other transactions charged
to the capital account. A savings bank must file an application for approval of
a capital distribution if; (1) the total capital distributions for the
applicable calendar year exceed the sum of the savings bank's net income for
that year to date plus the savings bank's retained net income for the preceding
two years; (2) the bank would not be at least adequately capitalized following
the distribution; (3) the distribution would violate any applicable statute,
regulation, agreement or OTS-imposed condition; or (4) the savings bank is not
eligible for expedited treatment of its filings. Even if an application is not
otherwise required, every savings bank that is a subsidiary of a holding company
must still file a notice with the OTS at least 30 days before the board of
directors declares a dividend or approves a capital distribution. The OTS may
disapprove a notice or application if; (1) the savings bank would be
undercapitalized following the distribution; (2) the proposed capital
distribution raises safety and soundness concerns; or (3) the capital
distribution would violate a prohibition contained in any statute, regulation or
agreement.
Community Reinvestment Act and Fair Lending Laws. All savings banks have
a responsibility under the Community Reinvestment Act and related regulations of
the OTS to help meet the credit needs of their communities, including low- and
moderate-income neighborhoods. In connection with its examination of a federal
savings bank, the OTS is required to assess the savings bank's record of
compliance with the Community Reinvestment Act. In addition, the Equal Credit
Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in
their lending practices on the basis of characteristics specified in those
statutes. A bank's failure to comply with the provisions of the Community
Reinvestment Act could, at a minimum, result in regulatory restrictions on its
activities. The failure to comply with the Equal Credit Opportunity Act and the
Fair Housing Act could result in enforcement actions by the OTS, as well as
other federal regulatory agencies and the Department of Justice. Citizens South
Bank received a "Satisfactory" Community Reinvestment Act rating in its most
recent federal examination.
Transactions with Affiliates. A federal savings bank's authority to
engage in transactions with its "affiliates" is limited by OTS regulations and
by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term
"affiliates" for these purposes generally means any company that controls or is
under common control with an institution. Citizens South Banking Corporation and
its non-savings institution subsidiaries are affiliates of Citizens South Bank.
In general, transactions with affiliates must be on terms that are as favorable
to the savings bank as comparable transactions with non-affiliates. In addition,
certain types of these transactions are restricted to an aggregate percentage of
the savings bank's capital. Collateral in specified amounts must usually be
provided by affiliates in order to receive loans from the savings bank. In
addition, OTS regulations prohibit a savings bank from lending to any of its
affiliates that are engaged in activities that are not permissible for bank
holding companies and from purchasing the securities of any affiliate, other
than a subsidiary.
Citizens South Bank's authority to extend credit to its directors,
executive officers and 10% shareholders, as well as to entities controlled by
such persons, is currently governed by the requirements of Sections 22(g) and
22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other
things, these provisions require that extensions of credit to insiders (i) be
made on terms that are substantially the same as, and follow credit underwriting
procedures that are not less stringent than, those prevailing for comparable
transactions with unaffiliated persons and that do not involve more than the
normal risk of repayment or present other unfavorable features, and (ii) not
exceed certain limitations on the amount of credit extended to such persons,
individually and in the aggregate, which limits are based, in part, on the
amount of Citizens South Bank's capital. In addition, extensions of credit in
excess of certain limits must be approved by Citizens South Bank's Board of
Directors.
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Qualified Thrift Lender Test. As a federal savings bank, Citizens South
Bank is subject to a qualified thrift lender, or "QTL," test. Under the QTL
test, Citizens South Bank must maintain at least 65% of its portfolio assets in
qualified thrift investments in at least nine months of the most recent 12-month
period. Portfolio assets generally means total assets of a savings institution,
less the sum of specified liquid assets up to 20% of total assets, goodwill and
other intangible assets, and the value of property used in the conduct of the
savings bank's business. Qualified thrift investments includes various types of
loans made for residential and housing purposes, investments related to such
purposes, including certain mortgage-backed and related securities, and loans
for personal, family, household and certain other purposes up to a limit of 20%
of portfolio assets. Qualified thrift investments also include 100% of an
institution's credit card loans, education loans and small business loans.
Citizens South Bank also may satisfy the QTL test by qualifying as a "domestic
building and loan association" as defined in the Internal Revenue Code of 1986.
A savings bank that fails the qualified thrift lender test must either convert
to a bank charter or operate under specified restrictions. At December 31, 2004,
Citizens South Bank maintained approximately 70% of its portfolio assets in
qualified thrift investments.
Insurance of Deposit Accounts. Deposit accounts in Citizens South Bank
are insured by the Savings Association Insurance Fund of the Federal Deposit
Insurance Corporation, generally up to a maximum of $100,000 per separately
insured depositor. Citizens South Bank's deposits therefore are subject to FDIC
deposit insurance assessments. The FDIC has adopted a risk-based system for
determining deposit insurance assessments. The FDIC is authorized to raise the
assessment rates as necessary to maintain the required ratio of reserves to
insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay
assessments to the FDIC at an annual rate of approximately 0.015% of insured
deposits to fund interest payments on bonds maturing in 2017 issued by a federal
agency to recapitalize the predecessor to the Savings Association Insurance
Fund.
Federal Home Loan Bank System. Citizens South Bank is a member of the
Federal Home Loan Bank System ("FHLB"), which provides a central credit facility
primarily for member institutions. As a member of the FHLB of Atlanta, Citizens
South Bank is required to acquire and hold shares of capital stock in the FHLB
in an amount at least equal to 1% of the aggregate principal amount of its
unpaid residential mortgage loans and similar obligations at the beginning of
each year, or 1/20 of its borrowings from the FHLB, whichever is greater. As of
December 31, 2004, Citizens South Bank was in compliance with this requirement.
Federal Reserve System. The Federal Reserve Board regulations require
savings banks to maintain non-interest-earning reserves against their
transaction accounts, such as negotiable order of withdrawal and regular
checking accounts. At December 31, 2004, Citizens South Bank was in compliance
with these reserve requirements. The balances maintained to meet the reserve
requirements imposed by the Federal Reserve Board may be used to satisfy
liquidity requirements imposed by the Office of Thrift Supervision.
The Gramm-Leach-Bliley Financial Modernization Act of 1999. The
Gramm-Leach-Bliley Act ("G-L-B Act") was enacted in November 1999. The G-L-B Act
restricted unitary savings and loan holding companies to those activities
permissible for financial holding companies or for multiple savings and loan
holding companies. A financial holding company may engage in activities that are
financial in nature, including underwriting equity securities and insurance,
incidental to financial activities or complementary to a financial activity. A
multiple savings and loan holding company is generally limited to activities
permissible for bank holding companies under Section 4(c)(8) of the Bank Holding
Company Act, subject to the prior approval of the OTS, and certain additional
activities authorized by OTS regulations.
Sarbanes-Oxley Act of 2002. In July 2002, the President signed into law
the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), which implemented legislative
reforms intended to address corporate and accounting fraud. In addition to the
establishment of a new accounting oversight board that will enforce auditing,
quality control and independence standards and will be funded by fees from all
publicly traded companies, Sarbanes-Oxley places certain restrictions on the
scope of services that may be provided by accounting firms to their public
company audit clients. Any non-audit services being provided to a public company
audit client will require preapproval by the company's audit committee. In
addition, Sarbanes-Oxley makes certain changes to the requirements for audit
partner rotation after a period of time. Sarbanes-Oxley requires chief executive
officers and chief financial officers, or their equivalent, to certify to the
accuracy of periodic reports filed with
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the Securities and Exchange Commission, subject to civil and criminal penalties
if they knowingly or willingly violate this certification requirement. The
Company's Chief Executive Officer and Chief Financial Officer have signed
certifications to this Form 10-K as required by Sarbanes-Oxley. In addition,
under Sarbanes-Oxley, counsel will be required to report evidence of a material
violation of the securities laws or a breach of fiduciary duty by a company to
its chief executive officer or its chief legal officer, and, if such officer
does not appropriately respond, to report such evidence to the audit committee
or other similar committee of the board of directors or the board itself.
Under Sarbanes-Oxley, longer prison terms will apply to corporate
executives who violate federal securities laws; the period during which certain
types of suits can be brought against a company or its officers is extended; and
bonuses issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from trading the company's
securities during retirement plan "blackout" periods, and loans to company
executives (other than loans by financial institutions permitted by federal
rules and regulations) are restricted. In addition, a provision directs that
civil penalties levied by the Securities and Exchange Commission as a result of
any judicial or administrative action under Sarbanes-Oxley be deposited to a
fund for the benefit of harmed investors. The Federal Accounts for Investor
Restitution provision also requires the Securities and Exchange Commission to
develop methods of improving collection rates. The legislation accelerates the
time frame for disclosures by public companies, as they must immediately
disclose any material changes in their financial condition or operations.
Directors and executive officers must also provide information for most changes
in ownership in a company's securities within two business days of the change.
Sarbanes-Oxley also increases the oversight of, and codifies certain
requirements relating to audit committees of public companies and how they
interact with the company's "registered public accounting firm." Audit committee
members must be independent and are absolutely barred from accepting consulting,
advisory or other compensatory fees from the company. In addition, companies
must disclose whether at least one member of the committee is a "financial
expert" (as such term is defined by the Securities and Exchange Commission) and
if not, why not. Under Sarbanes-Oxley, a company's registered public accounting
firm is prohibited from performing statutorily mandated audit services for a
company if such company's chief executive officer, chief financial officer,
comptroller, chief accounting officer or any person serving in equivalent
positions had been employed by such firm and participated in the audit of such
company during the one-year period preceding the audit initiation date.
Sarbanes-Oxley also prohibits any officer or director of a company or any other
person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent accountant engaged in
the audit of the company's financial statements for the purpose of rendering the
financial statements materially misleading.
The USA PATRIOT Act. In response to the events of September 11, 2001,
the Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was signed
into law in October 2001. The USA PATRIOT Act gives the federal government new
powers to address terrorist threats through enhanced domestic security measures,
expanded surveillance powers, increased information sharing and broadened
anti-money laundering requirements. By way of amendments to the Bank Secrecy
Act, Title III of the USA PATRIOT Act takes measures intended to encourage
information sharing among bank regulatory agencies and law enforcement bodies.
Further, certain provisions of Title III impose affirmative obligations on a
broad range of financial institutions, including banks, thrifts, brokers,
dealers, credit unions, money transfer agents and parties registered under the
Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT
Act imposes the following requirements with respect to financial institutions:
1) all financial institutions must establish anti-money laundering programs that
include, at minimum: (i) internal policies, procedures, and controls; (ii)
specific designation of an anti-money laundering compliance officer; (iii)
ongoing employee training programs; and (iv) an independent audit function to
test the anti-money laundering program; 2) minimum standards must be established
with respect to customer identification at the time new accounts are opened; 3)
financial institutions that establish, maintain, administer, or manage private
banking accounts or correspondence accounts in the United States for non-United
States persons or their representatives (including foreign individuals visiting
the United States) to establish appropriate, specific, and, where necessary,
enhanced due diligence policies, procedures, and controls designed to detect and
report money laundering; 4) financial institutions are prohibited
6
from establishing, maintaining, administering or managing correspondent accounts
for foreign shell banks (foreign banks that do not have a physical presence in
any country), and will be subject to certain record keeping obligations with
respect to correspondent accounts of foreign banks and 5) bank regulators are
directed to consider a holding company's effectiveness in combating money
laundering when ruling on Federal Reserve Act and Bank Merger Act applications.
Federal Securities Laws. Citizens South Banking Corporation common stock
is registered with the Securities and Exchange Commission under the Securities
Exchange Act of 1934. Citizens South Banking Corporation is subject to the
information, proxy solicitation, insider trading restrictions and other
requirements under the Securities Exchange Act of 1934. Shares of common stock
purchased by persons who are not affiliates of Citizens South Banking
Corporation may be resold without registration. Shares purchased by an affiliate
of Citizens South Banking Corporation will be subject to the resale restrictions
of Rule 144 under the Securities Act of 1933. If Citizens South Banking
Corporation meets the current public information requirements of Rule 144 under
the Securities Act of 1933, each affiliate of Citizens South Banking Corporation
that complies with the other conditions of Rule 144, including those that
require the affiliate's sale to be aggregated with those of other persons, would
be able to sell in the public market, without registration, a number of shares
not to exceed, in any three-month period, the greater of 1% of the outstanding
shares of Citizens South Banking Corporation, or the average weekly volume of
trading in the shares during the preceding four calendar weeks. In the future,
Citizens South Banking Corporation may permit affiliates to have their shares
registered for sale under the Securities Act of 1933.
TAXATION
Federal. The Company and the Bank are subject to the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") in the same general
manner as other corporations. For federal income tax purposes, the Bank reports
its income and expenses on the accrual method of accounting and uses a tax year
ending December 31 for filing its federal income tax returns.
The Small Business Protection Act of 1996 (the "1996 Act") eliminated
the use of the reserve method of accounting for bad debt reserves by savings
institutions, effective for taxable years beginning after 1995. Prior to the
1996 Act, the Bank was permitted to establish a reserve for bad debts and to
make annual additions to the reserve. As a result of the 1996 Act, the Bank was
required to use the specific charge off method in computing its bad debt
deduction beginning with its 1996 federal tax return. In addition, the 1996 Act
required the recapture of the excess of tax bad debt reserves at September 30,
1996 over those established as of September 30, 1988. The reserve was recaptured
over a six-year period and was completely amortized as of December 31, 2004.
State of North Carolina. Under North Carolina law, the corporate income
tax is 7.0% of federal taxable income as computed under the Code, subject to
certain prescribed adjustments. In addition, an annual state franchise tax is
imposed at a rate of 0.15% applied to the greatest of the company's capital
stock, surplus and undivided profits, investment in tangible property in North
Carolina or 55% of the appraised valuation of property in North Carolina.
State of Delaware. Delaware franchise taxes are imposed on the Company.
Two methods are provided for calculating the tax and the lesser tax is payable.
The first method is based on the authorized number of shares. The tax under this
method is $90.00 for the first 10,000 authorized number of shares plus $50.00
for each additional 10,000 shares or part thereof. The second method is based on
an assumed par value capital. The tax rate under this method is $200 per
$1,000,000 or portion thereof of assumed par value capital. Assumed par is
computed by dividing total assets by total issued shares (including treasury
shares). Assumed par value capital is calculated by multiplying the lesser of
assumed par or stated par value by total authorized shares.
7
ITEM 2. PROPERTIES
The following table sets forth certain information regarding offices
currently in operation at December 31, 2004. Management considers the facilities
to be well maintained and sufficiently suitable for present operations. The net
book value of the properties, including land, building, and improvements, net of
accumulated depreciation was $13.5 million at December 31, 2004.
Approximate Owned
Location Principal Use Facility Size or Leased
- --------------------------------------- ---------------------- ------------- ---------
(square feet)
519 South New Hope Road Headquarters and 22,400 Owned
Gastonia, North Carolina 28054-4040 Banking Office
245 West Main Avenue Banking Office and 12,400 Owned
Gastonia, North Carolina 28052-4140 Back Office Processing
1630 East Franklin Boulevard Hispanic Banking 180 Leased
Gastonia, North Carolina 28054-4747 Office
233 South Main Street Banking Office 2,370 Owned
Mount Holly, North Carolina 28120-1620
1670 Neal Hawkins Road Banking Office and 5,320 Owned
Gastonia, North Carolina 28056-6429 Mortgage Center
3135 Dallas High Shoals Highway Banking Office 3,225 Owned
Dallas, North Carolina 28034-1307
412 South Highway 27 Banking Office 3,225 Owned
Stanley, North Carolina 28164-2055
401 West Innes Street Banking Office 5,560 Owned
Salisbury, North Carolina 28144-4232
106 West Main Street Banking Office 1,500 Owned
Rockwell, North Carolina 28138-8859
307 North Center Street Banking Office and 8,260 Owned
Statesville, North Carolina 28677-4063 Leased Space
649 Brawley School Road Banking Office 3,800 Owned
Mooresville, North Carolina 28177-9121
8
ITEM 3. LEGAL PROCEEDINGS
Periodically, there have been various claims and lawsuits involving the
Company or the Bank, such as claims to enforce liens, condemnation proceedings
on properties in which we hold security interests, claims involving the making
and servicing of real property loans and other issues incident to our business.
We are not a party to any pending legal proceedings that we believe would have a
material adverse effect on the financial condition, operations, or cash flows of
the Company or the Bank.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the
fourth quarter of 2004.
9
PART II
- -------
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK, RELATED STOCKHOLDER MATTERS,
AND PURCHASES OF EQUITY SECURITIES
The Company's common stock, $0.01 par value, trades on the Nasdaq
National Market under the symbol CSBC. Price and volume information is contained
in The Wall Street Journal and other daily newspapers in the Nasdaq section
under the National Market System listings. As of February 1, 2005, the Company
had 1,234 stockholders of record (excluding the number of persons or entities
holding stock in street name through various brokerage firms), and 7,432,144
shares outstanding. The following brokers made a market in the Company's stock
during 2004:
Citigroup Global Markets, Inc. 1-800-223-7743
Fig Partners, LLC 1-404-601-7200
Friedman, Billings, Ramsey & Co. 1-800-688-3272
FTN Midwest Securities Corp. 1-800-880-7264
Goldman, Sachs & Co. 1-212-902-1000
Hill, Thompson, Magid and Co. 1-800-631-3083
Keefe, Bruyette & Woods, Inc. 1-800-342-5529
Knight Equity Markets, L.P. 1-800-222-4910
McDonald Investments (Trident) 1-404-495-2050
Merrill Lynch, Pierce, Fenner 1-800-937-0501
Moors & Cabot, Inc. 1-800-723-9866
Morgan Stanley & Co., Inc. 1-800-223-6559
Ryan Beck & Co., Inc. 1-800-325-7926
Sandler O'Neill & Partners 1-212-466-8020
UBS Capital Markets L.P. 1-212-804-3437
The following table sets forth quarterly market sales price ranges,
dividend information, and repurchase activity for the Company's common stock
over the past two years.
2004 QUARTER 1 QUARTER 2 QUARTER 3 QUARTER 4
- ------------------------------ ---------- ---------- ---------- ----------
Price Range
High $ 14.40 $ 13.74 $ 13.27 $ 14.27
Low 13.37 12.60 12.41 12.41
Dividend 0.065 0.065 0.065 0.065
Shares Repurchased 242,000 909,438 70,000 20,000
Avg. Price Paid Per Share $ 13.64 $ 13.03 $ 12.98 $ 12.69
2003 Quarter 1 Quarter 2 Quarter 3 Quarter 4
- ------------------------------ ---------- ---------- ---------- ----------
Price Range
High $ 11.89 $ 13.71 $ 15.24 $ 15.15
Low 10.04 11.99 12.90 13.70
Dividend 0.06 0.06 0.06 0.06
Shares Repurchased 0 210,000 132,200 353,235
Avg. Price Paid Per Share $ 0.00 $ 12.98 $ 14.76 $ 14.51
10
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain information concerning the
financial position of Citizens South Banking Corporation and its subsidiaries as
of and for the dates indicated. The consolidated data is derived from, and
should be read in conjunction with the Consolidated Financial Statements of the
Company and its subsidiaries and related notes presented in Item 8.
AT AND FOR THE TWELVE MONTHS ENDED DECEMBER 31,
--------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
(Dollars in thousands, except per share data) (unaudited)
Income Statement Data:
Interest income ............................................ $ 21,110 $ 21,969 $ 24,716 $ 16,382 $ 16,833
Interest expense ........................................... 7,943 8,732 10,195 9,770 9,684
---------- ---------- ---------- ---------- ----------
Net interest income ........................................ 13,167 13,237 14,521 6,612 7,149
Provision for loan losses .................................. 330 60 225 120 53
---------- ---------- ---------- ---------- ----------
Net interest income after provision for loan losses ........ 12,837 13,177 14,296 6,492 7,096
Noninterest income ......................................... 4,824 5,561 4,121 3,006 2,473
Noninterest expense ........................................ 13,629 13,891 11,381 7,092 6,975
---------- ---------- ---------- ---------- ----------
Income before income taxes ................................. 4,032 4,847 7,036 2,406 2,594
Income tax expense ......................................... 1,077 1,456 2,528 702 846
---------- ---------- ---------- ---------- ----------
Net income ................................................. $ 2,955 $ 3,391 $ 4,508 $ 1,704 $ 1,748
========== ========== ========== ========== ==========
Per Share Data (1):
Basic net income ........................................... $ 0.39 $ 0.39 $ 0.51 $ 0.20 $ 0.20
Diluted net income ......................................... 0.38 0.39 0.51 0.20 0.20
Cash dividends declared .................................... 0.26 0.24 0.16 0.14 0.11
Period-end book value ...................................... 9.74 10.11 10.64 4.62 4.40
Balance Sheet Data:
Total assets ............................................... $ 508,961 $ 495,751 $ 492,873 $ 447,581 $ 252,750
Loans receivable, net ...................................... 314,127 295,026 299,906 334,321 158,820
Mortgage-backed and related securities ..................... 81,169 89,168 70,409 25,405 22,955
Investment securities ...................................... 52,407 56,233 39,594 25,946 32,822
Deposits ................................................... 374,744 342,446 340,862 353,692 167,931
Borrowings ................................................. 55,772 58,981 47,575 42,057 42,737
Stockholders' equity ....................................... 72,394 87,669 96,383 41,630 39,763
Performance Ratios:
Return on average assets ................................... 0.59% 0.68% 0.98% 0.65% 0.71%
Return on average equity ................................... 3.78 3.61 7.61 4.17 4.46
Avg. interest-earning assets to avg. interest-bearing
liabilities ............................................... 110.96 118.65 109.19 116.08 117.85
Noninterest expense to average total assets ................ 2.81 2.81 2.48 2.70 2.85
Interest rate spread ....................................... 2.78 2.57 3.26 2.05 2.34
Net interest margin (2) .................................... 2.63 2.67 3.17 2.52 2.92
Asset Quality Ratios:
Allowance for loan losses to total loans at the end of
period .................................................... 0.95% 1.00% 0.99% 0.93% 0.97%
Nonperforming loans to total loans ......................... 0.30 0.18 0.17 0.35 0.30
Nonperforming assets to total assets ....................... 0.34 0.14 0.37 0.59 0.19
Capital Ratios:
Average equity to average total assets ..................... 15.64% 18.96% 12.93% 15.55% 16.02%
Equity to assets at period end ............................. 14.22 17.68 19.56 9.30 15.73
Dividend payout ratio (1) (3) ............................. 66.67 61.54 31.37 70.00 55.00
(1) All per share data for periods prior to September 30, 2002, has been
adjusted to reflect the exchange ratio of 2.1408-to-1 in conjunction with
the Company's stock offering.
(2) Net interest margin is calculated by dividing net interest income by average
assets for the period.
(3) Dividend payout ratio is calculated by dividing cash dividends per share
declared for the period by net income per share for the period. Citizens
South Holdings, MHC, the former mutual holding company for Citizens South
Banking Corporation, began waiving dividends in August 2000 and as of
September 30, 2002, had waived dividends totaling approximately $1.8
million. The MHC owned between 53% and 58% of the outstanding common stock
of the Company during the period in which the dividends were waived.
11
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Citizens South Banking Corporation (the "Company") is a Delaware
corporation that owns all of the outstanding shares of common stock of Citizens
South Bank (the "Bank"), a federally chartered savings bank headquartered in
Gastonia, North Carolina. The Company's principal business activities are
overseeing and directing the business of the Bank and investing the net stock
offering proceeds retained by the Company. The Company's assets consist
primarily of the outstanding capital stock of the Bank, deposits held at the
Bank, and investment securities. The Bank's principal business activity is
offering FDIC-insured deposit accounts to local customers through its eleven
branch offices and investing those deposits, together with funds generated from
operations and borrowings, in residential and nonresidential real estate loans,
construction loans, commercial business loans, consumer loans, investment
securities, and mortgage-backed securities. The Bank also acts as a broker in
both the origination of loans secured by one-to-four family dwellings and in the
sale of uninsured financial products (see Item 1. "Business" of this report).
Our primary business strategy since our initial public stock offering in
1998 has been to transform the Bank from a traditional retail savings bank to a
full-service community bank, offering a complete array of both commercial and
retail loan and deposits, wealth management services, mortgage banking
activities, brokerage services, and other related financial services. In
executing this strategy, the Company has 1) concentrated much of its lending
efforts on nonresidential real estate and construction loans, 2) originated
substantially all fixed rate one-to-four family residential loans as a broker
for a third party, and 3) focused its deposit gathering efforts on core deposits
(demand deposit accounts, money market accounts, and savings accounts). As a
result, nonresidential real estate and construction loans comprised
approximately 44% of the Company's loan portfolio at December 31, 2004, compared
to approximately 11% at December 31, 2000. Also, during the same period, the
Company's portfolio of one-to-four family residential loans decreased from 68%
of the Company's loan portfolio at December 31, 2000, to 29% of the Company's
loan portfolio at December 31, 2004. Core deposits have increased as a
percentage of total deposits from approximately 34% at December 31, 2002 to
approximately 43% at December 31, 2004. Management expects to continue to
execute this business strategy in 2005.
On September 30, 2002, the Company completed its mutual-to-stock
conversion and related stock offering, resulting in an equity to assets ratio of
19.56% at December 31, 2002. In order to properly leverage the Company's capital
position, the Company has executed a number of strategies including 1)
repurchasing Company stock at prices that are considered attractive, 2) paying
dividends on outstanding stock, 3) building new banking offices in areas that
the Company believes improves the value of the franchise, and 4) patiently
pursuing acquisitions of other financial institutions or related companies. As
of December 31, 2004, the Company had repurchased a total of 1,945,435 shares,
or 21.5% of the outstanding shares of common stock, at an average price of
$13.48. As a result of the execution of these capital management strategies, the
Company's equity to assets ratio was 14.22% at December 31, 2004. Management
plans to continue to execute these strategies until the Company's capital is
appropriately leveraged.
The Bank's results of operations are heavily dependent on net interest
income, which is the difference between the interest earned on loans and
securities and the interest paid on deposits and borrowings. Results of
operations are also materially affected by the Bank's provision for loan losses,
gains or losses from the sales of assets, fee income generated from deposit and
loan accounts, commissions earned from the sale of uninsured investment
products, and noninterest expenses. The Bank's noninterest expense primarily
consists of compensation and employee benefits, occupancy expense, professional
services, advertising, and other noninterest expenses. Results of operations are
also significantly affected by general economic and competitive conditions,
changes in interest rates, and actions of regulatory and governmental
authorities.
Net income was $3.0 million, or $0.38 per diluted share, for the year
ended December 31, 2004, compared to $3.4 million, or $0.39 per diluted share,
for the year ended December 31, 2003. The earnings provided a return on average
equity of 3.78% in 2004, compared to 3.61% in 2003, and a return on average
assets of 0.59% in 2004, compared to 0.68% in 2003.
12
Certain actions have been taken have adversely impacted our results of
operations for the years ended December 31, 2004 and 2003. Specifically, during
2003, we recognized a $1.3 million pre-tax prepayment penalty associated with
the restructuring of $15.0 million in borrowed funds. This action was taken by
the Company in an effort to capitalize on historically low interest rates, lower
the Company's cost of funds, and improve the Company's net interest margin. This
restructuring reduced the average interest rate paid on these borrowed funds
from 5.8% to 1.8%, resulting in an immediate reduction in interest expense of
$150,000 per quarter for the first year. The reduction in interest expense is
expected to amount to approximately $1.7 million over the next five years. Also,
during 2004, we determined that unrealized losses on $2.0 million in perpetual
preferred stock issued by Fannie Mae and $2.0 million in perpetual preferred
stock issued by Freddie Mac were "other-than-temporary" impairments. As a
result, management recorded a noncash, pretax loss of $983,000. The unrealized
losses on these securities were considered to be "other-than-temporary" by
management for the following reasons: 1) both Fannie Mae and Freddie Mac have
experienced recent accounting irregularities that have resulted in restated
financial results from prior periods; 2) the yield on perpetual preferred stock
recently issued by Fannie Mae is much higher than the yield of the preferred
stock held by the Company, which decreases the value of the Company's security;
3) the preferred stock for Fannie Mae was recently downgraded and the preferred
stock for both Companies are on a negative watch list; 4) the Freddie Mac
preferred stock repriced in December 2004, yet it continued to have significant
unrealized losses at year end; 5) neither of the preferred stock issues have
stated maturity dates, so the recovery of the unrealized losses is not expected
to occur in the foreseeable future. The credit issues facing Fannie Mae and
Freddie Mac only impact the performance of the Company's perpetual preferred
stock. The Company does not have any other perpetual preferred stock on its
books at December 31, 2004.
Management's Discussion and Analysis is provided to assist in
understanding and evaluating the results of operations and financial condition
of the Company and its subsidiaries. The following discussion should be read in
conjunction with the consolidated financial statements and related notes
included in Item 8. of this report.
FORWARD-LOOKING STATEMENTS
This report may contain certain "forward-looking statements" that
represent the Company's expectations or beliefs concerning future events. Such
forward-looking statements are about matters that are inherently subject to
certain risks and uncertainties that could cause actual results to differ
materially from those projected in the forward-looking statements. Factors that
could cause such a difference include, but are not limited to, the timing and
amount of revenues that may be recognized by the Company, continuation of
current revenue and expense trends (including trends affecting chargeoffs and
provisions for loan losses), unforeseen changes in the Company's markets, legal
and regulatory changes, and general changes in the economy. Because of the risks
and uncertainties inherent in forward-looking statements, readers are cautioned
not to place undue reliance on these statements. The Company assumes no
obligation to update or revise these forward-looking statements to reflect
events or circumstances that occur after the date of this report. Readers should
carefully review the risk factors described in other documents the Company files
from time to time with the SEC, including annual reports on Form 10-K, quarterly
reports on Form 10-Q, and current reports on Form 8-K.
CRITICAL ACCOUNTING POLICIES
The accounting and financial policies of the Company and its
subsidiaries are prepared in accordance with accounting principles generally
accepted in the United States and conform to general practices in the banking
industry. We consider accounting policies that require significant judgment and
assumptions by management that have, or could have, a material impact on the
carrying value of certain assets or on income to be critical accounting
policies. Changes in underlying factors, assumptions or estimates could have a
material impact on our future financial condition and results of operations.
Based on the size of the item or significance of the estimate, the following
accounting policies are considered critical to our financial results.
13
Allowance for Loan Losses. The allowance for loan losses is calculated
with the objective of maintaining an allowance sufficient to absorb estimated
probable loan losses. Management's determination of the adequacy of the adequacy
of the allowance is based on quarterly evaluations of the loan portfolio and
other relevant factors. However, this evaluation is inherently subjective, as it
requires an estimate of the loss for each type of loan and for each impaired
loan, an estimate of the amounts and timing of expected future cash flows, and
an estimate of the value of the collateral.
Management has established a systematic method for periodically
evaluating the credit quality of the loan portfolio in order to establish an
allowance for loan losses. The methodology is set forth in a formal policy and
includes a review of all loans in the portfolio on which full collectibility may
or may not be reasonably assured. The loan review considers among other matters,
the estimated fair value of the collateral, economic conditions, historical loan
loss experience, our knowledge of inherent losses in the portfolio that are
probable and reasonable estimable and other factors that warrant recognition in
providing an appropriate loan loss allowance. Specific allowances are
established for certain individual loans that management considers impaired
under Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting
by Creditors for Impairment of a Loan." The remainder of the portfolio is
segmented into groups of loans with similar risk characteristics for evaluation
and analysis. In originating loans, we recognize that losses will be experienced
and that the risk of loss will vary with, among other things, the type of loan
being made, the creditworthiness of the borrower, the term of the loan, general
economic conditions, and in the case of a secured loan, the quality of the
collateral. We increase our allowance for loan losses by charging provisions for
loan losses against our current period income. Management's periodic evaluation
of the adequacy of the allowance is consistently applied and is based on our
past loan loss experience, particular risks inherent in the different kinds of
lending that we engage in, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral, current
economic conditions, and other relevant internal and external factors that
affect loan collectibility. Management believes this is a critical accounting
policy because this evaluation involves a high degree of complexity and requires
us to make subjective judgments that often require assumptions or estimates
about various matters.
Other-Than-Temporary Impairment of Securities. We have historically
reviewed investment securities with significant declines in fair value for
potential other-than-temporary impairment pursuant to the guidance provided by
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Effective December 31, 2004, management determined that unrealized
losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and
$2.0 million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000. The unrealized losses on these securities were
considered to be "other-than-temporary" by management for the following reasons:
1) both Fannie Mae and Freddie Mac have experienced recent accounting
irregularities that have resulted in restated financial results from prior
periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae
is much higher than the yield of the preferred stock held by the Company, which
decreases the value of the Company's security; 3) the preferred stock for Fannie
Mae was recently downgraded and the preferred stock for both Companies are on a
negative watch list; 4) the Freddie Mac preferred stock repriced in December
2004, yet it continued to have significant unrealized losses at year end; 5)
neither of the preferred stock issues have stated maturity dates, so the
recovery of the unrealized losses is not expected to occur in the foreseeable
future. The credit issues facing Fannie Mae and Freddie Mac only impact the
performance of the Company's perpetual preferred stock. The Company did not own
any other perpetual preferred stock at December 31, 2004.
14
COMPARISON OF FINANCIAL CONDITION FOR THE YEARS ENDED DECEMBER 31, 2004
AND 2003
Total assets increased by $13.2 million, or 2.7%, from $495.8 million at
December 31, 2003, to $509.0 million at December 31, 2004. Most of this asset
growth was funded from a $32.3 million increase in deposits, the effects of
which were partly offset by a $3.3 million decrease in borrowed money and stock
repurchases totaling $16.4 million.
Cash and cash equivalents increased by $3.4 million, or 41.1%, from $8.2
million at December 31, 2003, to $11.6 million at December 31, 2004. This
increase in cash and cash equivalents was primarily the result of deposit growth
of $32.3 million, a $3.8 million decrease in investment securities, an $8.0
million decrease in mortgage-backed securities, and earnings of $3.0 million,
the effects of which were partly offset by a $19.1 million increase in net
loans, $16.4 million in stock repurchases, a $3.3 million decrease in borrowed
money, $2.0 million in dividend payments, and $3.7 million in building and
improvements. Investment securities decreased by $3.8 million, or 6.8%, from
$56.2 million at December 31, 2003, to $52.4 million at December 31, 2004. This
decrease was the result of $22.4 million in maturities and calls of investments,
$1.8 million in sales of investment securities, and the purchase of $20.3
million in investments during 2004. Management expects that fewer investment
securities will be called during 2005 due to the recent increase in short-term
interest rates. Mortgage-backed securities decreased by $8.0 million, or 9.0%,
from $89.2 million at the end of 2003, to $81.2 million at the end of 2004. This
decrease was primarily due to the maturity and principal amortization of $22.7
million of mortgage-backed securities, the sale of $6.4 million of
mortgage-backed securities, and the purchase of $21.3 million of mortgage-backed
securities during the year. Management expects that the principal amortization
of its mortgage-backed securities portfolio will decrease in 2005 if an expected
increase in mortgage loan interest rates occurs during the year. Management
plans to reinvest the proceeds received from investment and mortgage-backed
securities into higher-yielding commercial and consumer loans as cash flows are
generated from these investments through maturities and principal and interest
payments.
Net outstanding loans increased by $19.1 million, or 6.5%, from $295.0
million at December 31, 2003, to $314.1 million at December 31, 2004. Management
continues to emphasize the origination of shorter-term commercial and consumer
loans in order to reduce the Company's vulnerability to rising interest rates.
During 2004, these loans, which include construction loans, multifamily
residential loans, nonresidential real estate loans, consumer loans, and
commercial business loans, increased by $30.3 million, or 15.5%, to $225.5
million at December 31, 2004. Also during 2004, the Company's portfolio of
one-to-four family residential loans decreased from $102.8 million to $91.7
million. This decrease of $11.1 million, or 10.8%, was primarily due to the high
level of mortgage loan refinancings during 2004 resulting from continued low
mortgage interest rates. The Company originates and closes substantially all new
fixed-rate one-to-four family residential loans as a broker for an independent
third party on a servicing-released basis. This generates additional fee income
and reduces the potential adverse effects of rising interest rates on the
Company's future earnings that normally result from holding long-term fixed-rate
loans. Management expects that in 2005 the Company's portfolio of one-to-four
family dwelling loans will stabilize while the remaining loan portfolio
continues to experience strong growth due to the recent expansion into the
Cornelius, North Carolina market with a loan production office and the continued
strong local economy of the Charlotte metropolitan area.
Also during 2004, the Company completed the construction of its new
corporate office in Gastonia, North Carolina, which resulted in the
consolidation and sale of an existing office, opened a Hispanic banking office
in Gastonia, and upgraded its computer system in order to offer check imaging,
online banking, cash management services, and document imaging. As a result,
premises and equipment increased by $2.4 million, or 16.2%, to $17.4 million at
December 31, 2004. The Company plans to complete construction of its twelfth
banking office, to be located in Belmont, North Carolina, during the third
quarter of 2005 and plans to enter into the York County, South Carolina market
in 2006.
Total liabilities increased by $28.5 million, or 7.0%, from $408.1
million at December 31, 2003, to $436.6 million at December 31, 2004. This
increase was primarily due to a $32.3 million increase in deposits, the effects
of which were offset by a $3.3 million decrease in borrowed money. Total
deposits increased from $342.4 million at December 31, 2003, to $374.7 million
at December 31, 2004. This represents an increase of $32.3 million, or 9.4%,
during 2004. The majority of the increase in deposits came from core deposits,
15
which management considers to be checking accounts, money market accounts, and
savings accounts. The Company's core deposits increased by $31.2 million, or
24.2%, to $159.7 million at December 31, 2004. This increase in core deposits
reflects management's commitment to building new and enhancing existing customer
relationships through improving technology and an expanding branch network.
Certificates of deposit, which tend to be more transactional in nature and are a
higher-costing source of funds compared to core deposits, increased by $1.2
million, or 0.5%, to $215.0 million at December 31, 2004. Borrowed money
decreased by $3.3 million, or 5.7%, due to normal maturities of advances.
Management will continue to use borrowed money in the future to fund any
liquidity needs that may arise.
Total stockholders' equity decreased by $15.3 million, or 17.4%, from
$87.7 million at December 31, 2003 to $72.4 million at December 31, 2004. This
decrease was primarily due to the repurchase of 1,250,000 shares of common stock
for $16.4 million at an average price of $13.12 per share. These shares were
repurchased as a part of stock repurchase plans announced in October 2003 and
May 2004. The plan announced in October 2003 provided for the repurchase of
879,900 shares of stock, or approximately 10% of the outstanding shares. All of
the shares authorized under this plan were repurchased by May 2004. The May 2004
repurchase plan provides for the repurchase of up to 815,000 shares of stock, or
approximately 10% of the outstanding shares. As of December 31, 2004, the
Company had repurchased 726,000 shares under the plan and had 89,000 shares
remaining to be repurchased. Management plans to continue to repurchase shares
of common stock in the Company at prices that are considered to be attractive
and in the best interests of both the Company and its stockholders.
Total stockholders' equity also decreased in 2004 as a result of the
payment of $2.0 million in cash dividends, or $0.26 per share, and a $379,000
increase in accumulated net unrealized losses on investments available for sale.
These decreases were partly offset by $3.0 million in net income and $281,000 in
vesting of stock issued under the Citizens South Banking Corporation 2003
Recognition and Retention Plan which is described in more detail in "Note 12 -
Employee Benefit Plans" under Item 8. of this report.
RESULTS OF OPERATIONS
The following discussion relates to operations for the year ended
December 31, 2004, compared to the year ended December 31, 2003, as well as the
year ended December 31, 2003, compared to the year ended December 31, 2002. The
net income of the Company is heavily dependent upon net interest income. Net
interest income is the difference between the interest earned on loans,
investment and mortgage-backed securities, and interest-bearing deposits in
other banks, offset by the interest paid on deposits and borrowings.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31,
2004 AND 2003
Net income was $3.0 million, or $0.38 per diluted share, for the year
ended December 31, 2004, compared to $3.4 million, or $0.39 per diluted share,
for the year ended December 31, 2003. The earnings provided a return on average
equity of 3.78% in 2004, compared to 3.61% in 2003, and a return on average
assets of 0.59% in 2004, compared to 0.68% in 2003.
Net interest income, the Company's largest source of income, decreased
slightly in 2004 by $70,000, or 0.5%. This decrease was due in part to the
declining ratio of average interest-earning assets to average interest-bearing
liabilities during 2004. The Company's ratio of average interest-earning assets
to average interest-bearing liabilities decreased from 118.65% in 2003 to
110.96% in 2004 due primarily from the repurchase of 1,250,000 shares of common
stock for $16.4 million. This also contributed to a slight decrease in the
Company's net interest margin from 2.67% in 2003 to 2.63% in 2004. However, the
spread between the yield on interest-earning assets and the cost of
interest-bearing liabilities has improved by 21 basis points from 2.57% in 2003
to 2.78% in 2004. This increase was largely due to a series of 25 basis point
increases in the federal funds rate by the Federal Reserve Board that resulted
in a 1.25% increase in the prime-lending rate during the year to 5.25% at
December 31, 2004. Approximately 57% of the Company's loan portfolio reprices
each month, the majority of which are tied to the prime lending rate. As such,
management believes that the Company's net interest margin and resulting net
interest income will improve in 2005, if short-term interest rates continue to
increase, prepayments on loans and mortgage-backed securities slow to more
normalized levels, and loan demand improves. However, if short-term interest
rates decline, loan prepayments accelerate, or loan demand slows, management's
expectations for 2005 may not be realized.
16
Interest income for the year ended December 31, 2004, decreased by
$859,000, or 3.9%, to $21.1 million. This decrease was primarily due to a
$682,000, or 4.1%, reduction in interest income on loans. During the year,
average outstanding loans decreased by $2.9 million, or 1.0%, from $297.5
million to $294.6 million, while the average yield on loans decreased from 5.7%
to 5.5%. These changes were primarily the result of a continued high level of
loan prepayments and refinancings that reduced both yields and outstanding
balances. The reduction in average outstanding loans was primarily concentrated
in the Company's portfolio of one-to-four family residential loans due to the
fact that the Company originates and closes substantially all new fixed-rate
residential loans as a broker for an independent third party. This reduces the
Company's vulnerability to increases in interest rates and provides current
period fee income. During 2004 loans secured by one-to-four family residences
decreased by $11.1 million, or 10.8%, to $91.7 million at December 31, 2004,
while the remaining loan portfolio, which consists of construction loans,
multifamily residential loans, commercial real estate loans, commercial business
loans and consumer loans, increased by $30.3 million, or 15.5%, to $225.5
million at December 31, 2004. The Company has expanded into the high growth
market of Cornelius, North Carolina with a loan production office and has
recently hired three additional commercial lenders and one additional mortgage
loan originator. Management believes that these actions, coupled with the recent
increases in the prime lending rate, will improve the level of outstanding loans
and the yield on the loan portfolio in 2005.
Interest earned on interest-bearing bank balances decreased by $107,000,
or 43.0%, to $142,000 in 2004. The average balance of interest-bearing bank
balances decreased by $11.2 million, or 49.3%, to $11.6 million. These funds
were primarily used to repurchase stock and purchase higher yielding investment
securities. The average yield on these interest-earning bank balances increased
slightly from 1.09% in 2003 to 1.22% in 2004. Interest earned on investment
securities increased by $410,000, or 27.4%, to $1.9 million in 2004. This
increase in interest income was primarily due to a $15.7 million, or 40.8%,
increase in the average outstanding balance of investment securities. These
additional securities were funded primarily by deposit growth and existing
interest-bearing bank balances. The average yield on investment securities
decreased by 37 basis points to 3.51% for 2004 due to the historically low
levels of short-term interest rates during 2004. Interest income from
mortgage-backed securities decreased by $480,000, or 14.0%, to $2.9 million in
2004. This decrease was largely due to a $9.9 million, or 10.8%, decrease in the
average balance of mortgage-backed securities during 2004, resulting in part
from the sale of $6.4 million of mortgage-backed securities during the year.
These proceeds were used, in part, to repurchase shares of the Company's common
stock in the Company. Also, during 2004, the average yield on mortgage-backed
securities decreased from 3.73% to 3.59%, due in part to higher prepayment
levels resulting from attractive mortgage interest rates during the year.
Management expects the levels of investment and mortgage-backed securities will
decline during 2005, with the proceeds of any sales, maturities, and normal
amortization, to be used to fund additional loan originations and stock
repurchases.
Interest expense for the year ended December 31, 2004 decreased
$789,000, or 9.0%, to $7.9 million. This decrease was due to a $374,000, or
5.8%, decrease in interest expense on deposits and a $415,000, or 18.6%,
decrease in interest expense on borrowed funds. Average interest-bearing
deposits increased $17.0 million, or 5.2%, to $345.7 million at December 31,
2004. Most of this increase was attributable to a $13.6 million increase in
average core deposits, which includes checking accounts, money market demand
accounts, and savings accounts. The remaining increase of $3.4 million was
attributable to certificates of deposits. This change in the deposit mix
reflects management's commitment to building new and enhancing existing customer
relationships by focusing on a customer's primary financial needs such as
checking accounts, savings accounts, and money market demand accounts. The
average interest rate paid on deposits decreased from 1.97% in 2003 to 1.73% in
2004 due to lower market rates and an emphasis on lower-costing core deposits.
Average borrowings increased by $1.8 million, or 3.5%, to $53.1 million at
December 31, 2004, while the average rate paid on borrowings decreased from
4.35% in 2003 to 3.42% in 2004 due to lower market interest rates in 2004 and
the restructuring of $15.0 million in Federal Home Loan Bank advances in 2003.
This restructuring reduced the average interest rate on these $15.0 million in
advances from 5.8% to 1.8%. Management expects that the cost of funds for
deposits and borrowings will increase in 2005 if short-term interest rates
continue to increase.
17
The Company provided $330,000 and $60,000 in loan loss provisions for
the years ended December 31, 2004 and 2003, respectively. The allowance for loan
losses as a percentage of loans was 0.95% at December 31, 2004, and 1.00% at
December 31, 2003. The provision for loan losses increased due to strong growth
in the Company's loan portfolio of $19.1 million, coupled with net charge-offs
of $270,000 during the year. The level of nonperforming loans increased by
$417,000 to $946,000 at December 31, 2004. Most of this increase was
attributable to a $434,000 increase in nonperforming one-to-four family
residential loans, which are secured by real estate. As a result, the ratio of
nonperforming loans to net loans increased from 0.18% at December 31, 2003, to
0.30% at December 31, 2004. Also, real estate owned increased by $661,000 to
$806,000 at December 31, 2004. All of the properties acquired through
foreclosure are one-to-four family residential properties that are in various
stages of disposition. As a result, the ratio of nonperforming assets to total
assets increased from 0.14% at December 31, 2003, to 0.34% at December 31, 2004.
Refer to the "Allowance for Loan Losses" section of Item 7. of this report for
further discussion.
For the year ended December 31, 2004, noninterest income decreased by
$737,000, or 13.3%, from $5.6 million to $4.8 million. Excluding the net gain on
sale of securities and other assets of $674,000 for the year ended December 31,
2004, and $1.0 million for the year ended December 31, 2003, noninterest income
decreased by $390,000, or 8.6%. The primary reasons for the decrease were a
$286,000 reduction in mortgage banking and loan fee income and a $134,000
reduction in the fair value adjustment on rabbi trust accounts. The decrease in
mortgage-banking and loan fee income was primarily due to a reduced number of
residential loan originations in 2004 as compared to 2003. This was largely due
to a moderate increase in longer-term mortgage interest rates during 2004.
Management expects that mortgage lending activity will continue to slow down in
2005 if long-term mortgage interest rates continue to rise during the year. The
reduction in the fair value adjustment on rabbi trust accounts is offset by a
corresponding decrease in compensation expense, resulting in no net impact on
net income. The Company also realized moderate decreases in fee income on
deposit accounts, commissions on sale of uninsured products, dividends on FHLB
stock, and other income. Fee income on deposit accounts decreased by $23,000, or
1.0%, due to a slight reduction of fees generated from overdrawn checking
accounts. Management believes that a continued focus on growing retail and
commercial checking accounts will result in a moderate improvement in fee income
on deposit accounts in 2005. Commissions earned from the sale of uninsured
products decreased by $41,000, or 25.6%, to $120,000 for the year ending
December 31, 2004. During 2004, the Company changed brokerage vendors from UVEST
to Raymond James and hired an additional sales representative. Management
believes that these actions will result in increased commissions during 2005.
The $6,000 decrease on dividends on FHLB stock is directly related to the rate
paid by the FHLB and the number of outstanding shares (based on outstanding
advances). Management expects that the dividend rate paid by the FHLB will
increase in 2005 due to recent increases in short-term interest rates. Other
income decreased by only $1,000, and is expected to be at a comparable level in
2005.
Gain on sale of securities decreased by $567,000, or 55.6%, from 2003 to
2004. During the year ended December 31, 2004, the Company sold $1.8 million in
investment securities and $6.4 million in mortgage-backed securities at a net
gain of $454,000. The proceeds from these sales were used to generate funds to
repurchase shares of stock and originate loans. During the year ended December
31, 2003, the Company sold $8.1 million in investment securities and $12.2
million in mortgage-backed securities at a net gain of $1.0 million. These gains
were used to offset the impact of vesting a portion of the shares of common
stock granted in the Citizens South Banking Corporation 2003 Recognition and
Retention Plan, which is described in "Note - 12 Employee Benefit Plans" under
Item 8. of this report. The Company also recognized a $219,000 increase in net
gain on sale of other assets from 2003 to 2004. This increase was primarily due
to the sale of a branch office in 2004 that resulted in a gain of $218,000. The
operations of this office were consolidated into the new corporate office in May
2004 and the office was subsequently vacated. The office was sold for $374,000
in December 2004.
Noninterest expense decreased by $262,000, or 1.9%, from $13.9 million
in 2003 to $13.6 million in 2004. The primary reasons for this decrease were a
$702,000 decrease in compensation, a $1.3 million prepayment penalty on FHLB
advances in 2003, and a $249,000 reduction in the amortization of intangible
assets. The $702,000, or 9.6%, decrease in compensation was largely due to a
$694,000 reduction in the vesting expense of the common stock granted in the
Citizens South Banking Corporation 2003 Recognition and Retention Plan. The
vesting schedule for this stock is 30% in 2003 and 10% in 2004 and each year
thereafter
18
until completely vested. Management expects that compensation expense will
increase in 2005 as additional loan officers are hired to increase loan
production, personnel are hired to staff a new office in Belmont, North Carolina
and a loan production office in Cornelius, North Carolina, and unvested options
are expensed in accordance with SFAS No. 123 (revised), Share Based Payment. The
$1.3 million prepayment penalty in 2003 was associated with the restructuring of
$15.0 million in borrowed funds. This action was taken by the Company in an
effort to capitalize on historically low interest rates, lower the Company's
cost of funds, and improve the Company's net interest margin. This restructuring
is expected to reduce interest expense by approximately $1.7 million over a
five-year period. The amortization of intangible assets decreased by $249,000,
or 37.0%, during 2004. The Company's core deposit intangible is being amortized
over a seven-year period on an accelerated basis. The unamortized balance of the
core deposit intangible as of December 31, 2004, was $783,000. Management
expects the expense from the amortization of intangible assets to continue to
decrease in 2005. The Company also realized moderate decreases in NOW account
expenses, professional expenses, and deposit insurance. Management expects that
these expenses will increase moderately in 2005, as the number of checking
accounts is expected to increase and additional professional services are
expected to be needed due to changing laws and regulations.
The decreases in noninterest expenses listed above were partly offset by
increases in occupancy expense, data processing, advertising, and other
noninterest expenses. Occupancy expense increased by $434,000, or 32.3%, to $1.8
million in 2004. This increase was primarily due to the opening of the corporate
office in 2004 and a new banking office in the third quarter of 2003. The
Company sold a banking office in December 2004 that was vacant as a result of
the opening of the new corporate office in May 2004. Management expects that
office occupancy will increase in 2005 as the Company opens a full-service
banking office in Belmont, North Carolina during the third quarter 2005 and
obtains leased space for its loan production office in Cornelius, North
Carolina. Data processing increased by $106,000, to $222,000 for the year ending
December 31, 2004. During 2004 the Company upgraded its technology capabilities
in the areas of online banking, cash management services, document imaging and
core processing. These new capabilities allow the Company to offer a higher
level of service to its existing customers, and to better compete for new
customers. Management expects that data processing costs will moderately
increase in 2005. Advertising expense increased by $60,000, or 21.4% during 2004
to $341,000. The Company has focused much of its marketing efforts on increasing
its core deposits. The Company will continue to focus on building new retail and
commercial loan and deposit relationships in 2005. Advertising costs are
expected to decrease slightly in 2005. Other noninterest expenses, which
includes expenses related to employee travel and training, deposit operations,
loan administration, financial reporting, franchise and other taxes, and other
miscellaneous items, increased by $471,000, or 33.9%. A large portion of the
increase was due to training on the new computer system and enhanced products,
relocating to the corporate office, and costs associated with supporting a
larger number of deposit and loan accounts. Management expects that other
noninterest expenses will decrease slightly in 2005. There were also moderate
increases in expenses related to office supplies and telephone and
communications. These expenses are expected to remain flat in 2005 due to
reduced per item costs prescribed in new vendor contracts for office supplies
and telecommunications.
Effective December 31, 2004, management determined that unrealized
losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and
$2.0 million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000. The unrealized losses on these securities were
considered to be "other-than-temporary" by management for the following reasons:
1) both Fannie Mae and Freddie Mac have experienced recent accounting
irregularities that have resulted in restated financial results from prior
periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae
is much higher than the yield of the preferred stock held by the Company, which
decreases the value of the Company's security; 3) the preferred stock for Fannie
Mae was recently downgraded and the preferred stock for both Companies are on a
negative watch list; 4) the Freddie Mac preferred stock repriced in December
2004, yet it continued to have significant unrealized losses at year end; 5)
neither of the preferred stock issues have stated maturity dates, so the
recovery of the unrealized losses is not expected to occur in the foreseeable
future. The credit issues facing Fannie Mae and Freddie Mac only impact the
performance of the Company's perpetual preferred stock. The Company did not own
any other perpetual preferred stock at December 31, 2004.
19
The Company's provision for income taxes was $1.1 million and $1.5
million for the years ended December 31, 2004 and 2003, respectively. The change
was primarily due to an $815,000 decrease in pretax income. The effective tax
rate decreased from 30.2% to 26.7% due to a larger percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income. Management expects that the effective tax rate for 2005 will increase as
a smaller percentage of pretax income is expected to be derived from
tax-advantaged assets.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31,
2003 AND 2002
Net income was $3.4 million, or $0.39 per share, for the year ended
December 31, 2003, compared to $4.5 million, or $0.51 per share, for the year
ended December 31, 2002. The earnings provided returns on average equity of
3.61% in 2003, compared to 7.61% in 2002, and returns on average assets of 0.68%
in 2003, compared to 0.98% in 2002.
Net interest income, the Company's largest source of income, decreased
by $1.3 million, or 8.8%, due in part to the decreasing spread between the yield
on interest-earning assets and the cost of interest-bearing liabilities caused
by the historically low interest rate environment. The interest rate spread
between interest-earning assets and interest-bearing liabilities decreased from
3.26% in 2002 to 2.57% in 2003, resulting in a decrease in the net interest
margin from 3.17% to 2.67% during the same period. The compression in the
Company's net interest margin reached its low point of 2.43% during the third
quarter of 2003, and showed signs of considerable improvement in the fourth
quarter of 2003, reaching 2.68%, an increase of 25 basis points from the
previous quarter.
Interest income for the year ended December 31, 2003, decreased by $2.7
million, or 11.1%, to $22.0 million. This decrease was primarily due to a $4.4
million, or 20.9%, reduction in interest income on loans. During the year,
average outstanding loans decreased by $23.0 million, or 7.2%, from $320.5
million to $297.5 million, while the average yield on loans decreased from 6.6%
to 5.7%. These changes were primarily the result of a 25 basis point decrease in
the prime lending rate in June 2003, and an abnormally high level of loan
prepayments and refinancings that reduced both yields and outstanding balances.
The reduction in average outstanding loans was primarily due to the fact that
the Bank originates and closes substantially all new fixed-rate residential
loans as a broker for an independent third party. This reduces the Bank's
vulnerability to increases in interest rates. The level of prepayments and
refinancings slowed during the fourth quarter of 2003 as interest rates began to
stabilize. Interest income on interest-bearing bank deposits also decreased,
with a reduction of $351,000, or 58.5%. Average balances of interest-bearing
bank deposits decreased by $15.1 million, or 39.8%, to $22.8 million. This
reduction was primarily due to the investment of the proceeds received in the
2002 stock offering (see the "Business" section of Item 1. for further
discussion) into higher-yielding investment and mortgage-backed securities.
Also, the average yield on interest-bearing bank deposits decreased to from 1.6%
to 1.1%, as short-term interest rates continued to decrease in 2003.
Interest earned on investment securities increased slightly to $1.5
million. The average balance of investment securities increased by $9.0 million,
or 30.5%, to $38.5 million; however, this increase was offset by a decrease in
the yield from 5.0% to 3.9%. Interest earned on mortgage-backed securities
increased by $2.0 million, or 144.4%. This increase was due to a $63.1 million,
or 219.6% increase in average outstanding balances to $91.9 million for 2003.
These average balances increased due to the investment in net proceeds received
in the September 2002 stock offering (see the "Business" section of Item 1. for
further discussion), the reinvestment of funds received from loan prepayments,
and the investment of funds received from borrowed money. The increase in
average balances was partly offset in a decrease in the average yield from 4.9%
to 3.7%. Management plans to reinvest the cash flows generated from these
mortgage-backed securities into new consumer and commercial loan originations.
Interest expense for the year ended December 31, 2003, decreased $1.5
million, or 14.3%, to $8.7 million. This decrease was due to a $1.5 million, or
18.3%, decrease in interest paid on deposits. Average interest-bearing deposits
decreased $8.7 million, or 2.6%, to $328.7 million. Most of this decrease was
attributable to a $19.0 million decrease in higher-costing certificates of
deposit. All other deposits, including demand deposits, money market demand
accounts, and savings accounts, increased by $10.3 million. This change in the
deposit
20
mix reflects management's commitment to building new and enhancing existing
customer relationships by focusing on a customer's primary financial needs such
as checking accounts, savings accounts, and money market demand accounts.
Average deposit balances decreased from 2002 to 2003 primarily as a result of
the maturity of higher-costing certificates of deposit acquired in the
acquisition of Innes Street in December 2001, which is detailed in the
"Business" section in Item 1. of this report. Actual year-end deposit balances
increased by $1.5 million from 2002 to 2003. The average interest rate paid on
deposits decreased from 2.3% to 1.9% due to lower market rates. Average
borrowings increased by $7.0 million, or 15.8%, to $51.2 million, while the rate
paid on borrowings decreased from 5.1% to 4.4% due to lower market interest
rates and the restructuring of $15.0 million in Federal Home Loan Bank advances.
This restructuring reduced the average interest rate on these advances from 5.8%
to 1.8%. These changes resulted in minor reduction of interest paid on
borrowings to $2.2 million.
The Company provided $60,000 and $225,000 in loan loss provisions for
the years ended December 31, 2003 and 2002, respectively. The allowance for loan
losses as a percentage of loans was 1.00% at December 31, 2003, and 0.99% at
December 31, 2002. The ratio of allowances to total loans has remained flat due
to the stable ratio of nonperforming loans to total loans of 0.17% at December
31, 2002, and 0.18% at December 31, 2003. Refer to the "Allowance for Loan
Losses" section of Item 7. of this report for further discussion.
For the year ended December 31, 2003, noninterest income increased by
$1.4 million, or 35.0%, from $4.1 million to $5.6 million. The primary reasons
for the change were a $161,000 increase in fees on deposit accounts, a $62,000
increase in mortgage banking loan fee income, a $779,000 increase in gains on
sale of assets, and a $311,000 increase in the fair value adjustment on deferred
compensation assets. The increase in fees on deposit accounts resulted from our
continued emphasis on building our portfolio of fee-generating demand deposit
accounts and a competitive fee structure on deposit products. Mortgage banking
loan fee income increased due to a higher number of loan originations resulting,
in part, from lower interest rates. We originated and closed many of these
residential loans as a broker for a third party, resulting in immediate fee
income for the Bank. The increase in the fair value adjustment on investments
associated with deferred compensation assets totaled $311,000, which was offset
by a corresponding $311,000 adjustment to compensation expense, resulting in no
net impact on net income. During the year ended December 31, 2003, the Company
sold $8.1 million in investment securities and $12.1 million in mortgage-backed
securities at a net gain of $1.0 million. These gains were used to offset the
impact of vesting a portion of the common stock granted in the Citizens South
Banking Corporation 2003 Recognition and Retention Plan, which is described in
"Note - 12 Employee Benefit Plans" under Item 8. of this report. During the
fiscal year ended December 31, 2002, the Company sold $4.0 million in investment
securities, $5.0 million in mortgage-backed securities, and $1.4 million of
residential loans at a gain of $243,000.
Noninterest expense increased by $2.5 million, or 22.1%, from $11.4
million in 2002 to $13.9 million in 2003. The primary reasons for the increase
were a $1.7 million increase in compensation, a $1.3 million prepayment penalty
on FHLB advances, a $255,000 increase in professional services, a $101,000
increase in telephone expense, and a $238,000 increase in other noninterest
expenses. Compensation increased due in part to the vesting of a portion of the
common stock granted in the Citizens South Banking Corporation 2003 Recognition
and Retention Plan, the opening of the Company's tenth full service office, and
fair value adjustments made on deferred compensation plans. These fair value
adjustments totaled $311,000 in 2003 and are offset by a corresponding $311,000
adjustment to other noninterest income, resulting in no net impact on net
income. During 2003, we recognized a $1.3 million pre-tax prepayment penalty
associated with the restructuring of $15.0 million in borrowed funds. This
action was taken by the Company in an effort to capitalize on historically low
interest rates, lower the Company's cost of funds, and improve the Company's net
interest margin. This restructuring reduced the average interest rate paid on
these borrowed funds from 5.8% to 1.8%, resulting in an immediate reduction in
interest expense of $150,000 per quarter for the first year. The reduction in
interest expense is expected to amount to approximately $1.7 million over the
next five years. Professional services increased by $255,000, or 78.0%, during
2003 due, in part, to additional outside services being needed to ensure proper
corporate governance in light of new regulatory requirements. Telephone expense
increased by $101,000, or 48.5%, due partly to the opening of a new branch
office and enhanced data communications service at the existing Bank offices.
Other noninterest expense increased by $238,000, or 16.7% due, in part, to
franchise tax payments to the state of Delaware and other miscellaneous
operating expenses.
21
These increases in noninterest expenses were partially offset by a
$428,000, or 38.8%, reduction in the amortization of the core deposit
intangible. The core deposit intangible was created as a result of the
acquisition of Innes Street in 2001, which is described in the "Business"
section of Item 1. of this report. It is being amortized over a seven-year
period on an accelerated basis. The unamortized balance of the core deposit
intangible as of December 31, 2003, was $1.1 million. The Company also
experienced decreased expenses associated with data processing expenses, office
supplies and advertising totaling $260,000, or 27.1%. These decreases were
primarily attributable to higher than normal expenses experienced in 2002
relating to the changing of the Bank's name and the consolidation of the Bank's
computer systems following the acquisition of Innes Street in December 2001,
which is described in the "Business" section of Item 1. of this report.
The Company's provision for income taxes was $1.5 million and $2.5
million for the years ended December 31, 2003 and 2002, respectively. The change
was primarily due to a $2.2 million decrease in pretax income. The effective tax
rate decreased from 35.9% to 30.2% due to a larger percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income.
22
NET INTEREST INCOME
The net income of the Company is heavily dependent upon net interest
income. Net interest income represents the difference between income on
interest-earning assets and expense on interest-bearing liabilities. Net
interest income also depends on the relative amounts of interest-earning assets
and interest-bearing liabilities and the interest rate earned or paid on them,
respectively. The following table sets forth certain information relating to the
Company for the years ended December 31, 2004, 2003 and 2002. For the periods
indicated, the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, is expressed both in dollars
and rates. No tax equivalent adjustments were made.
TABLE 1
AVERAGE BALANCES AND NET INTEREST INCOME ANALYSIS
December 31, 2004 December 31, 2003
-------------------------------------- -------------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost Balance Expense Cost
- ---------------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Assets:
Interest-earning assets:
Loans receivable (1) ................. $ 294,647 $ 16,116 5.47% $ 297,517 $ 16,798 5.65%
Interest-bearing bank deposits ....... 11,598 142 1.22 22,847 249 1.09
Investment securities ................ 54,234 1,906 3.51 38,523 1,496 3.88
Mortgage-backed securities ........... 82,025 2,946 3.59 91,939 3,426 3.73
---------- ---------- ---------- ---------- ---------- ----------
Total interest-earning assets .......... 442,504 21,110 4.77 450,826 21,969 4.87
Noninterest-earning assets. ............ 57,433 44,372
---------- ----------
Total assets............................ $ 499,937 $ 495,198
========== ==========
Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Demand deposit accounts .............. $ 32,964 $ 103 0.31% $ 28,525 $ 91 0.32%
Money market deposit accounts ........ 59,121 842 1.42 43,097 550 1.28
Savings accounts ..................... 32,802 165 0.50 39,705 305 0.77
Certificates of deposit .............. 220,838 5,017 2.27 217,395 5,555 2.56
Borrowed funds ....................... 53,053 1,816 3.42 51,238 2,231 4.35
---------- ---------- ---------- ---------- ---------- ----------
Total interest-bearing liabilities ..... 398,779 7,943 1.99 379,960 8,732 2.30
---------- ----------
Noninterest-bearing liabilities ........ 22,966 21,365
---------- ----------
Total liabilities....................... 421,745 401,325
Stockholders' equity.................... 78,192 93,873
---------- ----------
Total liabilities and equity ........... $ 499,937 $ 495,198
========== ==========
Net interest income..................... $ 13,167 $ 13,237
========== ==========
Interest rate spread (2)................ 2.78% 2.57%
========== ==========
Net interest margin (3)................. 2.63% 2.67%
========== ==========
Net yield on interest-earning
assets (4)............................. 2.98% 2.94%
========== ==========
Ratio of average interest-earning
assets to avg. interest-bearing
liabilities............................ 110.96% 118.65%
========== ==========
December 31, 2002
------------------------------------
Interest Average
Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost
- ---------------------------------------- ---------- ---------- ----------
Assets:
Interest-earning assets:
Loans receivable (1) ................. $ 320,505 $ 21,232 6.62%
Interest-bearing bank deposits ....... 37,963 600 1.58
Investment securities ................ 29,515 1,482 5.02
Mortgage-backed securities ........... 28,765 1,402 4.87
---------- ---------- ----------
Total interest-earning assets .......... 416,748 24,716 5.93
Noninterest-earning assets. ............ 41,568
----------
Total assets............................ $ 458,316
==========
Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Demand deposit accounts .............. 23,485 93 0.40%
Money market deposit accounts ........ 32,285 498 1.54
Savings accounts ..................... 45,292 638 1.41
Certificates of deposit .............. 236,360 6,733 2.85
Borrowed funds ....................... 44,242 2,233 5.05
---------- ---------- ----------
Total interest-bearing liabilities ..... 381,664 10,195 2.67
----------
Noninterest-bearing liabilities ........ 17,409
----------
Total liabilities....................... 399,073
Stockholders' equity.................... 59,243
----------
Total liabilities and equity ........... $ 458,316
==========
Net interest income..................... $ 14,521
==========
Interest rate spread (2)................ 3.26%
==========
Net interest margin (3)................. 3.17%
==========
Net yield on interest-earning
assets (4)............................. 3.48%
==========
Ratio of average interest-earning
assets to avg. interest-bearing
liabilities............................ 109.19%
==========
- ----------
(1) Average loan balances include nonaccrual loans.
(2) Interest rate spread represents the difference between the average yield on
interest-earning assets and the average cost of interest-earning
liabilities.
(3) Net interest margin is calculated by dividing net interest income by
average assets for the period.
(4) Net yield on interest-earning assets represents net interest income as a
percentage of average interest-earning assets.
23
Changes in interest income and expense can result from changes in both
volume and rates. The following table sets forth information regarding changes
in our interest income and interest expense for the periods indicated. For each
category of our interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (i) changes in volume
(changes in volume multiplied by old rate); (ii) changes in rate (changes in
rate multiplied by old volume); (iii) the net change. The changes attributable
to the combined impact of volume and rate have been allocated proportionately to
the changes due to volume and the changes due to rate.
TABLE 2
VOLUME AND RATE VARIANCE ANALYSIS
For The Year Ended For the Year Ended
December 31, 2004 vs December 31, 2003 December 31, 2003 vs December 31, 2002
Increase (Decrease) Increase (Decrease)
Due to Due to
-------------------------------------- -------------------------------------
(In Thousands) Volume Rate Net Volume Rate Net
- ---------------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Interest income:
Loans receivable ..................... $ (161) $ (521) $ (682) $ (1,449) $ (2,985) $ (4,434)
Interest-bearing bank deposits ....... (143) 36 (107) (197) (154) (351)
Investment securities ................ 534 (124) 410 55 (41) 14
Mortgage-backed securities ........... (359) (121) (480) 2,267 (243) 2,024
---------- ---------- ---------- ---------- ---------- ----------
Total interest income .................. (129) (730) (859) 676 (3,423) (2,747)
---------- ---------- ---------- ---------- ---------- ----------
Interest expense:
Deposits ............................. 234 (608) (374) (415) (1,046) (1,461)
Borrowed funds ....................... 82 (497) (415) (15) 13 (2)
---------- ---------- ---------- ---------- ---------- ----------
Total interest expense ................. 316 (1,105) (789) (430) (1,033) (1,463)
---------- ---------- ---------- ---------- ---------- ----------
Net interest income .................... $ (445) $ 375 $ (70) $ 1,106 $ (2,390) $ (1,284)
========== ========== ========== ========== ========== ==========
LOANS
The Company generally makes consumer loans, commercial loans and
residential mortgage loans within its market area. In the past, we concentrated
our lending activities on conventional first mortgage loans secured by
one-to-four family properties. However, since converting to a stock-owned
company in 1998, the Company has focused more of its lending activities on
construction loans, nonresidential real estate loans, commercial business loans
and consumer loans. A substantial portion of our loan portfolio is secured by
real estate, either as primary or secondary collateral, located in our primary
market area. The Company has a diversified loan portfolio with no material
concentrations to any one borrower or industry.
Our lending activities are subject to the written, non-discriminatory,
underwriting standards and loan origination procedures established by management
and approved by our Board of Directors. Loan originations come from a number of
sources including real estate agents, home builders, walk-in customers,
referrals and existing customers. Loan officers also call on local businesses
soliciting commercial products. We advertise our loan products in various print
media including the local newspaper. In our marketing, we emphasize our
community ties, personalized customer service, and an efficient underwriting and
approval process. All real estate collateral is appraised or evaluated in
accordance with regulatory requirements. On new loan originations, we require
hazard, title and, to the extent applicable, flood insurance on all security
property. The amounts and types of loans outstanding over the past five years
are shown on the following table.
24
TABLE 3
LOAN PORTFOLIO
December 31, 2004 December 31, 2003 December 31, 2002
------------------------ ------------------------ -----------------------
Amount Percent Amount Percent Amount Percent
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential ....... $ 91,714 28.92% $ 102,751 34.48% $ 140,360 46.32%
Multifamily residential .............. 10,632 3.35 11,987 4.02 8,962 2.96
Construction ......................... 25,033 7.89 8,913 2.99 9,903 3.27
Nonresidential ....................... 114,551 36.12 94,357 31.66 69,313 22.88
---------- ---------- ---------- ---------- ---------- ----------
Total real estate loans ................ 241,930 76.28 218,008 73.15 228,538 75.43
Commercial business loans .............. 14,002 4.41 14,001 4.70 12,084 3.99
Consumer loans ......................... 61,245 19.31 66,020 22.15 62,368 20.58
---------- ---------- ---------- ---------- ---------- ----------
Total gross loans ...................... 317,177 100.00% 298,029 100.00% 302,990 100.00%
========== ========== ==========
Less:
Deferred loan fees, net .............. 21 34 89
Allowance for loan losses ............ 3,029 2,969 2,995
---------- ---------- ----------
Total loans, net ....................... $ 314,127 $ 295,026 $ 299,906
========== ========== ==========
December 31, 2001 December 31, 2000
----------------------- -----------------------
Amount Percent Amount Percent
---------- ---------- ---------- ----------
(Dollars in Thousands)
---------- ---------- ---------- ----------
Real estate loans:
One-to-four family residential ....... $ 191,522 56.74% $ 109,907 68.40%
Multifamily residential .............. 8,696 2.58 2,003 1.25
Construction ......................... 11,219 3.32 4,839 3.01
Nonresidential ....................... 53,110 15.74 12,925 8.04
---------- ---------- ---------- ----------
Total real estate loans ................ 264,547 78.38 129,674 80.70
Commercial business loans .............. 6,930 2.05 12,834 7.99
Consumer loans ......................... 66,058 19.57 18,183 11.31
---------- ---------- ---------- ----------
Total gross loans ...................... 337,535 100.00% 160,691 100.00%
========== ==========
Less:
Deferred loan fees, net .............. 78 305
Allowance for loan losses ............ 3,136 1,566
---------- ----------
Total loans, net ....................... $ 334,321 $ 158,820
========== ==========
Our Board of Directors must approve all loans in excess of $3.0 million
or more, or in any amount to borrowers with existing exposure to us in excess of
$3.0 million, or in any amount that when added to the borrower's existing
exposure to us causes such total exposure to be in excess of $3.0 million. In
addition, all unsecured loans in excess of $500,000, or in any amount when added
to a borrower's existing unsecured exposure to us causes such unsecured exposure
to be in excess of $500,000, must be approved by our Board of Directors. Loans
of $3.0 million or less, or customers with exposure (including the proposed
loan) of $3.0 million or less, or unsecured loans of $500,000 or less, or
customers with unsecured exposure (including the proposed loan) of $500,000 or
less, as applicable, may be approved individually or jointly by our lending
officers within loan approval limits delegated by our Board of Directors. In
addition, the Board of Directors has delegated "incremental" loan approval
limits to certain lending officers which allows them to approve a new loan to an
existing customer in an amount equal to, or less than, their incremental loan
limit that would otherwise require approval by the Board of Directors or the
additional approval of another lending officer. Any loan approved by a lending
officer using their incremental loan limit must be ratified by the Board of
Directors or approved by another lending officer, as applicable, after the loan
has been made.
25
The following table represents the maturity distribution of the
Company's loans by type, including fixed rate loans, as of December 31, 2004.
Demand loans, loans having no stated schedule of repayments and no stated
maturity, and overdrafts are reported as becoming due within one year. Loan
balances do not include undisbursed loan proceeds, unearned discounts, unearned
income and allowance for loan losses.
TABLE 4
MATURITY DISTRIBUTION OF LOAN PORTFOLIO
One year One to Over Five
or Less Five Years Years Total
---------- ---------- ---------- ----------
(In thousands)
Real Estate:
One-to-four family residential ....... $ 305 $ 5,389 $ 86,020 $ 91,714
Multifamily residential .............. 454 9,016 1,162 10,632
Construction ......................... 12,375 10,194 2,464 25,033
Nonresidential ....................... 15,331 78,746 20,474 114,551
Commercial business .................... 4,106 9,718 178 14,002
Consumer ............................... 2,267 3,034 55,944 61,245
---------- ---------- ---------- ----------
Total loans ............................ $ 34,838 $ 116,097 $ 166,242 $ 317,177
========== ========== ========== ==========
The following table sets forth the dollar amount of all loans as of
December 31, 2004, for which final payment is not due until after December 31,
2005. The table also shows the amount of each type of loan that has a fixed rate
of interest and those that have an adjustable rate of interest.
TABLE 5
INTEREST RATE DISTRIBUTION OF LOAN PORTFOLIO
Adjustable
Fixed Rates Rates Total
------------ ------------ ------------
(In thousands)
Real Estate Loans:
One-to-four family residential ....... $ 32,698 $ 58,711 $ 91,409
Multifamily residential .............. 1,530 8,648 10,178
Construction ......................... 3,442 9,216 12,658
Nonresidential ....................... 17,940 81,280 99,220
------------ ------------ ------------
Total real estate loans ................ 55,610 157,855 213,465
Commercial business .................... 3,361 6,535 9,896
Consumer loans ......................... 3,995 54,983 58,978
------------ ------------ ------------
Total loans .......................... $ 62,966 $ 219,373 $ 282,339
============ ============ ============
Scheduled contractual principal repayments of loans do not reflect the
actual life of such assets. The average life of a loan is substantially less
than its contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give us the right to declare loans immediately due
and payable in the event, among other things, that the borrower sells the real
property subject to the mortgage and the loan is not repaid. The average life of
mortgage loans tends to increase, however, when current mortgage loan market
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgage loans are substantially
higher than current mortgage loan market rates.
Nonperforming Assets and Delinquencies. When a borrower fails to make a
required payment on a loan, we attempt to cure the deficiency by contacting the
borrower and collecting the payment. Computer generated late notices are mailed
15 days after a payment is due. In most cases, deficiencies are cured promptly.
If a delinquency continues, additional contact is made either through a notice
or other means and we will attempt to work out a payment schedule and actively
encourage delinquent residential mortgage borrowers to seek home ownership
counseling. While we generally prefer to work with borrowers to resolve such
problems, we will institute foreclosure or other proceedings, as necessary, to
minimize any potential loss. Loans are placed on nonaccrual status generally if,
in the opinion of management, principal or interest payments are not likely in
accordance with the terms of the loan agreement, or when principal or interest
is past due 90 days or more.
26
Interest accrued but not collected at the date the loan is placed on nonaccrual
status is reversed against income in the current period. Loans may be reinstated
to accrual status when payments are under 90 days past due and, in the opinion
of management, collection of the remaining past due balances can be reasonably
expected. Our Board of Directors is informed monthly of the total amount of
loans which are more than 30 days delinquent. Loans that are more than 90 days
delinquent or in foreclosure are reviewed by the Board on an individual basis
each month.
The following table sets forth information with respect to our
nonperforming assets at the dates indicated. As of such dates, we had no
restructured loans within the meaning of SFAS No. 15.
TABLE 6
SCHEDULE OF NONPERFORMING ASSETS
December 31,
------------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
Loans accounted for on a nonaccrual basis:
Real estate loans:
One-to-four family residential ............ $ 627 $ 193 $ 329 $ 756 $ 236
Multifamily residential ................... 0 0 0 70 71
Construction .............................. 0 0 90 0 0
Nonresidential real estate ................ 209 20 0 0 0
Commercial business ......................... 30 203 21 150 75
Consumer .................................... 80 113 76 196 97
---------- ---------- ---------- ---------- ----------
Total nonaccrual loans ...................... 946 529 516 1,172 479
Accruing loans which were contractually
past due 90 days or more ................... 0 0 0 0 0
---------- ---------- ---------- ---------- ----------
Total nonperforming loans ................... 946 529 516 1,172 479
Real estate owned ........................... 806 145 1,307 1,470 0
---------- ---------- ---------- ---------- ----------
Total nonperforming assets .................. $ 1,752 $ 674 $ 1,823 $ 2,642 $ 479
========== ========== ========== ========== ==========
Nonperforming loans to net loans ............ 0.30% 0.18% 0.17% 0.35% 0.30%
Nonperforming assets to total assets ........ 0.34% 0.14% 0.37% 0.59% 0.19%
Real Estate Acquired in Settlement of Loans. Real estate acquired by us
as a result of foreclosure or by deed-in-lieu of foreclosure is classified as
real estate acquired in settlement of loans until sold. Generally, foreclosed
assets are held for sale and such assets are carried at the lower of cost or
market value minus estimated cost to sell the property. After the date of
acquisition, all costs incurred in maintaining the property are expensed and
costs incurred for the improvement or development of such property are
capitalized up to the extent of their net realizable value. At December 31,
2004, we had $806,000 in real estate acquired in settlement of loans. This
balance is comprised of 15 single-family residences located in the Bank's normal
lending area. Thirteen of these properties are investor rental properties that
were acquired in 2004 from three separate borrowers. The Company has no other
direct material exposure to these three borrowers. These single-family
residences are in various stages of disposition.
Restructured Loans. Under accounting principles generally accepted in
the United States of America ("GAAP"), we are required to account for certain
loan modifications or restructuring as a "troubled debt restructuring." In
general, the modification or restructuring of a debt constitutes a troubled debt
restructuring if we, for economic or legal reasons related to the borrower's
financial difficulties, grant a concession to the borrowers that we would not
otherwise consider. Debt restructurings or loan modifications for a borrower do
not necessarily always constitute troubled debt restructurings, however, and
troubled debt restructurings do not necessarily result in nonaccrual loans. We
had no restructured loans as of December 31, 2004.
27
Asset Classification. The OTS has adopted various regulations regarding
problem assets of financial institutions. The regulations require that each
insured institution review and classify its assets on a regular basis. In
addition, in connection with examinations of insured institutions, OTS examiners
have the authority to identify problem assets and, if appropriate, require them
to be classified. There are three classifications for problem assets:
substandard, doubtful and loss. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the insured
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional
characteristic that the weaknesses make collection or liquidation in full on the
basis of currently existing facts, conditions and values questionable, and there
is a high possibility of loss. An asset classified as loss is considered
uncollectible and of such little value that continuance as an asset of the
institution is not warranted. If an asset or portion thereof is classified as
loss, we establish specific allowances for loan losses for the full amount of
the portion of the asset classified as loss. All or a portion of general loan
loss allowances established to cover possible losses related to assets
classified substandard or doubtful can be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses generally do not qualify as regulatory capital. Assets that do not
currently expose the insured institution to sufficient risk to warrant
classification in one of the aforementioned categories but possess weaknesses
are designated "special mention" and monitored by us.
As of December 31, 2004, we had $3.5 million in assets classified
substandard, $202,000 classified doubtful, and no assets classified as loss. The
aggregate amount designated special mention as of December 31, 2004, was $5.0
million. Pursuant to Statement of Financial Accounting Standards ("SFAS") No.
114, "Accounting by Creditors for Impairment of a Loan," management determined
that impaired loans were not material as of December 31, 2004.
As of December 31, 2003, we had $2.6 million classified as substandard,
$203,000 classified as doubtful and no assets classified as loss. The aggregate
amount designated special mention was $3.1 million. Pursuant to SFAS 114,
management determined that impaired loans were not material as of December 31,
2003.
ALLOWANCE FOR LOAN LOSSES
Management has established a systematic methodology for evaluating the
adequacy of the Company's allowance for loan losses. The methodology is set
forth in a formal policy and considers all loans in the portfolio. Specific
allowances are established for certain individual loans that management
considers impaired under SFAS 114. The remainder of the portfolio is segmented
into groups of loans with similar risk characteristics for evaluation and
analysis. In originating loans, we recognize that losses will be experienced and
that the risk of loss will vary with, among other things, the type of loan being
made, the creditworthiness of the borrower, the term of the loan, general
economic conditions, and in the case of a secured loan, the quality of the
collateral. We increase our allowance for loan losses by charging provisions for
loan losses against our current period income. Management's periodic evaluation
of the adequacy of the allowance is consistently applied and is based on our
past loan loss experience, particular risks inherent in the different kinds of
lending that we engage in, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral, current
economic conditions, and other relevant internal and external factors that
affect loan collectibility.
At December 31, 2004, we had an allowance for loan losses of $3.0
million. Management believes that this amount meets the requirement for losses
on loans that management considers to be impaired, for known losses, and for
risks inherent in the remaining loan portfolios. Although management believes
that it uses the best information available to make such determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be significantly adversely affected if circumstances differ
substantially from the assumptions used in making the determinations. The
allowance for loan losses is subject to periodic evaluation by various
regulatory authorities and may be subject to adjustment upon their examination.
The following table sets forth an analysis of our allowance for loan losses.
28
TABLE 7
ALLOWANCE OF LOAN LOSSES
At and For the Twelve Months Ended
December 31,
--------------------------------------------------------
2004 2003 2002 2001 2000
-------- -------- -------- -------- --------
(Dollars in Thousands)
Allowance at beginning of period ................. $ 2,969 $ 2,995 $ 3,136 $ 1,566 $ 1,517
Charge-offs:
One-to-four family residential ................. 14 0 16 0 0
Nonresidential mortgage loans .................. 174 0 175 0 0
Commercial business loans ...................... 76 0 150 0 0
Consumer loans ................................. 14 94 42 104 4
-------- -------- -------- -------- --------
Total charge-offs ................................ $ 278 $ 94 $ 383 $ 104 $ 4
Recoveries:
One-to-four family residential ................. 0 0 0 0 0
Nonresidential mortgage loans .................. 1 0 0 0 0
Commercial business loans ...................... 4 0 0 0 0
Consumer loans ................................. 3 8 17 1 1
-------- -------- -------- -------- --------
Total recoveries ................................. $ 8 $ 8 $ 17 $ 1 $ 1
-------- -------- -------- -------- --------
Net charge-offs .................................. $ 270 $ 86 $ 366 $ 103 $ 3
Provision for loan losses ........................ 330 60 225 120 52
Allowance acquired in acquisition ................ 0 0 0 1,553 0
-------- -------- -------- -------- --------
Allowance at end of period ..................... $ 3,029 $ 2,969 $ 2,995 $ 3,136 $ 1,566
======== ======== ======== ======== ========
Allowance for loan losses to total gross loans ... 0.95% 1.00% 0.99% 0.93% 0.97%
Net charge-offs to average loans ................. 0.09% 0.03% 0.11% 0.06% 0.00%
29
The following table sets forth the breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. The
allocation of the allowance to each category is not necessarily indicative of
future losses and does not restrict the use of the allowance to absorb losses in
any other category.
TABLE 8
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
December 31, 2004 December 31, 2003 December 31, 2002
------------------- ------------------- -------------------
% of % of % of
Total Total Total
Amount Loans Amount Loans Amount Loans
-------- -------- -------- -------- -------- --------
(dollars in thousands)
Real estate loans:
One-to-four family residential .. $ 250 28.92% $ 399 33.48% $ 475 46.32%
Multifamily residential ......... 100 3.35 100 4.02 100 2.96
Construction .................... 300 7.89 150 2.99 150 3.27
Nonresidential .................. 609 36.12 550 31.66 500 22.88
-------- -------- -------- -------- -------- --------
Total real estate loans ........... 1,259 76.28 1,199 73.15 1,225 75.43
Commercial business ............... 600 4.41 600 4.70 600 3.99
Consumer loans .................... 1,171 19.31 1,170 22.15 1,170 20.58
-------- -------- -------- -------- -------- --------
Total allowance for loan losses ... $ 3,029 100.00% $ 2,969 100.00% $ 2,995 100.00%
======== ======== ======== ======== ======== ========
December 31, 2001 December 31, 2000
------------------- -------------------
% of % of
Total Total
Amount Loans Amount Loans
-------- -------- -------- --------
(dollars in thousands)
Real estate loans:
One-to-four family residential .. $ 800 56.74% $ 400 68.40%
Multifamily residential ......... 100 2.58 50 1.25
Construction .................... 150 3.32 55 3.01
Nonresidential .................. 225 15.74 70 8.04
-------- -------- -------- --------
Total real estate loans ........... 1,275 78.38 575 80.70
Commercial business ............... 744 2.05 500 7.99
Consumer loans .................... 1,117 19.57 491 11.31
-------- -------- -------- --------
Total allowance for loan losses ... $ 3,136 100.00% $ 1,566 100.00%
======== ======== ======== ========
DEPOSITS
Our deposit products include a broad selection of deposit instruments,
including checking accounts, money market deposit accounts, savings accounts,
individual retirement accounts, and term certificate accounts. We offer these
products to both retail and commercial customers. Deposit account terms vary
with the principal difference being the minimum balance deposit, early
withdrawal penalties and the interest rate. We review our deposit mix and
pricing weekly. We do not utilize brokered deposits, nor have we aggressively
sought jumbo certificates of deposit. We believe that we are competitive in the
type of accounts and interest rates we offer on our deposit products. We do not
seek to pay the highest deposit rates, but a competitive rate. Management
determines the rates paid based on a number of conditions, including rates paid
by competitors, rates on U.S. Treasury securities, rates offered on alternative
lending programs, and the deposit growth rate we are seeking to achieve. The
following table sets forth information concerning our deposit accounts.
30
TABLE 9
DEPOSIT PORTFOLIO COMPOSITION
December 31, 2004 December 31, 2003 December 31, 2002
----------------------- ----------------------- -----------------------
Average Average Average
Actual Interest Actual Interest Actual Interest
Category Balance Rate Balance Rate Balance Rate
- ------------------------------ ---------- ---------- ---------- ---------- ---------- ----------
(dollars in thousands)
Noninterest bearing demand ... $ 19,734 0.0% $ 12,906 0.0% $ 11,203 0.0%
Interest bearing demand ...... 32,949 0.3 30,780 0.3 25,773 0.4
Money market deposit ......... 77,924 1.4 48,189 1.3 35,811 1.5
Savings accounts ............. 29,174 0.5 36,754 0.8 43,670 1.4
Certificates of deposit ...... 214,962 2.3 213,817 2.6 224,405 2.9
---------- ---------- ---------- ---------- ---------- ----------
Total Deposits ............... $ 374,744 1.7% $ 342,446 1.9% $ 340,862 2.3%
========== ========== ========== ========== ========== ==========
The following table indicates the amount of our time deposits (also
referred to as certificates of deposits) with a principal balance greater than
$100,000 by time remaining until maturity as of December 31, 2004.
TABLE 10
MATURITIES OF TIME DEPOSITS OVER $100,000
Maturity Period Time Deposits
--------------------------------------------- -------------
(In Thousands)
Within three months ......................... $ 10,209
Three to six months ......................... 15,464
Six through twelve months ................... 14,342
Over twelve months .......................... 22,496
-------------
Total time deposits over $100,000 ......... $ 62,511
=============
The following table sets forth the amount of time deposits in the Bank
categorized by rates as of December 31st at the dates indicated.
TABLE 11
TIME DEPOSIT INTEREST RATE COMPOSITION
At December 31,
------------------------------------
2004 2003 2002
---------- ---------- ----------
(In Thousands)
Interest Rate
Less than 2.00% ........................ $ 74,951 $ 85,060 $ 38,066
2.01-4.00% ............................. 118,275 108,170 159,893
4.01-6.00% ............................. 21,616 20,470 24,145
6.01-8.00% ............................. 120 117 2,301
---------- ---------- ----------
$ 214,962 $ 213,817 $ 224,405
========== ========== ==========
31
The following table sets forth the amount of time deposits in the Bank
categorized by rates and maturities at December 31, 2004.
TABLE 12
TIME DEPOSIT MATURITY SCHEDULE
During the Years Ended December 31,
------------------------------------------------------------------
2008
Interest Rate 2005 2006 2007 or Later Total
- ---------------------------------------- ---------- ---------- ---------- ---------- ----------
(In Thousands)
Less than 2.0% ......................... $ 73,171 $ 1,723 $ 57 $ 0 $ 74,951
2.01-4.0% .............................. 74,347 28,965 10,556 4,407 118,275
4.01-6.0% .............................. 8,487 245 4,259 8,625 21,616
6.01-8.0% .............................. 120 0 0 0 120
---------- ---------- ---------- ---------- ----------
Total .................................. $ 156,125 $ 30,933 $ 14,872 $ 13,032 $ 214,962
========== ========== ========== ========== ==========
CAPITAL ADEQUACY AND RESOURCES
OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2004, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings bank is
placed in one of the following five categories based on the bank's capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). At December
31, 2004, Citizens South Bank met the criteria for being considered
"well-capitalized."
Funding for future growth is dependent upon the earnings of the Company
and its subsidiaries. At December 31, 2004, the Company had a capital to assets
ratio of 14.22%. As such, the Company fully expects to be able to meet future
capital needs caused by growth and expansion as well as regulatory requirements.
A primary reason for the Company's strong capital position was the successful
stock offering that was completed in September 2002 that raised net proceeds of
$45.5 million as discussed in the "Business" section of Item 1. of this report.
The Company plans to continue to repurchase its common stock in the open market
from time to time as market conditions warrant. During 2004, the Company
repurchased 1,250,000 shares of common stock for $16.4 million.
LIQUIDITY
The objectives of the Company's liquidity management policy include
providing adequate funds to meet the cash needs of both borrowers and
depositors, to provide for the on-going operations of the Company, and to
capitalize on opportunities for expansion. Liquidity management addresses the
Company's ability to meet deposit withdrawals on demand or at contractual
maturity, to repay borrowings as they mature, and to fund new loans and
investments as opportunities arise. The primary sources of internally generated
funds are principal and interest payments on loans receivable, increases in
local deposits, cash flows generated from operations, and cash flows generated
by investments. If the Company requires funds beyond its internal funding
capabilities, it may rely upon external sources of funds such in brokered
deposits and Federal Home Loan Bank ("FHLB") advances. The Company has $71.8
million in additional advances available from its line of credit from the FHLB.
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As a member of the FHLB, we are required to own capital
stock in the FHLB and we are authorized to apply for advances on the security of
such stock and certain of our mortgage loans and other assets (principally
securities that are obligations of, or guaranteed by, the U.S. Government)
provided certain creditworthiness standards have been met. Advances are made
pursuant to several different credit programs. Each credit program has its own
interest rate and range of maturities. Depending on the program, limitations on
32
the amount of advances are based on the financial condition of the member
institution and the adequacy of collateral pledged to secure the credit. The
Company may also solicit brokered deposits for providing funds for asset growth;
however, to date, the Company has not used such deposits to supplement its
liquidity position.
In the normal course of business, various commitments are outstanding
that are not reflected in the consolidated financial statements. Commitments to
extend credit and undisbursed advances on customer lines of credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. The funding of these commitments and
previously approved undisbursed lines of credit could effect the Company's
liquidity position. At December 31, 2004, the Company had loan commitments of
$15.9 million and unused lines of credit of $62.4 million. The Company believes
that it has adequate resources to fund loan commitments and lines of credit as
they arise. The Company does not have any special purpose entities of other
similar forms of off-balance sheet financing.
Under existing contractual obligations, the Company will be required to
make payments in future periods. The following table presents aggregated
information about payments due under such contractual obligations at December
31, 2004. The Company expects that a portion of the deposits will not be renewed
upon maturity. If there is a higher than normal level of time deposits that are
not renewed at maturity, then the Company may experience a decrease in
liquidity. This may result in the Company offering higher than market interest
rates to maintain deposits, which would increase interest expense. Transaction
deposit accounts with indeterminate maturities have been classified as having
payments due in one year or less.
TABLE 13
CONTRACTUAL MATURITIES
Payments Due by Period at December 31, 2004
-------------------------------------------------------------------
One Year One to Three to Over Five
Or Less Three Years Five Years Years Total
----------- ----------- ----------- ----------- -----------
(in thousands)
Borrowed Funds ............... $ 13,771 $ 20,500 $ 11,500 $ 10,000 $ 55,771
Deposits ..................... 315,907 45,805 13,032 0 374,744
Lease Obligations ............ 46 119 0 0 165
----------- ----------- ----------- ----------- -----------
Total ........................ $ 329,724 $ 66,424 $ 24,532 $ 10,000 $ 430,680
=========== =========== =========== =========== ===========
MARKET RISKS
Market risk reflects the risk of economic loss resulting from adverse
changes in market price and interest risks. The risk of loss can be reflected in
diminished market values and/or reduced net interest income in future periods.
The Company's most significant form of market risk is interest rate
risk, as the majority of the Company's assets and liabilities are sensitive to
changes in interest rates. The structure of the Company's loan and deposit
portfolios is such that significant declines in interest rates could adversely
impact net market values and net interest income. The Company does not maintain
a trading account, nor is it subject to currency exchange risk or commodity
price risk. The Company's Asset/Liability Committee ("ALCO") is responsible for
monitoring and managing exposure to interest rate risk, as discussed below in
"Interest Rate Sensitivity".
INTEREST RATE SENSITIVITY
The Company's ALCO monitors the Company's level of interest rate
sensitivity and ensures that the level of sensitivity of the Company's net
portfolio value is maintained within limits established by the Board of
Directors. Through such management, the ALCO seeks to reduce the vulnerability
of the Company's operations to changes in interest rates. During the past year,
the ALCO utilized the following strategies to manage interest rate risk: (1)
emphasizing the origination and retention of short-term commercial business
loans and nonresidential mortgage loans; (2) emphasizing the origination of
adjustable-rate home equity lines of credit; (3) emphasizing the origination and
retention of one-to-four family residential adjustable-rate mortgage loans; (4)
originating all new fixed-rate mortgage loans as a broker for a third party; and
(5) investing in shorter-term investment securities.
33
The Office of Thrift Supervision requires the computation of amounts by
which the net present value of the Bank's cash flow from assets, liabilities,
and off balance sheet items (the Bank's net portfolio value or "NPV") and the
net interest income ("NII") of the Bank would change in the event of a range of
assumed changes in market interest rates. These computations estimate the effect
on a bank's NPV and NII from instantaneous and permanent one hundred- to three
hundred-basis point increases and decreases in market interest rates. The
following table presents the Bank's projected change in NPV and NII at December
31, 2004, as calculated by an independent third party, based upon information
provided by the Bank. The Bank's level of sensitivity, given a hypothetical,
immediate, and sustained change in interest rates from + 300 basis points to -
300 basis points, is within the range of acceptable sensitivity established by
the Board of Directors.
TABLE 14
INTEREST RATE SENSITIVITY
Estimated Theoretical Estimated Theoretical
Hypothetical, Immediate, Net Interest Income Net Portfolio Value
and Sustained ----------------------- -----------------------
Changes in Interest Rates Amount % Change Amount % Change
- ------------------------------ ---------- ---------- ---------- ----------
(dollars in thousands)
300 basis point rise $ 16,051 15.5% $ 77,650 -2.3%
200 basis point rise 15,428 11.1% 78,700 -1.0%
100 basis point rise 14,709 5.9% 79,462 -0.1%
No change 13,894 0.0% 79,508 0.0%
100 basis point decline 12,552 -9.7% 76,944 -3.2%
200 basis point decline 11,092 -20.2% 73,014 -8.2%
300 basis point decline 9,564 -31.2% 68,405 -14.0%
Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurement. Modeling changes in NPV require the making of
certain assumptions, which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates. In this regard,
the NPV table presented assumes that the composition of the interest sensitive
assets and liabilities existing at the beginning of a period remains constant
over the period being measured and also assumes that a particular change in
interest rates is reflected uniformly across the yield curve regardless of the
duration to maturity or repricing of specific assets and liabilities.
Accordingly, although the NPV table provides an indication of the Bank's
interest rate risk exposure at a particular point in time, such measurements are
not intended to and do not provide a precise forecast of the effect of changes
in market interest rates on the Bank's net interest income and will differ from
actual results.
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and related notes have been
prepared in accordance with GAAP which require the measurement of financial
position and operating results in terms of historical dollars, without
considering the change in the relative purchasing power of money over time due
to inflation. Unlike most industrial companies, nearly all the assets and
liabilities of the Company are financial in nature. As a result, interest rates
have a more significant impact on the Company's performance than the effect of
inflation. Interest rates do not necessarily change in the same magnitude as the
price of goods and services.
34
TABLE 15
QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth
Quarter Quarter Quarter Quarter
---------- ---------- ---------- ----------
(in thousands, except per share data)
2004
Interest income .................................. $ 5,155 $ 4,995 $ 5,318 $ 5,642
Interest expense ................................. 1,871 1,911 2,058 2,103
---------- ---------- ---------- ----------
Net interest income .............................. 3,284 3,084 3,260 3,539
Provision for loan losses ........................ 30 30 60 210
---------- ---------- ---------- ----------
Net int. income after provision for loan losses .. 3,254 3,054 3,200 3,329
Noninterest income ............................... 1,326 1,165 1,076 1,257
Noninterest expense .............................. 3,197 2,862 3,265 4,305
---------- ---------- ---------- ----------
Income before income taxes ....................... 1,383 1,357 1,011 281
Income taxes ..................................... 422 409 241 5
---------- ---------- ---------- ----------
Net income ....................................... $ 961 $ 948 $ 770 $ 276
========== ========== ========== ==========
Per share data:
Net income:
Basic ........................................ $ 0.12 $ 0.12 $ 0.11 $ 0.04
Diluted ...................................... 0.12 0.12 0.11 0.04
Cash dividends declared ........................ 0.065 0.065 0.065 0.065
Common stock price:
High ......................................... 14.40 13.74 13.27 14.27
Low .......................................... 13.37 12.60 12.41 12.41
2003
Interest income .................................. $ 5,903 $ 5,645 $ 5,206 $ 5,215
Interest expense ................................. 2,328 2,286 2,202 1,916
---------- ---------- ---------- ----------
Net interest income .............................. 3,575 3,359 3,004 3,299
Provision for loan losses ........................ 15 15 15 15
---------- ---------- ---------- ----------
Net int. income after provision for loan losses .. 3,560 3,344 2,989 3,284
Noninterest income ............................... 1,085 1,358 1,159 1,959
Noninterest expense .............................. 2,763 3,131 4,148 3,849
---------- ---------- ---------- ----------
Income before income taxes ....................... 1,882 1,571 0 1,394
Income taxes ..................................... 675 447 (94) 428
---------- ---------- ---------- ----------
Net income ....................................... $ 1,207 $ 1,124 $ 94 $ 966
========== ========== ========== ==========
Per share data:
Net income:
Basic ........................................ $ 0.14 $ 0.13 $ 0.01 $ 0.11
Diluted ...................................... 0.14 0.13 0.01 0.11
Cash dividends declared ........................ 0.06 0.06 0.06 0.06
Common stock price:
High ......................................... 11.89 13.71 15.24 15.15
Low .......................................... 10.04 11.99 12.90 13.70
35
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information responsive to this item in contained in Item 7. above under
the captions "Management of Market Risk" and "Liquidity and Capital Resources".
36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
[LOGO OF CHERRY BEKAERT & HOLLAND]
REPORT OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM
The Board of Directors
Citizens South Banking Corporation
We have audited the accompanying consolidated statements of condition of
Citizens South Banking Corporation and subsidiaries as of December 31, 2004 and
2003 and the related consolidated statements of operations, comprehensive
income, changes in stockholders' equity and cash flows for each of the years in
the three-year period ended December 31, 2004. These financial statements are
the responsibility of management. Our responsibility is to express an opinion on
these 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 Citizens South
Banking Corporation and subsidiaries as of December 31, 2004 and 2003 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2004, in conformity with accounting
principles generally accepted in the United States of America.
/s/ Cherry, Bekaert & Holland, L.L.P.
Gastonia, North Carolina
March 3, 2005
37
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Condition
DECEMBER 31,
-------------------------------
2004 2003
-------------- --------------
Assets
Cash and due from banks $ 5,799,611 $ 5,374,150
Interest-earning bank balances 5,790,650 2,840,035
-------------- --------------
Cash and cash equivalents 11,590,261 8,214,185
Investment securities available-for-sale 52,407,378 56,233,140
Mortgage-backed and related securities available-for-sale 81,169,479 89,168,143
Loans, net of deferred fees 317,156,086 297,994,856
Allowance for loan losses (3,029,108) (2,968,510)
-------------- --------------
Loans, net 314,126,978 295,026,346
Premises and equipment, net 17,362,825 14,938,818
Accrued interest receivable 1,662,085 1,942,899
Federal Home Loan Bank stock 3,460,700 2,915,000
Intangible assets 7,559,512 7,984,320
Bank owned life insurance 12,885,164 12,317,201
Other assets 6,736,962 7,010,742
-------------- --------------
Total assets $ 508,961,344 $ 495,750,794
============== ==============
Liabilities and Equity
Deposits $ 374,744,428 $ 342,445,676
Advances from Federal Home Loan Bank 55,000,000 58,300,000
Repurchase agreements 771,538 681,394
Deferred compensation 5,850,061 6,164,432
Other liabilities 201,060 490,384
-------------- --------------
Total liabilities 436,567,087 408,081,886
Commitments and contingencies
Stockholders' Equity
Preferred stock, 10,000,000 shares authorized, none issued - -
Common stock, $0.01 par value, 20,000,000 shares authorized
in 2004 and 2003, issued and outstanding 9,062,727 in 2004 and 2003 90,628 90,628
Additional paid-in-capital 68,380,746 68,280,596
Unallocated common stock held by Employee Stock Ownership Plan (1,795,877) (1,978,722)
Unearned compensation related to Recognition and Retention Plan (1,698,424) (1,979,449)
Retained earnings, substantially restricted 29,765,725 28,823,864
Accumulated unrealized loss on securities available-for-sale,
net of tax (418,552) (39,963)
Treasury stock of 1,630,583 shares at December 31, 2004, and
392,414 shares at December 31, 2003, at cost (21,929,989) (5,528,046)
-------------- --------------
Total stockholders' equity 72,394,257 87,668,908
-------------- --------------
Total liabilities and stockholders' equity $ 508,961,344 $ 495,750,794
============== ==============
See notes to consolidated financial statements.
38
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Operations
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2004 2003 2002
------------ ------------ ------------
Interest income
Loans $ 16,115,649 $ 16,797,651 $ 21,232,156
Investment securities 2,048,161 1,745,240 2,082,359
Mortgage-backed and related securities 2,946,442 3,426,438 1,401,924
------------ ------------ ------------
Total interest income 21,110,252 21,969,329 24,716,439
Interest expense
Deposits 6,127,372 6,501,361 7,961,809
Borrowed funds 1,815,867 2,230,995 2,233,383
------------ ------------ ------------
Total interest expense 7,943,239 8,732,356 10,195,192
------------ ------------ ------------
Net interest income 13,167,013 13,236,973 14,521,247
Provision for loan losses 330,000 60,000 225,000
------------ ------------ ------------
Net interest income after provision for loan losses 12,837,013 13,176,973 14,296,247
Noninterest income
Fee income on deposit accounts 2,426,137 2,448,921 2,287,598
Fee income on mortgage banking activities 545,948 831,806 769,337
Gain on sale of securities 453,725 1,020,673 243,233
Gain on sale of other assets 220,543 1,213 -
Commissions on sales of financial products 120,035 161,296 161,951
Dividends on FHLB stock 96,289 102,057 177,119
Fair market adjustment on deferred compensation assets 177,983 312,230 2,356
Increase in value of bank owned life insurance 591,862 490,082 325,215
Other income 191,755 192,833 153,704
------------ ------------ ------------
Total noninterest income 4,824,277 5,561,111 4,120,513
Noninterest expense
Compensation and benefits 6,579,309 7,281,487 5,555,507
Occupancy 1,779,070 1,345,107 1,430,026
Office supplies expense 321,375 303,640 377,080
NOW account expense 212,926 261,490 251,300
Advertising 340,773 280,597 384,620
Professional services 534,723 581,321 326,596
Telephone 317,665 310,356 208,959
Data processing 221,678 115,192 197,764
Deposit insurance 53,916 59,666 61,475
Loss on sale of assets - - 137,647
Amortization of intangible assets 424,808 674,184 1,102,873
Prepayment penalty on FHLB advances - 1,289,000 65,059
Impairment on investment securities 982,893 - -
Other expense 1,859,693 1,389,071 1,281,868
------------ ------------ ------------
Total noninterest expense 13,628,829 13,891,111 11,380,774
------------ ------------ ------------
Income before income taxes 4,032,461 4,846,973 7,035,986
Provision for income taxes 1,077,040 1,456,407 2,528,052
------------ ------------ ------------
Net income $ 2,955,421 $ 3,390,566 $ 4,507,934
============ ============ ============
Earnings per share
Basic earnings per share $ 0.39 $ 0.39 $ 0.51
Diluted earnings per share $ 0.38 $ 0.39 $ 0.51
See notes to consolidated financial statements
39
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Comprehensive Income
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2004 2003 2002
------------ ------------ ------------
Net income $ 2,955,421 $ 3,390,566 $ 4,507,934
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities
Unrealized holding gains (losses) arising
during period, net of tax effect of
$49,616, $520,397, and
$(324,917), respectively (88,205) (925,151) 577,630
Reclassification adjustment for gains
included in net income, net of tax effect of
$163,341, $367,442, and
$87,564, respectively (290,384) (653,231) (155,669)
------------ ------------ ------------
Other comprehensive income (378,589) (1,578,382) 421,961
------------ ------------ ------------
Comprehensive income $ 2,576,832 $ 1,812,184 $ 4,929,895
------------ ------------ ------------
See notes to consolidated financial statements.
40
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Additional Unallocated
Preferred Common Paid-In Common Stock
Stock Stock Capital Held by ESOP
-------------- -------------- -------------- --------------
Balance, December 31, 2001 $ - $ 4,581,034 $ 16,843,428 $ (1,239,831)
Comprehensive results:
Net income - - - -
Other comprehensive results, net of tax - - - -
Loan to ESOP for purchase of common stock - - - (1,051,980)
Allocation from shares purchased with loan to ESOP - - 143,733 130,245
Exercise of options - 24,052 264,572 -
Issuance of common stock - (4,514,458) 50,923,990 -
Cash dividends declared on common stock - - - -
-------------- -------------- -------------- --------------
Balance, December 31, 2002 - 90,628 68,175,723 (2,161,566)
Comprehensive results:
Net income - - - -
Other comprehensive results, net of tax - - - -
Allocation from shares purchased with loan to ESOP - - 104,873 182,844
Repurchase of common stock - - - -
Issuance of Recognition and Retention Plan stock - - - -
Vesting of Recognition and Retention Plan - - - -
Exercise of options - - - -
Cash dividends declared on common stock - - - -
-------------- -------------- -------------- --------------
Balance, December 31, 2003 - 90,628 68,280,596 (1,978,722)
Comprehensive results:
Net income - - - -
Other comprehensive results, net of tax - - - -
Allocation from shares purchased with loan to ESOP - - 100,150 182,845
Repurchase of common stock - - - -
Issuance of Recognition and Retention Plan stock - - - -
Vesting of Recognition and Retention Plan - - - -
Exercise of options - - - -
Issuance of common stock (100 shares) - - - -
Cash dividends declared on common stock - - - -
-------------- -------------- -------------- --------------
Balance, December 31, 2004 $ - $ 90,628 $ 68,380,746 $ (1,795,877)
============== ============== ============== ==============
Unearned Retained Accumulated
Compensaton Earnings Unrealized Total
Related to Substantially Gains(Losses), Treasury Stockholders'
RRP Restricted net of tax Stock Equity
-------------- -------------- -------------- ------------- --------------
Balance, December 31, 2001 $ - $ 25,105,261 $ 1,116,458 $ (4,776,003) $ 41,630,347
Comprehensive results:
Net income - 4,507,934 - - 4,507,934
Other comprehensive results, net of tax - - 421,961 - 421,961
Loan to ESOP for purchase of common stock - - - - (1,051,980)
Allocation from shares purchased with loan to ESOP - - - - 273,978
Exercise of options - - - - 288,624
Issuance of common stock - - - 4,776,003 51,185,535
Cash dividends declared on common stock - (873,719) - - (873,719)
-------------- -------------- -------------- ------------- --------------
Balance, December 31, 2002 - 28,739,476 1,538,419 - 96,382,680
Comprehensive results:
Net income - 3,390,566 - - 3,390,566
Other comprehensive results, net of tax - - (1,578,382) - (1,578,382)
Allocation from shares purchased with loan to ESOP - - - - 287,717
Repurchase of common stock - - - (9,801,707) (9,801,707)
Issuance of Recognition and Retention Plan stock (2,954,297) - - 2,954,297 -
Vesting of Recognition and Retention Plan 974,848 - - - 974,848
Exercise of options - (1,169,571) - 1,319,364 149,793
Cash dividends declared on common stock - (2,136,607) - - (2,136,607)
-------------- -------------- -------------- ------------- --------------
Balance, December 31, 2003 (1,979,449) 28,823,864 (39,963) (5,528,046) 87,668,908
Comprehensive results:
Net income - 2,955,421 - - 2,955,421
Other comprehensive results, net of tax - - (378,589) - (378,589)
Allocation from shares purchased with loan to ESOP - - - - 282,995
Repurchase of common stock - - - (16,403,258) (16,403,258)
Issuance of Recognition and Retention Plan stock - - - - -
Vesting of Recognition and Retention Plan 281,025 - - - 281,025
Exercise of options - - - - -
Issuance of common stock (100 shares) - - - 1,315 1,315
Cash dividends declared on common stock - (2,013,560) - - (2,013,560)
-------------- -------------- -------------- ------------- --------------
Balance, December 31, 2004 $ (1,698,424) $ 29,765,725 $ (418,552) $ (21,929,989) $ 72,394,257
============== ============== ============== ============= ==============
See notes to consolidated financial statements.
41
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Cash Flows
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2004 2003 2002
-------------- -------------- --------------
Operating Activities
Net Income $ 2,955,421 $ 3,390,566 $ 4,507,934
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for loan losses 330,000 60,000 225,000
Depreciation 1,036,209 697,578 744,650
Impairment on investment securities 982,893 - -
Deferred income tax (benefit) (40,661) (238,800) 198,052
(Gain) on sale of investments available-for-sale (453,725) (1,020,673) (243,233)
(Gain) loss on sale of other assets (220,543) (1,213) (31,756)
Deferred loan origination fees (74,330) 176,411 12,191
Amortization of intangible assets 424,808 674,184 1,102,873
Allocation of shares to the ESOP 282,995 287,717 273,978
Vesting of shares issued for the RRP Plan 281,025 974,848 -
(Increase) decrease in interest receivable 280,814 (30,289) (185,996)
Purchase of bank-owned life insurance - (5,000,000) -
Net (increase) in other operating assets (1,821,284) (1,359,526) (66,885)
-------------- -------------- --------------
Net cash (used in) provided by operating activities 3,963,622 (1,389,197) 6,536,808
Investing Activities
Net decrease(increase) in loans made to customers (19,256,152) 4,642,964 33,094,308
Proceeds from the sale of loans - - 1,418,648
Proceeds from the sale of premises
and equipment 428,835 25,000 26,281
Proceeds from the sale of investment securities 1,810,745 8,051,817 4,000,000
Proceeds from the sale of mortgage-backed
and related securities 6,381,533 12,153,771 5,043,176
Proceeds from sale of REO 64,909 1,014,791 300,357
Maturities and prepayments of investment
securities 22,363,848 16,109,679 6,856,814
Maturities and prepayments of mortgage-backed
and related securities 22,733,334 33,630,059 11,257,899
Purchases of investment securities (20,302,959) (41,263,571) (24,200,000)
Purchases of mortgage-backed and related
securities (21,330,211) (65,652,143) (60,754,560)
Purchases (sales) of FHLB stock (545,700) (275,500) 1,253,200
Purchases of premises and equipment (3,668,508) (6,852,372) (934,824)
-------------- -------------- --------------
Net cash used in investing activities (11,320,326) (38,415,505) (22,638,701)
Financing Activities
Net increase (decrease) in deposits 32,298,752 1,583,744 (8,143,224)
Issuance of common stock 1,315 - 45,446,376
Dividends to stockholders (2,013,560) (2,136,607) (873,719)
Exercise of options - 149,793 288,624
Repurchase of common stock (16,403,258) (9,801,707) -
Advances from FHLB 20,000,000 17,800,000 7,500,000
Repayments of advances from FHLB (23,300,000) (6,000,000) (1,500,000)
Increase (decrease) in repurchase agreements 90,144 (393,788) (481,510)
Decrease in advances from
borrowers for insurance and taxes 59,387 (181,336) (75,180)
-------------- -------------- --------------
Net cash provided by financing activities 10,732,780 1,020,099 42,161,367
Net increase (decrease) in cash and cash equivalents 3,376,076 (38,784,603) 26,059,474
Cash and cash equivalents at the beginning of the year 8,214,185 46,998,788 20,939,314
-------------- -------------- --------------
Cash and cash equivalents at the end of the year $ 11,590,261 $ 8,214,185 $ 46,998,788
-------------- -------------- --------------
See notes to consolidated financial statements.
42
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Citizens South Banking Corporation (the "Company"), formerly Gaston Federal
Bancorp, Inc., is a stock holding company whose activities are primarily limited
to holding the stock of Citizens South Bank, formerly Gaston Federal Bank (the
"Bank"). The Bank is a community-oriented federal stock savings bank engaged
primarily in the business of offering deposits to customers through its branch
offices and investing those deposits, together with funds generated from
operations and borrowings, in residential, commercial and consumer loans and in
mortgage-backed and investment securities. The Bank's wholly-owned subsidiary,
Citizens South Financial Services, Inc. (doing business as Citizens South
Investment Services) acts as an independent agent selling various uninsured
financial products.
The Board of Directors of the Citizens South Holdings, MHC (the "MHC") a federal
mutual holding company which owned a majority of the Company's outstanding
shares of common stock, the Company and the Bank approved the Plan of Conversion
and Reorganization (the "Plan") on May 23, 2002. Pursuant to the Plan, the MHC
converted from the mutual holding company form of organization to the fully
public form and merged into the Bank. Pursuant to the plan, the Company, which
owned 100% of the Bank, was succeeded by a new Delaware corporation with the
same name, Citizens South Banking Corporation. As part of the conversion, shares
of common stock of Citizens South Banking Corporation representing the ownership
interest of the MHC were offered for sale in the offering. The existing publicly
held shares of the Company, which represented the remaining ownership interest
in the Company, were exchanged for new shares of common stock of Citizens South
Banking Corporation, the new Delaware corporation. The exchange ratio of 2.1408
shares of $0.01 par value common stock for each share of $1.00 par value common
stock ensured that immediately after the reorganization and the share exchange,
the public stockholders of the Company owned the same aggregate percentage of
Citizens South Banking Corporation common stock that they owned immediately
prior to the reorganization. At the time of the Conversion, the Bank established
a memo liquidation account in an amount equal to its equity for the benefit of
eligible account holders and supplemental eligible account holders who continue
to maintain their accounts at the Bank after the Conversion.
On September 30, 2002, the mutual-to-stock conversion of Citizens South
Holdings, MHC, and the related stock offering of the Mutual Holding Company's
ownership in Citizens South Banking Corporation were completed. In conjunction
with the stock offering, the Company sold 5,259,945 shares of common stock at
$10.00 per share, which represented the "super maximum" range of the stock
offering. Gross proceeds from the stock offering amounted to $52.6 million. Net
proceeds amounted to $45.5 million and reflect the following reductions from
gross proceeds: 1) $1.4 million in costs incurred related to the stock offering;
2) $1.0 million used to purchase stock for the ESOP; and 3) $4.7 million in
withdrawals from Citizens South Bank deposit accounts (the stock purchased by
the ESOP via loan and the application of deposits for shares are non-cash
financing activities).
As a result of the conversion, all historical financial information that is
based on or derived from the actual or average number of outstanding shares of
common stock during any period prior to September 30, 2002, has been
appropriately adjusted to reflect the exchange ratio of 2.1408-to-1. The
conversion was accounted for as a change in corporate form with no subsequent
change in historical basis for the Company's assets, liabilities and equity.
Principles of Consolidation - The consolidated financial statements include the
accounts of Citizens South Banking Corporation, its wholly-owned subsidiary,
Citizens South Bank, and the Bank's wholly-owned subsidiary, Citizens South
Financial Services, Inc. All significant intercompany accounts and transactions
have been eliminated.
43
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Use of Estimates - The financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America which
require management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.
Cash and Cash Equivalents - The Company considers cash on hand, cash due from
banks, which are maintained in financial institutions, and interest-earning
deposits, which are maintained with the Federal Home Loan Bank (FHLB), as cash
and cash equivalents.
Securities - Management determines the appropriate classification of securities
at the time of purchase.
Securities classified as available-for-sale are carried at fair value. Such
securities are used to execute asset/liability management strategies and to
manage liquidity. Purchases and sales of securities are recorded on a trade-date
basis. Gains and losses are determined using the specific identification method.
Adjustments for unrealized gains or losses, net of related income tax effect,
are recorded as an addition or deduction from equity in the form of other
comprehensive results.
The Company has no securities classified as held-to-maturity.
Amortization of premiums and accretion of discounts are included in interest
income over the life of the related security, or in the case of mortgage-backed
and related securities, the estimated life of the security. Gains or losses on
the sale of securities are recognized on a specific identification, trade-date
basis.
Loans and Allowance for Loan Losses - Loans are carried at their principal
amount outstanding. Income on loans is accrued based upon the outstanding
principal balance. Generally, loans are classified as nonaccrual, and the
accrual of interest is discontinued, when the contractual payment of principal
and interest has become 90 days past due or when, in management's judgment,
principal or interest is not collectible in accordance with the terms of the
obligation. Cash receipts on nonaccrual loans are applied to principal. The
accrual of interest resumes when the loan returns to performing status.
The Company evaluates impairment of its residential mortgage and consumer loans
on a collective basis. Commercial loans are considered to be impaired when,
based on current information, it is probable that the Company will not collect
all amounts due in accordance with contractual terms. Management monitors
internally generated reports, including past due reports, payment histories,
criticized asset reports, which include loans with historical payment problems
or borrowers in troubled industries as well as other sources of information such
as borrower financial statements, the value collateral, etc. to identify
impaired loans. Discounted cash flow analyses or the estimated fair value of
collateral are used in determining the fair value of impaired loans. When the
ultimate collectibility of the principal balance of an impaired loan is in
doubt, cash receipts are applied to principal.
The allowance for loan losses is determined by management and maintained at a
level based on losses inherent in the portfolio that are probable and reasonably
estimated at the balance sheet date. Management's determination of the adequacy
of the allowance is based on an evaluation of the portfolio, historical loan
loss experience, availability and quality of collateral, changes in economic
conditions, and the quality of the loan portfolio. Loans are charged to the
allowance at the time they are determined to be losses. Subsequent recoveries
are credited to the allowance.
Mortgage Servicing Rights - Statement of Financial Accounting Standards ("SFAS")
No. 140 requires the recognition of mortgage servicing rights ("MSRs") as assets
by allocating total costs incurred between the originated loan sold and the
servicing rights retained based on their relative fair values. MSRs are
amortized in proportion to the servicing income over the estimated life of the
related mortgage loan using the interest method.
44
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Concentrations of Credit Risk - The Company makes loans to individuals and small
businesses primarily in the Company's normal lending area which includes the
North Carolina Counties of Gaston, Rowan, and Iredell Counties, and the
surrounding counties. The Company has a diversified loan portfolio, and the
borrowers' ability to repay their loans is not dependent upon any specific
economic segment.
Premises and Equipment - Premises and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization are
computed over the estimated useful lives of the assets (from 3 to 30 years)
primarily by the straight-line method. Leasehold improvements are amortized on a
straight-line basis over the shorter of the estimated useful life of the
improvement or the lease term.
Goodwill and Other Intangible Assets - SFAS No. 142, Goodwill and Other
Intangible Assets, requires that goodwill and intangible assets with indefinite
useful lives no longer be amortized, but instead tested for impairment at least
annually in accordance with its provisions. In connection with adoption of SFAS
No. 142, the Company is required to perform an initial assessment of whether
there is an indication that goodwill is impaired. During the second quarter of
2002, the Company completed its initial analysis of potential impairment under
the provisions of SFAS No. 142, and determined based on that analysis that
goodwill was not impaired. The Company also completed its annual impairment
tests at December 31, 2004 and 2003 and determined based on that analysis that
goodwill was not impaired. Goodwill will be tested for impairment annually, or
between annual tests if an event occurs or circumstances change that would more
likely than not reduce the fair value of a reporting unit below its carrying
amount. The Company had no goodwill related to acquisitions initiated prior to
July 1, 2001, or other intangible assets recorded prior to the adoption of the
provisions of SFAS No. 142 whose carrying amounts or amortization were changed
by the adoptions of the provisions of SFAS No. 142.
SFAS No. 142 also requires that intangible assets with definite useful lives be
amortized over their respective estimated useful lives to their estimated
residual values. In accordance with SFAS No. 142 the Company's core deposit
intangibles, are amortized over their estimated useful life of seven years.
Other Real Estate Owned - Other real estate owned is comprised of real estate
properties acquired in partial or total satisfaction of problem loans. The
properties are recorded at the lower of cost or fair value less estimated costs
to sell at the date acquired. Losses arising at the time of acquisition of such
properties are charged against the allowance for loan losses. Subsequent
write-downs that may be required to the carrying value of these properties are
charged to noninterest expenses. Gains and losses realized from the sale of
other real estate owned are included in noninterest income.
Loan Origination Fees - Origination fees received and direct costs incurred are
deferred and amortized to interest income over the contractual lives of the
loans, using the level yield method.
Income Taxes - Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Amounts
provided for deferred income taxes relate primarily to differences between tax
and financial reporting for unrealized gains and losses on securities
available-for-sale, allowances for loan losses, depreciation, and deferred
compensation.
Advertising - Advertising costs are expensed as incurred.
45
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Reclassifications - Certain of the prior year amounts have been reclassified to
conform to current year presentation. Such reclassifications are immaterial to
the financial statements.
Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income, establishes
standards for the reporting and display of comprehensive income and its
components in financial statements. SFAS No. 130 defines comprehensive income as
net income, as currently reported, as well as unrealized gains and losses on
assets available for sale and certain other items not currently included in the
income statement. The disclosure requirements of SFAS No. 130 have been included
in the Consolidated Statements of Comprehensive Income.
Operating Segments - SFAS No. 131, Disclosures about Segments of an Enterprise
and Related Information, establishes standards for the way public business
enterprises report information about operating segments. This statement also
establishes standards for related disclosures about products, services,
geographic areas and major customers. In adopting SFAS No. 131, the Company has
determined that, using the definitions contained in the statement, all of its
activities constitute only one reportable operating segment.
Stock-Based Compensation - SFAS No. 148, Accounting for Stock-Based Compensation
- - Transition and Disclosure - An Amendment of FASB Statement No. 123, was issued
in December 2002 and provides alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
The Company applies the provisions of Accounting Principles Board Opinion No. 25
in accounting for the plans and accordingly, no compensation expense has been
recognized in connection with the granting of the stock options. In accordance
with SFAS No. 123, Accounting for Stock-Based Compensation, the Company adopted
the disclosure-only option and elected to apply the provisions of APB No. 25 for
financial statement purposes. The Company recognizes compensation expense for
fixed awards with pro rata vesting on a straight-line basis.
Had the compensation cost for the Company's stock option plan been determined in
accordance with the fair-value accounting provisions of SFAS No. 123, net
income, basic earnings per share, and diluted earnings per share would have been
as follows:
Year Ended Year Ended Year Ended
December 31 December 31 December 31
2004 2003 2002
------------- ------------- -------------
Net income:
As reported $ 2,955,421 $ 3,390,566 $ 4,507,934
Pro forma $ 2,860,909 $ 1,847,027 $ 4,398,801
Basic earnings per share:
As reported $ 0.39 $ 0.39 $ 0.51
Pro forma $ 0.38 $ 0.21 $ 0.50
Diluted earnings per share:
As reported $ 0.38 $ 0.39 $ 0.51
Pro forma $ 0.37 $ 0.21 $ 0.50
46
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used for the year ended December 31, 2004: dividend yield of 1.97%,
expected volatility of 31%, a risk-free interest rate of 3.32%, and expected
lives of 6 years. The following weighted average assumptions were used for the
year ended December 31, 2003: dividend yield of 1.85%, expected volatility of
30%, a risk-free interest rate of 3.50%, and expected lives of 5 years. The
following weighted average assumptions were used for the years ended December
31, 2002; dividend yield of 3.27%, expected volatility of 34%, a risk-free
interest rate of 5.00%, and expected lives of 7 years for the options.
SFAS No. 123 (revised), Share Based Payment, was issued by the FASB in December
2004 and establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or
services that are based on the fair value of the entity's equity instruments or
that may be settled by the issuance of those equity instruments. The primary
focus of this statement is on accounting for transactions in which an entity
obtains employee services in exchange for share-based payment transactions. This
Statement is effective for the beginning of the first interim or annual
reporting period that begins after June 15, 2005. SFAS No. 123 (revised) will be
adopted by the Company beginning with the third quarter ending September 30,
2005. Based on the unvested options outstanding at December 31, 2004, the
Company expects that the adoption of SFAS 123 (revised) will result in
additional compensation expense of $65,000 during 2005 and $125,000 during 2006.
SFAS No. 153, Exchanges of Nonmonetary Assets, was issued by the FASB in
December 2004. This Statement amends APB Opinion No. 29, Accounting for
Nonmonetary Transactions, and is based on the principle that exchanges on
nonmonetary assets should be measured based on the fair value of the assets
exchanged. The provisions of this statement are effective for nonmonetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. The
adoption of FAS No. 153 is not expected to have a material impact on the
consolidated financial statements of the Company.
Staff Accounting Bulletin ("SAB") No. 105, Application of Accounting Principles
to Loan Commitments, was issued in March 2004 by the SEC. This SAB summarizes
the application of accounting principles generally accepted in the United States
to loan commitments accounted for as derivative instruments. The provisions of
this SAB were effective after March 31, 2004. The adoption of this Staff
Accounting Bulletin did not have a material impact on the consolidated financial
statements of the Company.
47
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 2 - INVESTMENT SECURITIES
The aggregate book and fair values, as well as gross unrealized gains and
losses, of investment securities as of December 31 were as follows:
December 31, 2004
-------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
------------- ------------- ------------- -------------
Investment securities Available for Sale
U.S. government agencies $ 34,293,006 $ 13,764 $ (257,255) $ 34,049,515
Municipals 10,319,824 263,472 (7,466) 10,575,830
Corporate bonds 2,000,000 - (60,000) 1,940,000
Trust preferred securities 2,000,000 34,000 - 2,034,000
Fannie Mae preferred stock 1,439,428 - - 1,439,428
Freddie Mac preferred stock 1,577,678 - - 1,577,678
Other equity securities 759,690 31,237 - 790,927
------------- ------------- ------------- -------------
Total available-for-sale $ 52,389,626 $ 342,473 $ (324,721) $ 52,407,378
============= ============= ============= =============
December 31, 2004
-------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
------------- ------------- ------------- -------------
Mortgage-backed and related securities
Available-for-Sale
Fannie Mae $ 47,660,078 $ 85,638 $ (536,615) $ 47,209,101
Freddie Mac 27,879,867 64,831 (319,674) 27,625,024
Ginnie Mae 3,140,070 4,117 (18,041) 3,126,146
CMO 1,913,759 - (3,886) 1,909,873
SBA's 1,280,960 18,375 - 1,299,335
------------- ------------- ------------- -------------
Total mortgage-backed and
related securities $ 81,874,734 $ 172,961 $ (878,216) $ 81,169,479
============= ============= ============= =============
48
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 2 - INVESTMENT SECURITIES (CONTINUED)
December 31, 2003
-------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
------------- ------------- ------------- -------------
Investment securities Available for Sale
U.S. government agencies $ 35,476,026 $ 387,200 $ (17,909) $ 35,845,317
Municipals 11,048,565 324,965 (9,493) 11,364,037
Corporate bonds 2,000,000 - - 2,000,000
Trust preferred securities 2,000,000 - - 2,000,000
Fannie Mae preferred stock 2,000,000 - (361,770) 1,638,230
Freddie Mac preferred stock 2,051,806 - (139,791) 1,912,015
Other equity securities 1,254,817 218,724 - 1,473,541
------------- ------------- ------------- -------------
Total available-for-sale $ 55,831,214 $ 930,889 $ (528,963) $ 56,233,140
============= ============= ============= =============
December 31, 2003
-------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
------------- ------------- ------------- -------------
Mortgage-backed and related securities
Available-for-Sale
Fannie Mae $ 56,528,234 $ 125,231 $ (429,795) $ 56,223,670
Freddie Mac 23,836,379 105,262 (227,679) 23,713,962
Ginnie Mae 4,746,663 4,877 (21,919) 4,729,621
CMO 2,972,800 - (17,270) 2,955,530
SBA's 1,551,636 - (6,276) 1,545,360
------------- ------------- ------------- -------------
Total mortgage-backed and
related securities $ 89,635,712 $ 235,370 $ (702,939) $ 89,168,143
============= ============= ============= =============
49
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 2 - INVESTMENT SECURITIES (CONTINUED)
The book value and estimated fair value of debt securities at December 31, 2004,
by contractual maturity, are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
December 31, 2004
-----------------------------
Book Fair
Value Value
------------- -------------
Available-for-Sale
Due in one year or less $ 2,501,249 $ 2,509,920
Due after one year through five years 34,205,523 34,025,649
Due after five years through ten years 3,697,205 3,774,448
Due after ten years 8,208,853 8,289,328
Equities 3,776,796 3,808,033
------------- -------------
$ 52,389,626 $ 52,407,378
============= =============
Mortgage-backed and related securities $ 81,874,734 $ 81,169,479
============= =============
Gross realized gains on the sale of securities available for sale were $453,725,
$1,105,627, and $256,661 for the years ended December 31, 2004, December 31,
2003, and December 31, 2002, respectively. Gross realized losses on the sale of
securities available for sale were $0, $84,954, and $13,428 for the years ended
December 31, 2004, December 31, 2003, and December 31, 2002, respectively.
After-tax net gains on the sale of securities were $290,384, $653,231, and
$155,669 for the years ended December 31, 2004, December 31, 2003, and December
31, 2002, respectively.
Investment securities having a carrying amount of approximately $28,815,000 have
been pledged as collateral to secure public deposits at December 31, 2004.
Investment securities having a carrying amount of $3,000,000 have been pledged
as collateral for repurchase agreements at December 31, 2004.
Interest earned from municipal securities, which is exempt from income taxes,
for the past three years were $405,335, $329,101, and 270,827, for the years
ending December 31, 2004, December 31, 2003, and December 31, 2002,
respectively.
50
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 2 - INVESTMENT SECURITIES (CONTINUED)
The unrealized losses and fair value of the investments by investment type
segregated between those that have been in a continuous unrealized loss position
for less than twelve months and more than twelve months at December 31, 2004 and
December 31, 2003 are as follows:
December 31, 2004
-----------------------------------------------------------------------------------------
Less than 12 months 12 months or more Total
--------------------------- --------------------------- ---------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of Securities Value Loss Value Loss Value Loss
- ------------------------------ ------------ ------------ ------------ ------------ ------------ ------------
US government agencies $ 25,079,444 $ (220,009) $ 2,962,754 $ (37,246) $ 28,042,198 $ (257,255)
Municipals 1,006,887 (348) 1,382,271 (7,118) 2,389,158 (7,466)
Federal agency mortgage
backed securities 20,930,494 (132,840) 42,036,013 (745,376) 62,966,507 (878,216)
Corporate bonds 1,940,000 (60,000) - - 1,940,000 (60,000)
------------ ------------ ------------ ------------ ------------ ------------
Subtotal, debt
securities 48,956,825 (413,197) 46,381,038 (789,740) 95,337,863 (1,202,937)
Preferred stock - - - - - -
------------ ------------ ------------ ------------ ------------ ------------
Total temporarily
impaired securities $ 48,956,825 $ (413,197) $ 46,381,038 $ (789,740) $ 95,337,863 $ (1,202,937)
============ ============ ============ ============ ============ ============
December 31, 2003
-----------------------------------------------------------------------------------------
Less than 12 months 12 months or more Total
--------------------------- --------------------------- ---------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of Securities Value Loss Value Loss Value Loss
- ------------------------------ ------------ ------------ ------------ ------------ ------------ ------------
US agency securities $ 7,981,023 $ (17,909) $ - $ - $ 7,981,023 $ (17,909)
Municipals 1,778,144 (9,493) - - 1,778,144 (9,493)
Federal agency mortgage
backed securities 62,299,543 (696,663) 1,541,026 (6,276) 63,840,569 (702,939)
------------ ------------ ------------ ------------ ------------ ------------
Subtotal, debt
securities 72,058,710 (724,065) 1,541,026 (6,276) 73,599,736 (730,341)
Preferred stock 1,912,015 (139,791) 1,638,230 (361,770) 3,550,245 (501,561)
------------ ------------ ------------ ------------ ------------ ------------
Total temporarily
impaired securities $ 73,970,725 $ (863,856) $ 3,179,256 $ (368,046) $ 77,149,981 $ (1,231,902)
============ ============ ============ ============ ============ ============
Management considers all of the unrealized losses that have been outstanding for
12 or more months to be temporary impairments since these impairments are
primarily due to changes in interest rates. Management has the ability and
intent to hold these securities until they are no longer considered to be
impaired, which may be maturity.
51
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 2 - INVESTMENT SECURITIES (CONTINUED)
Effective December 31, 2004, management determined that unrealized losses on
$2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0 million
in perpetual preferred stock issued by Freddie Mac were "other-than-temporary"
impairments. As a result, management recorded a noncash, pretax loss of
$983,000. The unrealized losses on these securities were considered to be
"other-than-temporary" by management for the following reasons: 1) both Fannie
Mae and Freddie Mac have experienced recent accounting irregularities that have
resulted in restated financial results from prior periods; 2) the yield on
perpetual preferred stock recently issued by Fannie Mae is much higher than the
yield of the preferred stock held by the Company, which decreases the value of
the Company's security; 3) the preferred stock for Fannie Mae was recently
downgraded and the preferred stock for both Companies are on a negative watch
list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it
continued to have significant unrealized losses at year end; 5) neither of the
preferred stock issues have stated maturity dates, so the recovery of the
unrealized losses is not expected to occur in the foreseeable future. The credit
issues facing Fannie Mae and Freddie Mac only impact the performance of the
Company's perpetual preferred stock. The Company does not have any other
perpetual preferred stock on its books at December 31, 2004.
NOTE 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES
The following is a summary of loans outstanding by category at December 31:
2004 2003
-------------- --------------
Real estate:
One-to-four family residential $ 91,714,382 $ 102,750,899
Multi-family residential 10,632,018 11,987,054
Commercial mortgage 85,617,699 72,503,276
Construction 25,033,055 8,912,874
Land 28,932,963 21,853,560
Commercial 14,001,972 14,001,527
Consumer 61,245,859 66,019,917
-------------- --------------
Gross loans 317,177,948 298,029,107
Less:
Deferred loan fees, net 21,862 34,251
Allowance for loan losses 3,029,108 2,968,510
-------------- --------------
Net loans $ 314,126,978 $ 295,026,346
============== ==============
The Company evaluates impairment of its residential mortgage and consumer loans
on a collective basis. Commercial loans individually evaluated and considered
impaired under SFAS No. 114 at December 31, 2004 and 2003 were immaterial.
52
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)
Changes in the allowance for loan losses for the years ended December 31, 2004,
December 31, 2003 and December 31, 2002 were as follows:
Year Ended Year Ended Year Ended
December December December
2004 2003 2002
----------- ----------- -----------
Balance at beginning of year $ 2,968,510 $ 2,994,576 $ 3,136,058
Provision for loan losses 330,000 60,000 225,000
Loans charged off (277,818) (94,008) (383,515)
Recoveries on loans previously charged off 8,416 7,942 17,033
----------- ----------- -----------
Balance at end of year $ 3,029,108 $ 2,968,510 $ 2,994,576
=========== =========== ===========
Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are outstanding loans and commitments, all of which were
made under normal credit terms and did not involve more than normal risk of
collection. The aggregate amounts of these loans were $11,487,133 and $7,630,171
at December 31, 2004 and 2003, respectively. During the year ended December 31,
2004, new loans of $5,071,988 were made and payments totaled $1,215,026. During
the year ended December 31, 2003, new loans of $1,984,678 were made, payments
totaled $1,387,759 and seven previously existing loans in the aggregate amount
of $3,429,035 to newly appointed directors of the Company's subsidiary Bank were
included at December 31, 2003.
The Bank held no loans for sale at December 31, 2004 and 2003.
NOTE 4 - PREMISES AND EQUIPMENT
Premises and equipment at December 31 are summarized as follows:
2004 2003
-------------- --------------
Land $ 4,206,470 $ 4,542,235
Buildings 12,194,563 10,559,124
Land Improvements 260,944 289,599
Furniture and equipment 3,823,638 3,173,267
-------------- --------------
20,485,615 18,564,225
Less: accumulated depreciation 3,122,790 3,625,407
-------------- --------------
$ 17,362,825 $ 14,938,818
============== ==============
NOTE 5 - BANK OWNED LIFE INSURANCE
The Company owns bank-owned life insurance to fund certain employee benefit
plans. The Company purchased $5,000,000 of bank-owned life insurance during the
year ended December 31, 2003. No purchases of bank-owned life insurance were
made during the years ended December 31, 2004, and December 31, 2002. The
bank-owned life insurance policies are recorded in other assets at their cash
surrender values of $12,885,164 and $12,317,201 at December 31, 2004 and 2003,
respectively.
53
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 6 - INTANGIBLE ASSETS
Amortized intangible assets at December 31, 2004 and 2003 are summarized as
follows:
December 31, 2004 December 31, 2003
----------------- -----------------
Core deposit intangible $ 2,447,000 $ 2,447,000
Mortgage servicing rights 673,896 673,896
----------------- -----------------
3,120,896 3,120,896
Less: accumulated amortization 2,231,906 1,807,098
----------------- -----------------
$ 888,990 $ 1,313,798
================= =================
Amortization expense for intangible assets subject to amortization was $424,808
during the year ended December 31, 2004, $674,184 during the year ended December
31, 2003, and $1,102,873 during the year ended December 31, 2002. The fair value
of MSRs at December 31, 2004 and 2003 approximated carrying value. The total
amount of loans serviced for others at December 31, 2004, December 31, 2003, and
December 31, 2002 were $12,640,595, $17,550,135, and $33,503,785, respectively.
Estimated amortization expense for the next five succeeding years ending
December 31 are as follows:
2005 $ 327,000
2006 $ 250,000
2007 $ 180,000
2008 $ 132,000
2009 $ 0
The balance of goodwill was $6,670,522 at December 31, 2004 and 2003.
NOTE 7 - DEPOSITS
Deposit balances and interest expense and average rates paid for the years ended
December 31, 2004, December 31, 2003, and December 31, 2002 are summarized as
follows:
December 31, December 31,
2004 2003
--------------------------------------------- ---------------------------------------------
Actual Interest Average Actual Interest Average
Balance Expense Rate Balance Expense Rate
------------- ------------ ------------- ------------- ------------ -------------
Noninterest bearing $ 19,734,227 $ - - $ 12,906,002 $ - -
Interest bearing checking 32,949,447 103,320 0.3% 30,779,656 91,383 0.3%
Money market deposit 77,924,198 841,817 1.4% 48,188,873 549,917 1.3%
Savings 29,174,129 164,700 0.5% 36,754,570 305,298 0.8%
Certificates of deposit 214,962,427 5,017,535 2.3% 213,816,575 5,554,763 2.6%
------------- ------------ ------------- ------------- ------------ -------------
$ 374,744,428 $ 6,127,372 1.7% $ 342,445,676 $ 6,501,361 1.9%
============= ============ ============= ============= ============ =============
54
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 7 - DEPOSITS (CONTINUED)
December 31,
2002
---------------------------------------------
Actual Interest Average
Balance Expense Rate
------------- ------------- -------------
Noninterest bearing $ 11,203,428 $ - -
Interest bearing checking 25,772,621 93,452 0.4%
Money market deposit 35,810,998 497,398 1.5%
Savings 43,670,086 637,769 1.4%
Certificates of deposit 224,404,799 6,733,190 2.9%
------------- ------------- -------------
$ 340,861,932 $ 7,961,809 2.3%
============= ============= =============
Contractual maturities of certificates of deposit as of December 31, 2004 and
2003 are as follows:
2004 2003
--------------- ---------------
Under 1 year $ 156,125,605 $ 176,956,932
1 to 2 years 30,933,304 25,646,184
2 to 3 years 14,871,833 4,134,446
3 to 4 years 4,318,059 5,869,583
4 years or greater 8,713,626 1,209,430
--------------- ---------------
$ 214,962,427 $ 213,816,575
=============== ===============
Certificates of deposit in excess of $100,000 totaled $62,511,274 and
$56,639,500 at December 31, 2004 and 2003, respectively, and may not be fully
insured by the FDIC. Interest paid on deposits and other borrowings was
$7,566,978 for the year ended December 31, 2004, and $8,941,122 for the year
ended December 31, 2003, and $10,186,555 for the year ended December 31, 2002.
Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are deposit accounts, all of which were made under normal
terms. The aggregate amount of these deposit accounts was $539,837 and
$1,668,391 at December 31, 2004 and 2003, respectively.
The deposits of the Bank are insured by the Savings Association Insurance Fund
(SAIF), one of two funds administered by the FDIC. The Bank's annual SAIF
premium rates were $0.015, $0.016, and $0.020, per $100 of deposits for the
years ended December 31, 2004, December 31, 2003 and December 31, 2002,
respectively.
NOTE 8 - ADVANCES FROM THE FEDERAL HOME LOAN BANK
Advances from the Federal Home Loan Bank of Atlanta are pursuant to lines of
credit and are collateralized by a lien on qualifying first mortgage loans in an
amount necessary to satisfy outstanding indebtedness plus accrued interest.
Advances had interest rates ranging from 1.15% to 6.25% at December 31, 2004 and
1.18% to 6.25% at December 31, 2003. The total amount available on the line of
credit is 25% of total assets of the Bank. The unused portion of the line of
credit available to the Company at December 31, 2004 was approximately $71.8
million.
55
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 8 - ADVANCES FROM THE FEDERAL HOME LOAN BANK (CONTINUED)
Maturities of advances at December 31 are as follows:
2004 2003
--------------- ---------------
Advances from FHLB due:
Less than 1 year $ 13,000,000 $ 21,300,000
1 to 2 years 18,000,000 10,000,000
2 to 3 years 2,500,000 4,000,000
3 to 4 years 8,500,000 2,000,000
4 to 5 years 3,000,000 8,000,000
5 to 10 years 10,000,000 13,000,000
After 10 years - -
--------------- ---------------
$ 55,000,000 $ 58,300,000
=============== ===============
Interest rates on certain convertible advances may be reset on certain dates at
the option of the Federal Home Loan Bank in accordance with the terms of the
note. The Bank has the option of repaying the outstanding advance or converting
the interest rate from a fixed rate to a floating rate at the time the advance
is called by the Federal Home Loan Bank. The Bank has one $5.0 million advance
that will be callable quarterly beginning November 2005 until it matures in
November 2012. The Bank also has one $5.0 million advance that has a one time
call feature in November 2005, that matures in November 2010.
During the year ended December 31, 2003, the Company refinanced $15.0 million of
advances with the Federal Home Loan Bank to take advantage of significantly
lower finance rates. As a result of the early extinguishment of the advances,
the Company paid a prepayment penalty of approximately $1.2 million.
NOTE 9 - INCOME TAXES
The provision for income taxes is summarized below:
Year Ended Year Ended Year Ended
December December December
2004 2003 2002
--------------- --------------- ---------------
Currently payable
Federal $ 971,417 $ 1,457,207 $ 1,978,000
State 146,284 238,000 352,000
--------------- --------------- ---------------
1,117,701 1,695,207 2,330,000
56
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 9 - INCOME TAXES (CONTINUED)
Year Ended Year Ended December
December December Year Ended
2004 2003 2002
--------------- --------------- ---------------
Deferred
Federal (35,339) (229,800) 207,052
State (5,322) (9,000) (9,000)
--------------- --------------- ---------------
(40,661) (238,800) 198,052
--------------- --------------- ---------------
Total income taxes $ 1,077,040 $ 1,456,407 $ 2,528,052
=============== =============== ===============
The reasons for the difference between consolidated income tax expense and the
amount computed by applying the statutory federal income tax rate of 34% to
income before income taxes were as follows:
Year Ended Year Ended Year Ended
December December December
2004 2003 2002
--------------- --------------- ---------------
Federal income taxes at statutory rate $ 1,371,000 $ 1,648,000 $ 2,392,000
State income taxes, net of federal benefit 86,000 151,000 226,000
Effect of federal tax exempt interest (137,000) (112,000) (92,000)
Effect of earnings on life insurance (161,000) (161,000) (109,000)
Other (81,960) (69,593) 111,052
--------------- --------------- ---------------
$ 1,077,040 $ 1,456,407 $ 2,528,052
=============== =============== ===============
Effective tax rate 26.7% 30.2% 35.9%
=============== =============== ===============
Income taxes paid for the years ended December 31, 2004, 2003, and 2002 were
$1,978,000, $2,119,000, and $2,530,000 respectively.
57
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 9 - INCOME TAXES (CONTINUED)
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and liabilities at December 31 are as follows:
2004 2003
------------- -------------
Deferred tax assets
Deferred compensation $ 1,250,021 $ 1,132,374
Unrealized loss on securities
Available-for-sale 268,951 -
Allowance for loan losses 1,209,925 1,196,047
Other 159,616 117,552
------------- -------------
Gross deferred tax assets 2,888,513 2,445,973
Deferred tax liabilities
Excess carrying value of assets acquired
for financial reporting purposes over
tax basis 1,275,184 1,112,913
Deferred loan fees 191,034 181,650
Other - 13,098
------------- -------------
Gross deferred tax liabilities 1,466,218 1,307,661
------------- -------------
Net deferred tax asset $ 1,422,295 $ 1,138,312
============= =============
The Company, in accordance with SFAS No. 109, did not record a deferred tax
liability of approximately $3,140,000 as of December 31, 2004 related to the
cumulative special bad debt deduction for savings and loan associations
recognized for income tax reporting prior to September 30, 1988, Citizen South
Bank's base year.
Management believes that the Company will fully realize deferred tax assets
based on future taxable temporary differences, refundable income taxes from
carryback years, and current levels of operating income.
58
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 10 - COMMITMENTS
Commitments to extend credit are agreements to lend as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. These
commitments represent no more than normal lending risk that the Bank commits to
its borrowers and management believes that these commitments can be funded
through normal operations. Commitments to extend credit as of December 31 are as
follows:
2004 2003
------------ ------------
$ 3,397,000 $ 2,215,000
Residential mortgage loan commitments
Non-residential mortgage loan commitments 10,976,000 23,668,000
Commercial loan commitments 904,000 1,125,000
Consumer loan commitments 551,000 577,400
Unused lines of credit
Commercial 15,776,000 23,631,000
Consumer 46,621,000 47,013,000
NOTE 11 - REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of assets, liabilities,
and certain commitments as calculated under regulatory accounting practices. The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings and other factors. Failure to
meet minimum capital requirements can initiate certain mandatory, and possibly
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements.
The Bank is required to maintain: tangible capital of at least 1.5% of adjusted
total assets; core capital of at least 4.0% of adjusted total assets; and total
capital of at least 8.0% of risk weighted assets. At December 31, 2004, the
Bank's tangible capital and core capital were both $59,775,000, or 11.95% of
tangible assets, and total capital was $62,804,000, or 17.12% of risk-weighted
assets. The Company's primary regulator, the Office of Thrift Supervision,
informed the Bank that it was in the well-capitalized category as of the most
recent regulatory examination, and management is not aware of any events that
have occurred since that would have changed its classification.
59
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 11 - REGULATORY CAPITAL REQUIREMENTS (CONTINUED)
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------------------- --------------------------- ---------------------------
Amount Ratio Amount Ratio Amount Ratio
------------ ------------ ------------ ------------ ------------ ------------
(dollars in thousands) (dollars in thousands) (dollars in thousands)
As of December 31, 2004
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 62,804 17.12% 29,346 8.00% 36,682 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 59,775 16.30% 14,673 4.00% 22,010 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 59,775 11.95% 20,011 4.00% 25,014 5.00%
Tangible Capital
(to Adjusted Total Assets) 59,775 11.95% 7,504 1.50% 15,008 3.00%
As of December 31, 2003
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 64,415 18.38% 28,037 8.00% 35,046 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 61,389 17.52% 14,019 4.00% 21,028 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 61,389 12.65% 19,409 4.00% 24,261 5.00%
Tangible Capital
(to Adjusted Total Assets) 61,389 12.65% 7,278 1.50% 14,556 3.00%
On May 23, 2002, the MHC approved a Plan of Conversion and Reorganization. As a
result of the Conversion, the Bank established a memo liquidation account in an
amount equal to its equity at the time of the Conversion of approximately $44
million for the benefit of eligible account holders and supplemental eligible
account holders who continue to maintain their accounts at the Bank after the
Conversion. In the event of a complete liquidation of the Bank, each eligible
account holder and supplemental eligible account holder will be entitled to
receive a distribution from the liquidation account in an amount proportionate
to the current adjusted qualifying balances for accounts then held. As a result,
stockholders' equity is substantially restricted at December 31, 2004 and 2003.
60
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 12 - EMPLOYEE BENEFIT PLANS
The Bank provides supplemental benefits to substantially all employees through a
401(k) savings plan. Eligible participants may contribute up to 75% of eligible
compensation, with the Bank providing matching contributions of 50% of employee
contributions up to 6% of eligible compensation. The plan also provides for
discretionary employer contributions. During 2004, 2003 and 2002, no
discretionary employer contributions were made to the 401(k) plan. Total expense
relating to this plan was $104,591 for the year ended December 31, 2004,
$106,973 for the year ended December 31, 2003, and $93,032 for the year ended
December 31, 2002.
The Bank also maintains nonqualified deferred compensation and/or supplemental
retirement plans for certain of its directors and executive officers. The Bank
also adopted nonqualified deferred compensation plans for key employees and
directors of Citizens Bank, a wholly-owned subsidiary of Innes Street Financial
Corporation, which was acquired by the Company on December 31, 2001. The
deferred assets related to these plans are maintained in rabbi trusts, which are
included in Other Assets of the Company. The assets are accounted for at market
value in accordance with SFAS Statement No. 115, Accounting for Certain
Investments in Debt and Equity Securities, with the resulting gains or losses in
value recorded in income. The corresponding change in fair value of the deferred
compensation obligation is recorded as compensation expense. Total expense for
the all of the plans was $505,822 for the year ended December 31, 2004, $737,483
for the year ended December 31, 2003, and $312,182 for the year ended December
31, 2002.
2003 Recognition and Retention Plan ("2003 RRP") - Pursuant to resolutions of
the Board of Directors of Citizens South Banking Corporation adopted on August
18, 2003, and the subsequent approval by the stockholders of the Company on
October 23, 2003, the Company has adopted and implemented the Citizens South
Banking Corporation 2003 Recognition and Retention Plan with a total of 210,398
shares. On November 3, 2003, awards of 196,560 shares of restricted stock were
made under the 2003 RRP. All shares vest over a seven-year period commencing on
the date of the award, at the rate of 30% on November 3, 2003, 10% on January 2,
2004, 10% on November 3, 2005, and 10% per year on November 3 of each year
thereafter. The fair market value of the restricted stock at the time of the
grant was $15.04 per share. During 2004, 25,962 shares vested, no additional
shares were granted, and no shares were forfeited. At December 31, 2004, there
remain 13,838 restricted shares unissued and available for grants under the 2003
RRP.
1999 Stock Option Plan - On April 12, 1999, the Company's shareholders approved
the Citizens South Bank 1999 Stock Option Plan that provided the issuance of
211,335 options for directors and officers to purchase the Company's common
stock. Pursuant to the mutual holding company conversion and reorganization
completed on September 30, 2002, each share of the $1.00 par value common stock
of Citizens South Banking Corporation (the former Federal corporation) was
exchanged for 2.1408 shares of $0.01 par value common stock of the Citizens
South Banking Corporation (the new Delaware Corporation), which preserved the
previous shareholders' interest in Citizens South Banking Corporation. Thus, the
options for 211,335 shares of common stock in the 1999 Stock Option Plan were
exchanged for options for 452,425 shares, with the exercise prices of previously
granted options adjusted according to the same ratio.
During 2004, there were no options granted, 5,234 reload options issued, 16,965
shares were exercised, and 1,071 shares were forfeited under the 1999 Stock
Option Plan. Of the 16,965 shares exercised, 4,281 were exercised for cash and
12,684 were exercised by the exchange of stock and reload provisions of the
plan. At December 31, 2004, there remain 1,612 options unissued and available
for grants under the 1999 Stock Option Plan.
61
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 12 - EMPLOYEE BENEFIT PLANS (CONTINUED)
2003 Stock Option Plan - Pursuant to resolutions of the Board of Directors of
Citizens South Banking Corporation adopted on August 18, 2003, and the
subsequent approval by the stockholders of the Company on October 23, 2003, the
Company has adopted and implemented the Citizens South Banking Corporation 2003
Stock Option Plan with a total of 525,995 options available for award. On
November 3, 2003, the following awards of stock options were made under the 2003
Stock Option Plan: Non-statutory options of 157,020 shares at $15.04 to
directors and advisory board members, vesting over a five-year period at 20% per
year, commencing on the initial date of the optionee's board service to the Bank
or its predecessor, Gaston Federal Bank (excluding service to the former
Citizens Bank, Inc.); incentive options of 360,000 shares at $15.04 to
employees, vesting over a five-year period at 20% per year, commencing on the
initial date of the optionee's employment with the Bank or its predecessor,
Gaston Federal Bank (excluding service to the former Citizens Bank, Inc.).
During 2004, there were 7,500 incentive options granted at the market price of
the stock on the date of grant to an employee, vesting over a five-year period
at 20% per year, commencing on the date of the grant, no reload options were
issued, no options were exercised, and 12,500 options were forfeited. At
December 31, 2004, there remain 13,975options unissued and available for grants
under the 2003 Stock Option Plan.
The following is a summary of stock option activity and related information for
the years ended December 31, 2004, 2003 and 2002.
Year Ended December 31, 2004 Year Ended December 31, 2003 Year Ended December 31, 2002
------------------------------- ------------------------------- -------------------------------
Weighted Avg. Weighted Avg. Weighted Avg.
Options Exercise Price Options Exercise Price Options Exercise Price
-------------- -------------- -------------- -------------- -------------- --------------
Outstanding-
Beginning of period 810,953 $ 12.45 380,401 $ 5.72 410,482 $ 5.63
Granted 12,734 12.95 598,803 14.81 26,759 7.73
Exercised (16,965) 5.61 (168,251) 5.61 (51,488) 5.61
Forfeited (13,571) 14.30 - - (5,352) 9.78
-------------- -------------- -------------- -------------- -------------- --------------
Outstanding-end of
period 793,151 $ 12.58 810,953 $ 12.45 380,401 $ 5.72
============== ============== ============== ============== ============== ==============
Exercisable-end of
period 708,495 $ 12.43 690,795 $ 12.27 294,451 $ 5.63
============== ============== ============== ============== ============== ==============
Weighted average fair
value of options
granted during the period $ 3.90 $ 3.69 $ 1.60
============== ============== ==============
Exercise prices for options outstanding as of December 31, 2004 ranged from
$5.14 to $15.06. Exercise prices for options outstanding as of December 31, 2003
ranged from $5.14 to $15.06. The weighted average remaining contractual life of
those options is approximately six years at December 31, 2004, and four years at
December 31, 2003.
62
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 12 - EMPLOYEE BENEFIT PLANS (CONTINUED)
Employee Stock Ownership Plan - The Bank established an Employee Stock Ownership
Plan (ESOP) in 1998. The ESOP is a tax-qualified retirement plan designed to
invest primarily in the Company's common stock. All full-time employees of the
Bank who have completed one year of service with the Bank are eligible to
participate in the ESOP. The ESOP utilized funds borrowed from the Company
totaling $1,690,680, to purchase approximately 8%, or 169,068 shares of the
Company's common stock issued in the 1998 Conversion. The ESOP utilized funds
borrowed from the Company totaling $1,051,980 to purchase 105,198 additional
shares of the Company's common stock issued in the 2002 Conversion. The loans to
the ESOP will be primarily repaid with contributions from the Bank to the ESOP
over a period not to exceed 15 years for each loan. Under the terms of the ESOP,
the Bank makes contributions to the ESOP sufficient to cover all payments of
principal and interest as they become due. The 1998 loan had an outstanding
balance of $901,695 with an interest rate of 5.25% and $1,014,406 with an
interest rate of 4.00% at December 31, 2004 and 2003, respectively. The interest
rate on the loan is based on the Bank's prime rate. The 2002 loan had an
outstanding balance of $841,584 with an interest rate of 5.25% and $911,716 with
an interest rate of 4.00% at December 31, 2004 and 2003, respectively.
Shares purchased with the loan proceeds are held in a suspense account by the
trustee of the plan for future allocation among participants as the loan is
repaid. Contributions to the ESOP and shares released from the suspense account
are allocated among participants on the basis of compensation as described in
the plan. The number of shares released to participants will be determined based
upon the percentage of principal and interest payments made during the year
divided by the total remaining principal and interest payments including the
current year's payment. Participants will vest in the shares allocated to their
respective accounts over a period not to exceed 5 years. Any forfeited shares
are allocated to the then remaining participants in the same proportion as
contributions. As of December 31, 2004, 153,997 shares have been allocated to
participants and 248,341 shares remain unallocated. The fair value of the
unallocated shares was $3,543,826 at December 31, 2004. The Company recognizes
compensation expense attributable to the ESOP ratably over the fiscal year based
upon the estimated number of ESOP shares to be allocated each December 31st. The
Company recognized $223,231, $219,333, and $145,305, as compensation expense in
the years ended December 31, 2004, December 31, 2003 and December 31, 2002,
respectively.
The trustee for the ESOP must vote all allocated shares held in the ESOP trust
in accordance with the instructions of the participants. Unallocated shares held
by the ESOP trust are voted by the trustee in a manner calculated to most
accurately reflect the results of the allocated ESOP shares voted, subject to
the requirements of the Employee Retirement Income Security Act of 1974, as
amended (ERISA).
NOTE 13 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments. In cases where quoted market
prices are not available, fair values are based on estimates using present value
or other valuation techniques. The estimates are significantly affected by the
assumptions used, including discount rates and estimates of future cash flows.
These estimates may differ substantially from amounts that could be realized in
an immediate sale or settlement of the instrument.
63
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 13 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Fair value approximates book value for the following financial instruments due
to their short-term nature: cash and due from banks, interest-earning bank
balances, and advances from customers for taxes and insurance.
Fair value for investment securities and mortgage-backed and related securities
are based on quoted market prices. If a quoted market price is not available,
fair value is estimated using market prices for similar securities.
Fair value for variable rate loans that reprice frequently is based on the
carrying value reduced by an estimate of credit losses inherent in the
portfolio. Fair value for all other loans is estimated by discounting their
future cash flows using interest rates currently being offered for loans of
comparable terms and credit quality.
Fair value for demand deposit accounts and interest-bearing accounts with no
fixed maturity is equal to the carrying value. Certificate of deposit fair
values are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.
The carrying amount of repurchase agreements approximates fair value due to the
short-term nature of the agreements.
Fair value for the advances from the Federal Home Loan Bank Board is based on
discounted cash flows using current interest rates.
At December 31, 2004 and 2003, the Company had outstanding unfunded commitments
to extend credit offered in the normal course of business. Fair values of these
commitments are based on fees currently charged for similar instruments. At
December 31, 2004 and 2003, the carrying amounts and fair values of these
off-balance sheet financial instruments were immaterial.
The Company has used management's best estimates of fair values of financial
instruments based on the above assumptions. This presentation does not include
certain financial instruments, nonfinancial instruments or certain intangible
assets such as customer relationships, deposit base intangibles, or goodwill.
Accordingly, the aggregate fair value amounts presented do not represent the
underlying value of the Company. The estimated fair values of financial
instruments as of December 31 were as follows:
2004 2003
--------------------------------- ---------------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
--------------- --------------- --------------- ---------------
Financial assets
Cash and due from banks $ 5,799,611 $ 5,799,611 $ 5,374,150 $ 5,374,150
Interest-earning bank balances 5,790,650 5,790,650 2,840,035 2,840,035
Investments and mortgage-
backed securities 133,576,857 133,576,857 145,401,283 145,401,283
Loans 314,126,978 315,148,762 295,026,346 297,407,462
Financial liabilities
Deposits 374,744,428 366,115,439 342,445,676 349,743,577
Repurchase agreements 771,538 771,538 681,394 681,394
Advances from FHLB 55,000,000 55,467,576 58,300,000 59,928,212
64
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 14 - EARNINGS PER SHARE
Earnings per share has been determined under the provisions of SFAS No. 128,
Earnings Per Share. Basic earnings per share is computed by dividing net income
applicable to common stock by the weighted average number of common shares
outstanding during the period, without considering any dilutive items. Diluted
earnings per share is computed by dividing net income applicable to common stock
by the weighted average number of common shares and common stock equivalents for
items that are dilutive, net of shares assumed to be repurchased using the
treasury stock method. Common stock equivalents arise from the assumed
conversion of outstanding stock options.
The only potential stock of the Company as defined in SFAS No. 128, are stock
options granted to various directors and officers of the Bank and unvested RRP
shares. The following is a summary of the computation of basic and diluted
earnings per share:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2004 2003 2002
-------------- -------------- --------------
Net income $ 2,955,421 $ 3,390,566 $ 4,507,934
Weighted average outstanding shares 7,611,022 8,623,838 8,767,982
Basic earnings per share $ 0.39 $ 0.39 $ 0.51
Weighted average outstanding shares 7,611,022 8,623,838 8,767,982
Dilutive effect of stock options 101,648 138,707 102,072
-------------- -------------- --------------
Weighted average diluted shares 7,712,670 8,762,545 8,870,054
Diluted earnings per share $ 0.38 $ 0.39 $ 0.51
In conjunction with the 2002 Conversion, as described in Note 1. of the Notes to
Consolidated Financial Statements, the Company had 9,062,727 shares on common
stock issued and outstanding on September 30, 2002. In March 2003, the Company's
Board of Directors announced the authorization to repurchase of up to 343,027
shares of outstanding common stock. The Company repurchased 342,200 shares of
stock at an average price of $13.66 under this authority in October 2003. During
October 2003 the Company's Board of Directors announced the authorization to
repurchase up to 879,900 shares, or 10% of the outstanding common stock. The
Company repurchased 877,235 shares of stock at an average price of $13.80 under
this authority by May 2004. During May 2004, the Company's Board of Directors
authorized the repurchase of up to 815,000 shares, or 10% of the outstanding
common stock. As of December 31, 2004, the Company had repurchased 726,000
shares of stock at an average price of $13.02 under this authorization and had
89,000 shares remaining.
As of December 31, 2004, a total of 1,945,435 shares, or 21.5% of the
outstanding shares of common stock, have been repurchased under these plans at
an average price of $13.48 per share.
65
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 15 - PARENT-ONLY FINANCIAL INFORMATION
The earnings of the Bank are recognized by Citizens South Banking Corporation
using the equity method of accounting. Accordingly, undistributed earnings of
the Bank are recorded as increases in the Company's investment in the Bank. The
following are the condensed financial statements of the Company as of December
31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002.
Condensed Statements of Financial Condition
December 31, December 31,
2004 2003
------------- -------------
Assets
Cash and cash equivalents $ 2,687,014 $ 15,190,646
Investment in securities available-for-sale 2,476,936 3,095,237
Investment in subsidiary 66,828,552 69,044,166
Other assets 431,654 362,656
------------- -------------
Total assets $ 72,424,156 $ 87,692,705
============= =============
Liabilities and Stockholders' Equity
Liabilities $ 29,899 $ 23,797
Stockholders' equity 72,394,257 87,668,908
------------- -------------
Total liabilities and stockholders' equity $ 72,424,156 $ 87,692,705
============= =============
Condensed Statements of Operations
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2004 2003 2002
------------- ------------- -------------
Interest income $ 238,212 $ 474,295 $ 255,815
Interest expense - - (26,865)
Other noninterest income 163,800 10,177 81,592
Other noninterest expenses (631,667) (980,671) (94,346)
------------- ------------- -------------
Income before income taxes and undistributed
earnings from subsidiaries (229,655) (496,199) 216,196
Income taxes 96,000 204,995 (83,162)
------------- ------------- -------------
Income before undistributed earnings from
subsidiaries (133,655) (291,204) 133,034
Equity in undistributed earnings of subsidiaries 3,089,076 3,681,770 4,374,900
------------- ------------- -------------
Net income $ 2,955,421 $ 3,390,566 $ 4,507,934
============= ============= =============
66
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements (Continued)
NOTE 15 - PARENT-ONLY FINANCIAL INFORMATION (CONTINUED)
Condensed Statements of Cash Flows
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2004 2003 2002
------------- ------------- -------------
Operating activities
Net income $ 2,955,421 $ 3,390,566 $ 4,507,934
Adjustments to reconcile net income to net
Cash provided by operating activities
(Gain) on sale of investments (163,800) - (81,592)
Equity in undistributed (earnings) of
Subsidiaries (3,089,076) (3,681,770) (4,374,900)
Allocation of shares to ESOP 282,995 287,717 273,998
Vesting of shares issued for the RRP 281,025 974,848 -
(Increase) in other operating subsidiaries (21,514) (14,772) (48,551)
(Decrease) increase in other operating
liabilities 6,102 (309,536) 84,972
------------- ------------- -------------
Net cash provided by operating activities 251,153 647,053 361,861
Investing activities
Proceeds from the sale of investments 1,008,000 - -
Purchase of investments available-for-sale (347,282) (2,000,000) (94,117)
------------- ------------- -------------
Net cash used in investing activities 660,718 (2,000,000) (94,117)
Financing activities
Issuance of additional common stock 1,315 - 50,133,555
Repurchase of common stock (16,403,258) (9,801,707) -
Contributed capital to bank subsidiary - - (23,124,633)
Dividends received from bank subsidiary 5,000,000 - -
Exercise of options - 149,793 -
Dividends to stockholders (2,013,560) (2,136,607) (873,719)
------------- ------------- -------------
Net cash (used in) provided by financing
activities (13,415,503) (11,788,521) 26,135,203
Net increase (decrease) in cash and cash equivalents (12,503,632) (13,141,468) 26,402,947
Cash and cash equivalents, beginning of period 15,190,646 28,332,114 1,929,167
------------- ------------- -------------
Cash and cash equivalents, end of period $ 2,687,014 $ 15,190,646 $ 28,332,114
============= ============= =============
67
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, the Company has evaluated the effectiveness of the design and operation
of its disclosure controls and procedures (as defined in Rule 13a-15(e) and
15d-15(e) under the Exchange Act) as of the end of the period covered by this
report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the end of the period covered by this
report, the Company's disclosure controls and procedures were effective to
ensure that information required to be disclosed in the reports that the Company
files or submits under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the SEC's rules and forms.
There has been no change in the Company's internal control over
financial reporting identified in connection with the quarterly evaluation that
occurred during the Company's last fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Citizens South Banking Corporation (the "Company") is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act of 1934, as amended. The Company's internal control over
financial reporting is 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. The Company's internal control over financial reporting includes
those policies and procedures that:
. pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and
dispositions of the assets of the Company;
. provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and
that material receipts and expenditures of the Company are being
made only in accordance with the authorizations of management
and directors of the Company; and
. 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 of the Company.
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. Management
assessed the effectiveness of the Company's internal control over financial
reporting as of December 31, 2004. In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on our assessment and those criteria, management believes that the
Company maintained effective internal control over financial reporting as of
December 31, 2004.
The Company's independent registered public accounting firm has issued
an attestation report on management's assessment of the Company's internal
control over financial reporting. That report is presented on the following page
of this report.
68
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
Citizens South Banking Corporation
We have audited management's assessment, included in the accompanying
Management's Annual Report on Internal Control Over Financial Reporting, that
Citizens South Banking Corporation and subsidiaries (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 aspects. 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 accounting principles generally accepted in the United States of
America. 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 accounting principles generally accepted in the
United States of America, 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 COSO. Also in our opinion, the
Company maintained, in all material aspects, effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control-Integrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated statements
of condition of the Company as of December 31, 2004 and 2003 and the related
consolidated statements of operations, comprehensive income, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2004 and our report dated March 3, 2005 expressed an
unqualified opinion on these consolidated financial statements.
/s/ Cherry, Bekaert & Holland, L.L.P.
Gastonia, North Carolina
March 3, 2005
69
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The "Proposal I - Election of Directors" section of the Registrant's
Definitive Proxy Statement dated April 4, 2005, (the "Proxy Statement") as filed
pursuant to Section 14 of the Securities Exchange Act of 1034 in connection with
the 2004 Annual Meeting of Shareholders is incorporated herein by reference. In
addition, the Item 1. "Executive Officers of the Registrant" section of the
Proxy Statement is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The "Proposal I - Election of Directors" section of the Registrant's
Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The "Proposal I - Election of Directors" section of the Registrant's
Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The "Proposal I - Election of Directors" section of the Registrant's
Proxy Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The "Principal Accountant's Fees and Services" section of this
Registrant's Proxy Statement is incorporated herein by reference.
70
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
A. Index of Exhibits
3.1 Certificate of Incorporation of Citizens South Banking
Corporation (incorporated herein by reference to the Registration Statement on
Form S-1 (File No. 333-91498), originally filed with the Commission on June 28,
2002
3.2 Bylaws of Citizens South Banking Corporation (incorporated
herein by reference to the Registration Statement on Form S-1 (File No.
333-91498), originally filed with the Commission on June 28, 2002
4 Form of Common Stock Certificate of Citizens South Banking
Corporation (incorporated herein by reference to the Registration Statement on
Form S-1 (File No. 333-91498), originally filed with the Commission on June 28,
2002
10.1 Employment Agreement with Kim S. Price dated May 17, 2004
10.2 Deferred Compensation and Income Continuation Agreement
(incorporated by reference to the Registration Statement on Form SB-2 (File No.
333-42951), originally filed with the Commission on December 22, 1997
10.3 Employee Stock Ownership Plan (incorporated by reference to the
Registration Statement on Form SB-2 (File No. 333-42951), originally filed with
the Commission on December 22, 1997
10.4 Supplemental Executive Retirement Plan (incorporated by
reference to the Registration Statement on Form SB-2 (File No. 333-42951),
originally filed with the Commission on December 22, 1997
10.5 Severance Agreement with Gary F. Hoskins dated May 17, 2004
10.6 Severance Agreement with Paul L. Teem, Jr. dated May 17, 2004
10.7 Severance Agreement with Michael R. Maguire dated May 17, 2004
10.8 Severance Agreement with Daniel M. Boyd, IV dated May 17, 2004
10.9 Severance Agreement with V. Burton Brinson, Jr. dated
May 17, 2004
10.10 Salary Continuation Agreement with Kim S. Price dated
January 1, 2004
10.11 Salary Continuation Agreement with Gary F. Hoskins dated
January 1, 2004
10.12 Salary Continuation Agreement with Paul L. Teem, Jr. dated
January 1, 2004
10.13 Salary Continuation Agreement with Michael R. Maguire dated
January 1, 2004
10.14 Salary Continuation Agreement with Daniel M. Boyd, IV dated
January 1, 2004
10.15 Salary Continuation Agreement with V. Burton Brinson, Jr. dated
January 1, 2004
10.16 Endorsement Split Dollar Agreement with Kim S. Price dated
January 1, 2004
71
10.17 Endorsement Split Dollar Agreement with Gary F. Hoskins dated
January 1, 2004
10.18 Endorsement Split Dollar Agreement with Paul L. Teem, Jr. dated
January 1, 2004
10.19 Endorsement Split Dollar Agreement with Michael R. Maguire dated
January 1, 2004
10.20 Endorsement Split Dollar Agreement with Daniel M. Boyd, IV dated
January 1, 2004
10.21 Endorsement Split Dollar Agreement with V. Burton Brinson, Jr.
dated January 1, 2004
10.22 Amended Deferred Compensation and Income Continuation Agreement
with David W. Hoyle, Sr. dated March 15, 2004
10.23 Amended Deferred Compensation and Income Continuation Agreement
with Ben R. Rudisill, II dated March 15, 2004
10.24 Amended Deferred Compensation and Income Continuation Agreement
with James J. Fuller dated March 15, 2004
10.25 Amended Deferred Compensation and Income Continuation Agreement
with Charles D. Massey dated March 15, 2004
10.26 Amended Director Retirement Agreement with David W. Hoyle, Sr.
dated March 15, 2004
10.27 Amended Director Retirement Agreement with Ben R. Rudisill, II
dated March 15, 2004
10.28 Amended Director Retirement Agreement with James J. Fuller dated
March 15, 2004
10.29 Amended Director Retirement Agreement with Charles D. Massey
dated March 15, 2004
10.30 Amended Director Retirement Agreement with Eugene R. Matthews,
II dated March 15, 2004
14 Code of Ethics Policy (incorporated herein by reference to the
"Proposal I - Election of Directors" section of the Registrant's Proxy Statement
dated April 4, 2005
21 Subsidiaries of Registrant (incorporated herein by reference to
the Registration Statement on Form S-1 (File No. 333-91498), originally filed
with the Commission on June 28, 2002
23 Consent of Cherry, Bekaert & Holland, L.L.P.
24 Power of Attorney (set forth on signature page)
31 Certification of Chief Executive Officer and Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Statement of Chief Executive Officer and Chief Financial Officer
furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
72
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
Citizens South Banking Corporation
Date: March 10, 2005 By: /s/ Kim S. Price
--------------------------------
Kim S. Price
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange 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.
By: /s/ Kim S. Price By: /s/ Gary F. Hoskins
------------------------------- --------------------------------
Kim S. Price Gary F. Hoskins
President, Chief Executive Executive Vice President,
Officer and Director (Principal Treasurer and Chief Financial
Executive Officer) Officer (Principal Financial and
Accounting Officer)
Date: March 10, 2005 Date: March 10, 2005
By: /s/ David W. Hoyle By: /s/ Ben R. Rudisill, II
------------------------------- --------------------------------
David W. Hoyle Ben R. Rudisill, II
Chairman Vice Chairman
Date: March 10, 2005 Date: March 10, 2005
By: /s/ Eugene R. Matthews, II By: /s/ Charles D. Massey
------------------------------- --------------------------------
Eugene R. Matthews, II Charles D. Massey
Director Director
Date: March 10, 2005 Date: March 10, 2005
By: /s/ James J. Fuller
-------------------------------
James J. Fuller
Director
Date: March 10, 2005
73