UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission file number: 0-25859
1st STATE BANCORP, INC.
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(Exact Name of Registrant as Specified in Its Charter)
Virginia 56-2130744
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
445 S. Main Street, Burlington, North Carolina 27215
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(Address of Principal Executive Offices) (Zip Code)
(336) 227-8861
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Registrant's Telephone Number, Including Area Code
Not Applicable
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(Former Name, Former Address and Former Fiscal Year, if
Changed Since Last Report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of August 6, 2004, the issuer had 2,962,323 shares of common stock
issued and outstanding.
CONTENTS
PAGE
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2004 (unaudited) and September 30, 2003.......................2
Consolidated Statements of Income for the Three Months Ended June 30, 2004 and
2003 (unaudited)................................................................................3
Consolidated Statements of Income for the Nine Months Ended June 30, 2004 and
2003 (unaudited)................................................................................4
Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Nine
Months Ended June 30, 2004 and 2003 (unaudited).................................................5
Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2004 and
2003 (unaudited)................................................................................6
Notes to Consolidated Financial Statements...............................................................8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................11
Item 3. Quantitative and Qualitative Disclosures About Market Risk..............................................21
Item 4. Controls and Procedures.................................................................................21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.......................................................................................22
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities........................22
Item 3. Defaults Upon Senior Securities.........................................................................22
Item 4. Submission of Matters to a Vote of Security Holders.....................................................22
Item 5. Other Information.......................................................................................22
Item 6. Exhibits and Reports on Form 8-K........................................................................23
SIGNATURES
1
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2004 AND SEPTEMBER 30, 2003
(IN THOUSANDS, EXCEPT SHARE DATA)
AT AT
JUNE 30, SEPTEMBER 30,
2004 2003
------------------ ------------
(Unaudited)
ASSETS
Cash and cash equivalents $ 10,735 $ 9,359
Investment securities:
Held to maturity (fair value of $22,780 and $19,397
at June 30, 2004 and September 30, 2003, respectively) 23,228 19,462
Available for sale (cost of $100,365 and $92,971
at June 30, 2004 and September 30, 2003, respectively) 97,604 91,709
Loans held for sale, at lower of cost or fair value 1,222 645
Loans receivable (net of allowance for loan losses of $3,910
and $3,856 at June 30, 2004 and September 30, 2003,
respectively) 230,377 225,725
Real estate owned 26 95
Federal Home Loan Bank stock, at cost 2,425 1,675
Premises and equipment 8,038 8,413
Accrued interest receivable 2,229 1,967
Other assets 4,501 3,590
----------- ----------
Total assets $ 380,385 $ 362,640
=========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposit accounts 263,838 262,712
Advances from Federal Home Loan Bank 47,500 31,500
Advance payments by borrowers for property taxes and insurance 288 57
Dividend payable 296 297
Other liabilities 4,693 5,373
----------- ----------
Total liabilities 316,615 299,939
----------- ----------
Stockholders' Equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized;
none issued -- --
Common stock, $0.01 par value, 7,000,000 shares authorized;
2,962,323 and 2,971,977 shares issued and outstanding
at June 30, 2004 and September 30, 2003, respectively 33 33
Additional paid-in capital 35,987 35,778
Unallocated ESOP shares (2,712) (3,141)
Deferred compensation payable in treasury stock 6,252 5,466
Treasury stock (13,897) (12,785)
Retained income - substantially restricted 39,787 38,118
Accumulated other comprehensive loss - net unrealized
loss on investment securities available for sale (1,680) (768)
----------- ----------
Total stockholders' equity 63,770 62,701
----------- ----------
Total liabilities and stockholders' equity $ 380,385 $ 362,640
=========== ==========
See accompanying notes to the consolidated financial statements.
2
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
FOR THE THREE MONTHS ENDED
JUNE 30,
-----------------------------
2004 2003
---------- ----------
Interest income:
Interest and fees on loans $ 2,812 $ 3,097
Interest and dividends on investments 1,288 982
Overnight deposits 6 43
--------- ---------
Total interest income 4,106 4,122
--------- ---------
Interest expense:
Deposit accounts 824 1,040
Borrowings 346 273
--------- ---------
Total interest expense 1,170 1,313
--------- ---------
Net interest income 2,936 2,809
Provision for loan losses 60 60
--------- ---------
Net interest income after provision for loan losses 2,876 2,749
--------- ---------
Other income:
Customer service fees 253 218
Commissions from sales of annuities and mutual funds 99 100
Mortgage banking income, net 126 422
Securities gains, net -- 103
Other 208 65
--------- ---------
Total other income 686 908
--------- ---------
Operating expenses:
Compensation and related benefits 1,351 1,313
Occupancy and equipment 351 353
Real estate operations, net (4) (2)
Other expenses 375 443
--------- ---------
Total operating expenses 2,073 2,107
--------- ---------
Income before income taxes 1,489 1,550
Income taxes 516 562
--------- ---------
Net income $ 973 $ 988
========= =========
Earnings per share:
Basic $ 0.35 $ 0.35
Diluted $ 0.33 $ 0.34
See accompanying notes to the consolidated financial statements.
3
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
FOR THE NINE MONTHS ENDED
JUNE 30,
----------------------------
2004 2003
---------- ---------
Interest income:
Interest and fees on loans $ 8,495 $ 9,764
Interest and dividends on investments 3,588 3,194
Overnight deposits 24 128
--------- ---------
Total interest income 12,107 13,086
--------- ---------
Interest expense:
Deposit accounts 2,629 3,500
Borrowings 965 825
--------- ---------
Total interest expense 3,594 4,325
--------- ---------
Net interest income 8,513 8,761
Provision for loan losses 180 180
--------- ---------
Net interest income after provision for loan losses 8,333 8,581
--------- ---------
Other income:
Customer service fees 699 648
Commissions from sales of annuities and mutual funds 263 346
Mortgage banking income, net 337 1,259
Securities gains, net 185 103
Other 318 183
--------- ---------
Total other income 1,802 2,539
-------- ---------
Operating expenses:
Compensation and related benefits 3,999 4,058
Occupancy and equipment 1,034 1,088
Real estate operations, net (9) 7
Other expenses 1,208 1,282
--------- ---------
Total operating expenses 6,232 6,435
--------- ---------
Income before income taxes 3,903 4,685
Income taxes 1,393 1,717
--------- ---------
Net income $ 2,510 $ 2,968
========= =========
Earnings per share:
Basic $ 0.89 $ 1.06
Diluted $ 0.85 $ 1.01
See accompanying notes to the consolidated financial statements.
4
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS'
EQUITY AND COMPREHENSIVE INCOME
FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND
2003 (UNAUDITED)
(IN THOUSANDS)
DEFERRED
COMPENSATION
ADDITIONAL UNALLOCATED PAYABLE IN
COMMON PAID-IN ESOP TREASURY TREASURY RETAINED
STOCK CAPITAL SHARES STOCK STOCK INCOME
----- ------- ----------- ----- ----- ------
Balance at September 30, 2002 $ 33 35,623 (3,739) 5,466 (11,899) 35,258
Comprehensive income:
Net income -- -- -- -- -- 2,968
Other comprehensive loss-unrealized
loss on securities available-for-sale
net of income tax benefit of $252 -- -- -- -- -- --
Total comprehensive income
Allocation of ESOP shares -- 107 448 -- -- --
Acquisition of treasury stock -- -- -- -- (796) --
Cash dividends declared ($0.28 per share) -- -- -- -- -- (834)
Cash dividends on unallocated ESOP shares -- -- -- -- -- 53
--------- ---------- ---------- ----------- ---------- -------------
Balance at June 30, 2003 $ 33 35,730 (3,291) 5,466 (12,695) 37,445
========= ========== ========== =========== ========== =============
Balance at September 30, 2003 $ 33 35,778 (3,141) 5,466 (12,785) 38,118
Comprehensive income:
Net income -- -- -- -- -- 2,510
Other comprehensive loss-unrealized
loss on securities available-for-sale
net of income tax benefit of $587 -- -- -- -- -- --
Total comprehensive income
Allocation of ESOP shares -- 190 429 -- -- --
Acquisition of treasury stock -- -- -- -- (1,112) --
Deferred compensation -- -- -- 786 -- --
Exercise of stock options -- 19 -- -- -- --
Cash dividends declared ($0.30 per share) -- -- -- -- -- (889)
Cash dividends on unallocated ESOP shares -- -- -- -- -- 48
--------- ---------- ---------- ----------- ---------- ------------
Balance at June 30, 2004 $ 33 35,987 (2,712) 6,252 (13,897) 39,787
========= ========== ========== =========== ========== ============
ACCUMULATED
OTHER TOTAL
COMPREHENSIVE STOCKHOLDERS'
INCOME (LOSS) EQUITY
------------- -----------
Balance at September 30, 2002 827 61,569
Comprehensive income:
Net income -- 2,968
Other comprehensive loss-unrealized
loss on securities available-for-sale
net of income tax benefit of $252 (392) (392)
-------
Total comprehensive income 2,576
Allocation of ESOP shares -- 555
Acquisition of treasury stock -- (796)
Cash dividends declared ($0.28 per share) -- (834)
Cash dividends on unallocated ESOP shares -- 53
-------- -------
Balance at June 30, 2003 435 63,123
======== =======
Balance at September 30, 2003 (768) 62,701
Comprehensive income:
Net income -- 2,510
Other comprehensive loss-unrealized
loss on securities available-for-sale
net of income tax benefit of $587 (912) (912)
-------
Total comprehensive income 1,598
Allocation of ESOP shares -- 619
Acquisition of treasury stock -- (1,112)
Deferred compensation -- 786
Exercise of stock options -- 19
Cash dividends declared ($0.30 per share) -- (889)
Cash dividends on unallocated ESOP shares -- 48
-------- -------
Balance at June 30, 2004 (1,680) 63,770
======== =======
See accompanying notes to the consolidated financial statements.
5
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
(IN THOUSANDS)
FOR THE NINE MONTHS ENDED
JUNE 30,
----------------------------
2004 2003
--------- ---------
Cash flows from operating activities:
Net income $ 2,510 $ 2,968
Adjustment to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 180 180
Depreciation 514 557
Deferred tax expense (benefit) (135) 137
Amortization of premiums and discounts, net 8 (34)
Deferred compensation 180 180
Release of ESOP shares 619 555
Loan origination fees and unearned discounts
deferred, net of current amortization (49) (66)
Loss (gain) on sale of other real estate (22) 11
Gain on sale of investment securities available for sale (185) (103)
Net (gain) loss on sale of loans 39 (302)
Proceeds from loans held for sale 21,072 73,457
Originations of loans held for sale (21,688) (75,841)
Decrease (increase) in other assets (190) 208
Decrease (increase) in accrued interest receivable (262) 723
Increase (decrease) in other liabilities (74) 2,835
---------- ---------
Net cash provided by operating activities 2,517 5,465
---------- ---------
Cash flows provided by (used in) investing activities:
Proceeds from redemption of FHLB stock 2,500 1,018
Purchases of FHLB stock (3,250) (268)
Purchases of investment securities held to maturity (9,776) (5,998)
Purchases of investment securities available for sale (48,504) (80,239)
Proceeds from sales of investment securities available for sale 10,993 1,103
Proceeds from maturities and issuer calls of investment securities
available for sale 30,302 96,473
Proceeds from maturities and issuer calls of investment securities
held to maturity 6,002 2,003
Net increase in loans receivable (4,965) (3,728)
Purchase of real estate acquired in settlement of loans (255) --
Proceeds from sales of REO 528 92
Purchases of premises and equipment net of disposals (139) (1,033)
---------- ---------
Net cash provided by (used in) investing activities (16,564) 9,423
---------- ---------
(Continued)
6
1st STATE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED
FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
(IN THOUSANDS)
FOR THE NINE MONTHS ENDED
JUNE 30,
-------------------------------
2004 2003
----------- ----------
Cash flows from financing activities:
Net increase (decrease) in deposits $ 1,126 $ (456)
Advances from the Federal Home Loan Bank 90,000 13,000
Repayments of advances from the Federal Home Loan Bank (74,000) (13,000)
Purchase of treasury stock (1,112) (796)
Exercise of stock options 19 --
Dividends paid on common stock (841) (725)
Increase in advance payments by borrowers for
property taxes and insurance 231 282
---------- ---------
Net cash provided by (used in) financing activities 15,423 (1,695)
---------- ----------
Net increase in cash and cash equivalents 1,376 13,193
Cash and cash equivalents at beginning of period 9,359 18,865
---------- ---------
Cash and cash equivalents at end of period $ 10,735 $ 32,058
========== =========
Payments are shown below for the following:
Interest $ 3,566 $ 4,343
========== =========
Income taxes $ 1,397 $ 1,133
========== =========
Noncash investing and financing activities:
Unrealized losses on investment securities
available for sale $ (1,499) $ (644)
========== =========
Cash dividends declared but not paid $ 280 $ 278
========== =========
Cash dividends on unallocated ESOP shares $ 48 $ 53
========== =========
Transfer from loans to real estate acquired in settlement of loans $ 182 $ 0
========== =========
See accompanying notes to the consolidated financial statements.
7
1st STATE BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2004 (UNAUDITED) AND SEPTEMBER 30, 2003
NOTE 1. NATURE OF BUSINESS
1st State Bancorp, Inc. (the "Company") was incorporated under the laws of
the Commonwealth of Virginia for the purpose of becoming the holding company for
1st State Bank (the "Bank") in connection with the Bank's conversion from a
North Carolina-chartered mutual savings bank to a North Carolina-chartered stock
savings bank (the "Converted Bank") pursuant to its Plan of Conversion (the
"Stock Conversion"). Upon completion of the Stock Conversion, the Converted Bank
converted from a North Carolina-chartered stock savings bank to a North Carolina
commercial bank (the "Bank Conversion"), retaining the name 1st State Bank (the
"Commercial Bank"), and the Commercial Bank succeeded to all of the assets and
liabilities of the Converted Bank. The Stock Conversion and the Bank Conversion
were consummated on April 23, 1999. The common stock of the Company began
trading on the Nasdaq National Market System under the symbol "FSBC" on April
26, 1999.
NOTE 2. BASIS OF PRESENTATION
The accompanying consolidated financial statements (which are unaudited,
except for the consolidated balance sheet at September 30, 2003, which is
derived from the September 30, 2003 audited consolidated financial statements)
have been prepared in accordance with accounting principles generally accepted
in the United States of America and with the rules and regulations of the
Securities and Exchange Commission. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements. In the
opinion of management, all adjustments (none of which were other than normal
recurring accruals) necessary for a fair presentation of the financial position
and results of operations for the periods presented have been included.
The results of operations for the three and nine month periods ended June
30, 2004 are not necessarily indicative of the results of operations that may be
expected for the year ending September 30, 2004. The preparation of consolidated
financial statements in accordance with accounting principles generally accepted
in the United States of America requires management to make certain estimates.
These amounts may be revised in future periods because of changes in the facts
and circumstances underlying their estimation.
NOTE 3. EARNINGS PER SHARE
For purposes of computing basic and diluted earnings per share, weighted
average shares outstanding excludes unallocated ESOP shares that have not been
committed to be released. The deferred compensation obligation discussed in Note
5 that is funded with shares of the Company's common stock has no net impact on
the Company's earnings per share computations. Diluted earnings per share
include the potentially dilutive effects of the Company's stock-based benefit
plans. There were no anti-dilutive stock options for the three and nine months
ended June 30, 2004 and 2003. A reconciliation of the denominators of the basic
and diluted earnings per share computations is as follows:
THREE MONTHS ENDED
JUNE 30,
------------------------------
2004 2003
---------- -----------
Average shares issued and outstanding 2,962,323 2,976,652
Less: Unallocated ESOP shares (142,207) (176,174)
--------- ---------
Average basic shares for earnings per share 2,820,116 2,800,478
Add: Potential common stock pursuant to stock option plan 145,534 123,595
--------- ---------
Average dilutive shares for earnings per share 2,965,560 2,924,073
========= =========
8
NINE MONTHS ENDED
JUNE 30,
------------------------------
2004 2003
---------- -----------
Average shares issued and outstanding 2,965,045 2,991,761
Less: Unallocated ESOP shares (149,527) (181,034)
--------- ---------
Average basic shares for earnings per share 2,815,518 2,810,727
Add: Potential common stock pursuant to stock option plan 150,436 124,192
--------- ---------
Average dilutive shares for earnings per share 2,965,954 2,934,919
========= =========
NOTE 4. EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP")
The Company sponsors an employee stock ownership plan (the "ESOP") whereby
an aggregate number of shares amounting to 253,050 or 8% of the stock issued in
the conversion was purchased for future allocation to employees. The ESOP was
funded by an 11-year term loan from the Company in the amount of $4,899,000. The
loan is secured by the shares of stock purchased by the ESOP. During the three
and nine months ended June 30, 2004 and 2003, 7,280 and 7,644 and 21,920 and
22,932 shares of stock were committed to be released and approximately $199,000
and $185,000 and $619,000 and $555,000, respectively, of compensation expense
was recognized.
NOTE 5. DEFERRED COMPENSATION
Directors and certain executive officers participate in a deferred
compensation plan, which was approved by the Board of Directors on September 24,
1997. This plan generally provides for fixed payments beginning after the
participant retires. Each participant is fully vested in his account balance
under the plan. Directors may elect to defer their directors' fees and executive
officers may elect to defer 25% of their salary and 100% of bonus compensation.
Prior to the Stock Conversion, amounts deferred by each participant
accumulated interest at a rate equal to the highest rate of interest paid on the
Bank's one-year certificates of deposit. In connection with the Stock
Conversion, participants in the plan were given the opportunity to prospectively
elect to have their deferred compensation balance earn a rate of return equal to
the total return of the Company's stock. All participants elected this option
concurrent with the Stock Conversion, so the Company purchases its common stock
to fund this obligation. Refer to the Company's notes to consolidated financial
statements, incorporated by reference in the Company's 2003 Annual Report on
Form 10-K for a discussion of the Company's accounting policy with respect to
this deferred compensation plan and the related treasury stock purchased by the
Company to fund this obligation.
The expense related to this plan for the three and nine months ended June
30, 2004 and 2003 was $60,000 and $60,000 and $180,000 and $180,000,
respectively. This expense is included in compensation expense.
NOTE 6. STOCK OPTION AND INCENTIVE PLAN
On June 6, 2000, the Company's stockholders approved the 1st State Bancorp,
Inc. 2000 Stock Option and Incentive Plan (the "Plan"). The purpose of this plan
is to advance the interests of the Company through providing select key
employees and directors of the Bank with the opportunity to acquire shares. By
encouraging such stock ownership, the Company seeks to attract, retain and
motivate the best available personnel for positions of substantial
responsibility and to provide incentives to the key employees and directors.
Under the Plan, the Company granted 316,312 options to purchase its $0.01 par
value common stock. The exercise price per share is equal to the fair market
value per share on the date of the grant. Options granted under the Stock Option
Plan are 100% vested on the date of the grant, and all options expire 10 years
from the date of the grant. As a result of the one-time cash dividend of $5.17
paid on October 2, 2000, the exercise price for the options repriced from $18.44
to $14.71. There were 2,077 options exercised during the nine months ended June
30, 2004. No options were granted during the three and nine months ended June
30, 2004 and 2003. At June 30, 314,235 options are outstanding, all of which are
exercisable.
9
NOTE 7. MORTGAGE SERVICING RIGHTS
The rights to service mortgage loans for others are included in other
assets on the consolidated balance sheet. Mortgage servicing rights ("MSRs") are
capitalized based on the allocated cost that is determined when the underlying
loans are sold. MSRs are amortized over a period that approximates the life of
the underlying loan as an adjustment of servicing income. Impairment reviews of
MSRs are performed on a quarterly basis. As of June 30, 2004 and September 30,
2003, MSRs totaled $508,000 and $547,000, respectively, and no valuation
allowance was required.
Amortization expense totaled $85,000 and $126,000 for the nine months ended
June 30, 2004 and 2003, respectively.
NOTE 8. STANDBY LETTERS OF CREDIT
In November 2002, the FASB issued Interpretation No. 45 (FIN 45),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", which addressed the disclosure
to be made by a guarantor in its interim and annual financial statements about
its obligations under guarantees. FIN 45 requires the guarantor to recognize a
liability for the non-contingent component of the guarantee, such as the
obligation to stand ready to perform in the event that specified triggering
events or conditions occur. The initial measurement of this liability is the
fair value of the guarantee at inception. The recognition of the liability is
required even if it is not probable that payments will be required under the
guarantee or if the guarantee was issued with a premium payment or as part of a
transaction with multiple events. The initial recognition and measurement
provisions are effective for all guarantees within the scope of FIN 45 issued or
modified after June 30, 2003. The Company issues standby letters of credit
whereby the Company guarantees performance if a specified triggering event or
condition occurs (primarily nonperformance under construction contracts entered
into by construction customers). The guarantees generally expire within one year
and may be automatically renewed depending on the terms of the guarantee. The
maximum potential amount of undiscounted future payments related to standby
letters of credit at June 30, 2004 is $2.0 million. At June 30, 2004, the
Company has recorded no liability for the obligation to perform as a guarantor.
In addition, no contingent liability is considered necessary as such amounts are
not deemed probable. Substantially all standby letters of credit are secured by
real estate and/or guaranteed by third parties in the event the Company had to
advance funds to fulfill the guarantee.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
When used in this Form 10-Q, the words or phrases "will likely result,"
"are expected to," "will continue," "is anticipated," "estimate," "project" or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties including changes in
economic conditions in our market area, changes in policies by regulatory
agencies, fluctuations in interest rates, demand for loans in our market area,
and competition that could cause actual results to differ materially from
historical earnings and those presently anticipated or projected. We wish to
caution you not to place undue reliance on any such forward-looking statements,
which speak only as of the date made. We wish to advise you that the factors
listed above could affect our financial performance and could cause our actual
results for future periods to differ materially from any opinions or statements
expressed with respect to future periods in any current statements.
We do not undertake, and specifically disclaim any obligation, to publicly
release the result of any revisions which may be made to any forward-looking
statements to reflect events or circumstances after the date of such statements
or to reflect the occurrence of anticipated or unanticipated events.
GENERAL
1st State Bancorp, Inc. was formed in November 1998 and became the holding
company for 1st State Bank on April 23, 1999.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of interest paid on
deposits and borrowed funds. Net interest income also is affected by the
relative amounts of interest-earning assets and interest-bearing liabilities.
When interest-earning assets approximate or exceed interest-bearing liabilities,
any positive interest rate spread will generate net interest income. Our
profitability is also affected by the level of other income and operating
expenses. Other income consists of miscellaneous fees related to our loans and
deposits, mortgage banking income and commissions from sales of annuities and
mutual funds. Operating expenses consist of compensation and benefits, occupancy
related expenses, federal deposit insurance premiums, data processing,
advertising and other expenses.
Our operations are influenced significantly by local economic conditions
and by policies of financial institution regulatory authorities. Our cost of
funds is influenced by interest rates on competing investments and by rates
offered on similar investments by competing financial institutions in our market
area, as well as general market interest rates. These factors can cause
fluctuations in our net interest income and other income. Lending activities are
affected by the demand for financing of real estate and other types of loans,
which in turn is affected by the interest rates at which such financing may be
offered. In addition, local economic conditions can impact the credit risk of
our loan portfolio, in that local employers may be required to eliminate
employment positions of many of our borrowers, and small businesses and other
commercial borrowers may experience a downturn in their operating performance
and become unable to make timely payments on their loans. Management evaluates
these factors in estimating its allowance for loan losses, and changes in these
economic conditions could result in increases or decreases to the provision for
loan losses.
Our business emphasis has been to operate as a well capitalized, profitable
and independent community-oriented financial institution dedicated to providing
quality customer service. We are committed to meeting the financial needs of the
communities in which we operate. We believe that we can be more effective in
servicing our customers than many of our nonlocal competitors because of our
ability to quickly and effectively provide senior management responses to
customer needs and inquiries. Our ability to provide these services is enhanced
by the stability of our senior management team.
Over the years, we have sought to gradually increase the percentage of our
assets invested in commercial real estate loans, commercial loans and consumer
loans, which have shorter terms and adjust more frequently to changes in
interest rates than single-family residential mortgage loans. These loans
11
generally carry added risk when compared to a single-family residential mortgage
loan, so we have concurrently increased our allowance for loan losses as we have
originated these loans.
Due to a general slowdown in the economy beginning in 2000, the Federal
Reserve acted to provide a stimulus through a series of interest rate reductions
that lowered the prime rate from 9.50% in January 2001 to 4.00% in June 2003.
These reductions in prime tended to negatively impact the Company's net interest
margin and net interest spread which resulted in lower net interest income for
the Company. The Company's asset growth has been slower as a result of heavy
refinancing as customers have taken advantage of these attractive interest
rates. The fee income associated with the heavy refinancing volume has replaced
some of the lost net interest income. Now as the refinancing activity has
slowed, the Company is looking to replace lost net interest income possibly with
leverage strategies. During periods of slow loan demand, the Company purchases
more investments, and the Company uses short-term borrowings as an alternative
to deposits for funding certain assets. The Company's balance sheet is currently
asset sensitive, that is, rate sensitive assets exceed rate sensitive
liabilities. We expect an increase in net interest income during periods of
rising interest rates and decreased net interest income during periods of
falling interest rates.
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are set forth in Note 1 of
the consolidated financial statements as of September 30, 2003, which was filed
on the Company's Annual Report on Form 10-K for the fiscal year ended September
30, 2003. Of these significant accounting policies, the Company considers its
policy regarding the allowance for loan losses to be its most critical
accounting policy, because it requires management's most subjective and complex
judgments. In addition, changes in economic conditions can have a significant
impact on the allowance for loan losses and therefore the provision for loan
losses and results of operations. The Company has developed appropriate policies
and procedures for assessing the adequacy of the allowance for loan losses,
recognizing that this process requires a number of assumptions and estimates
with respect to its loan portfolio. The Company's assessments may be impacted in
future periods by changes in economic conditions, the impact of regulatory
examinations, and the discovery of information with respect to borrowers that is
not known to management at the time of the issuance of the consolidated
financial statements.
12
COMPARISON OF FINANCIAL CONDITION AT JUNE 30, 2004 AND SEPTEMBER 30, 2003
Total assets increased $17.8 million from September 30, 2003 to June 30,
2004. Assets increased to $380.4 million at June 30, 2004 from $362.6 million at
September 30, 2003. The Company grew both loans receivable, net and loans held
for sale as well as investment securities. Asset growth was funded by increased
borrowings from the Federal Home Loan Bank of Atlanta and to a lesser extent
deposits.
Investment securities available for sale increased $5.9 million from $91.7
million at September 30, 2003 to $97.6 million at June 30, 2004. During the nine
months ended June 30, 2004, we purchased $48.5 million of securities and
received $41.3 million in proceeds from sales, maturities and issuer calls of
investment securities available for sale. Interest rates increased during the
nine months ended June 30, 2004 which caused the Company's gross unrealized loss
on investment securities available for sale to increase from $1.3 million at
September 30, 2003 to $2.8 million at June 30, 2004. Investment securities held
to maturity increased $3.7 million from $19.5 million at September 30, 2003 to
$23.2 million at June 30, 2004. During the nine months ended June 30, 2004, we
purchased $9.8 million of securities and received $6.0 million in proceeds from
maturities and issuer calls of investment securities held to maturity.
Loans held for sale increased to $1.2 million at June 30, 2004 from
$645,000 at September 30, 2003. Loans receivable, net increased from $225.7
million at September 30, 2003 to $230.4 million at June 30, 2004. The increase
in loans held for sale resulted from timing differences in the funding of loan
sales. During the nine months ended June 30, 2004, mortgage originations were
considerably slower than in previous quarters as refinance activity slowed down
in response to higher mortgage interest rates. During this same period, the
Company saw growth in commercial loans and equity lines.
Stockholders' equity increased by $1.1 million from $62.7 million at
September 30, 2003 to $63.8 million at June 30, 2004 as a result of net income
of $2.5 million and the release of ESOP shares of $619,000. These increases were
partially offset by cash dividends to stockholders declared of $841,000,
purchases of treasury stock of $326,000, and an increase in the net unrealized
loss on available for sale securities of $912,000. The increase in the net
unrealized loss on available for sale securities was a result of increases in
interest rates which caused bond prices to decrease.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND
2003
NET INCOME. We recorded net income of $973,000 for the quarter ended June
30, 2004, as compared to $988,000 for the quarter ended June 30, 2003,
representing a decrease of $15,000, or 1.5%. For the three months ended June 30,
2004, basic and diluted earnings per share were $0.35 and $0.33, respectively,
compared to the basic and diluted earnings per share for the quarter ended June
30, 2003 of $0.35 and $0.34, respectively. The decrease in net income resulted
primarily from decreased other income that was offset partially by increased net
interest income, decreased operating expenses and decreased income tax expense.
The increase in net interest income resulted from increased volumes which were
offset partially by lower net interest margins. The average prime interest rate
for the quarter ended June 30, 2004 was 4.00%, a decrease of 24 basis points
from 4.24%, which was the average prime for the quarter ended June 30, 2003. The
repricing of loans and investments decreased the Company's average asset yield
by 47 basis points whereas the average cost of funds decreased only 41 basis
points for the quarter ended June 30, 2004 compared to the prior year.
NET INTEREST INCOME. Net interest income, the difference between interest
earned on loans and investments and interest paid on interest-bearing
liabilities, increased by $127,000 or 4.5% for the three months ended June 30,
2004, compared to the same quarter in the prior year. This increase results from
a $143,000 decrease in interest expense that was partially offset by a $16,000
decrease in total interest income. The average net interest rate spread
decreased 6 basis points from 3.07% for the three months ended June 30, 2003 to
3.01% for the quarter ended June 30, 2004.
INTEREST INCOME. The decrease in interest income for the three months ended
June 30, 2004 was the result of a decrease in yield on interest-earning assets
of 47 basis points from 5.08% for the three months ended June 30, 2003 to 4.61%
for the three months ended June 30, 2004. This decrease was partially offset by
an increase of $32.3 million in average interest-earning assets compared to the
same quarter in the prior year. Average investment securities increased $40.5
million, average interest-bearing overnight funds decreased $11.9 million and
average loans receivable increased $3.7 million. The increase in average
interest-earning assets increased interest income by approximately $499,000 and
the decrease in the average asset yield decreased interest income by
approximately $515,000.
13
INTEREST EXPENSE. Interest expense decreased in the three months ended June
30, 2004 due to a decrease in the cost of interest-bearing liabilities of 41
basis points from 2.01% for the three months ended June 30, 2003 to 1.60% for
the three months ended June 30, 2004. This decrease was partially offset by an
increase in average interest-bearing liabilities of $31.7 million. Average
interest-bearing deposits increased by $7.7 million while average FHLB advances
increased $24.0 million for the three months ended June 30, 2004 compared to the
same quarter in the prior year. The increase in average interest-bearing
liabilities increased interest expense by approximately $359,000 and the
decrease in the average cost of interest-bearing liabilities decreased interest
expense by approximately $502,000.
The following table presents average balances and average rates earned/paid
by the Company for the quarter ended June 30, 2004 compared to the quarter ended
June 30, 2003.
THREE MONTHS ENDED THREE MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2003
------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
------------ ----------- ---------- ----------- ---------- ----------
Assets:
Loans receivable (1)......................... $ 231,111 $ 2,812 4.87% $ 227,367 $ 3,097 5.45%
Investment securities (2).................... 122,717 1,288 4.20 82,245 982 4.78
Interest-bearing overnight deposits ......... 2,796 6 0.93 14,687 43 1.17
------------ --------- ------ ----------- --------- ----
Total interest-earning assets (3).......... 356,624 4,106 4.61 324,299 4,122 5.08
Noninterest-earning assets................... 20,466 20,109
------------ -----------
Total assets............................... $ 377,090 $ 344,408
============ ===========
Liabilities and stockholders' equity:
Interest bearing checking.................... 36,805 19 0.21 34,322 27 0.31
Money market investment accounts............. 19,884 33 0.67 23,876 55 0.92
Passbook and statement savings............... 30,943 47 0.61 30,823 65 1.85
Certificates of deposit...................... 160,827 725 1.80 151,748 894 2.36
FHLB advances................................ 43,967 346 3.14 20,000 272 5.45
------------ --------- ------ ----------- --------- ----
Total interest-bearing liabilities......... 292,426 1,170 1.60 260,769 1,313 2.01
Noninterest-bearing liabilities.............. 21,411 20,797
------------ -----------
Total liabilities.......................... 313,837 281,566
Stockholders' equity......................... 63,253 62,842
------------ -----------
Total liabilities and stockholders' equity $ 377,090 $ 344,408
============ ===========
Net interest income.......................... $ 2,936 $ 2,809
========= =========
Interest rate spread......................... 3.01% 3.07%
====== ====
Net interest margin (4)...................... 3.29% 3.46%
====== ====
Ratio of average interest-earning assets to
Average interest-bearing liabilities........ 121.95% 124.36%
====== ======
--------
(1) Includes nonaccrual loans and loans held for sale, net of discounts and
allowance for loan losses.
(2) Includes FHLB of Atlanta stock.
(3) Due to immateriality, the interest income and yields related to certain tax
exempt assets have not been adjusted to reflect a fully taxable equivalent
yield.
(4) Represents net interest income divided by the average balance of
interest-earning assets.
PROVISION FOR LOAN LOSSES. We charge provisions for loan losses to earnings
to maintain the total allowance for loan losses at a level we consider adequate
to provide for probable loan losses, based on existing loan levels and types of
loans outstanding, nonperforming loans, prior loss experience, general economic
conditions and other factors. We
14
estimate the allowance using an allowance for loan losses model which takes into
considerations all of these factors. Our policies require the review of assets
on a regular basis, and we assign risk grades to loans based on the relative
risk of the credit, considering such factors as repayment experience, value of
collateral, guarantors, etc. Our credit management systems have resulted in low
loss experience; however, there can be no assurances that such experience will
continue. We believe we use the best information available to make a
determination with respect to the allowance for loan losses, recognizing that
future adjustments may be necessary depending upon a change in economic
conditions.
The provision for loan losses was $60,000 and net charge-offs were $42,000
for the three months ended June 30, 2004 compared with a provision of $60,000,
and net charge-offs of $8,000 for the three months ended June 30, 2003.
Nonperforming loans at June 30, 2004 and September 30, 2003 were $4.0 million
and $4.2 million, respectively. The majority of the non-performing loans
resulted from two unrelated, distinct credits which are not necessarily
indicative of the credit quality of the entire portfolio. There was no
significant impact on the provision as these loans are well secured by property
and equipment.
OTHER INCOME. Other income decreased $222,000 from $908,000 for the three
months ended June 30, 2003 to $686,000 for the three months ended June 30, 2004.
Mortgage banking income, net decreased $296,000 from $422,000 for the three
months ended June 30, 2003 to $126,000 for the three months ended June 30, 2004.
This decrease results from a decrease in volume of mortgage loan originations
and sales. We sold loans totaling $7.5 million in the three months ended June
30, 2004 compared with sales of $24.7 million in the previous year for the
comparable period. The increase in mortgage interest rates slowed the volume of
mortgage originations and sales. Given the current level of mortgage interest
rates, the Company believes that mortgage banking income will continue to
decrease in future quarters due to lower refinancing activity. The Company
relocated its Mebane branch to a new location in September 2003. In June 2004,
the Company sold the real estate that had previously served as the Bank's Mebane
office. A gain of $143,000 was recognized on this sale and is included in other
income and accounts for the increase in other income for the current quarter
compared to the previous year. Customer fees increased $35,000 or 16.1% to
$253,000 for the quarter ended June 30, 2004 compared with the $218,000 reported
in the prior year. This increase was the result of increased deposit service
charges compared with the prior year. The Company recorded gains on sales of
investments of $103,000 in the three months ended June 30, 2003 which were not
present in the current year.
OPERATING EXPENSES. Total operating expenses were $2.1 million for each of
the three months ended June 30, 2004 and 2003, respectively. The Company has
been able to control expenses during this period of slower loan and deposit
growth.
INCOME TAX EXPENSE. Income tax expense decreased $46,000 from tax expense
of $562,000 for the three months ended June 30, 2003 to $516,000 for the three
months ended June 30, 2004. The effective tax rates were 34.7% and 36.3% for the
three months ended June 30, 2004 and 2003, respectively. The decrease in the
effective tax rate was primarily due to an increase in the ratio of non-taxable
income as a percentage of net income before taxes.
COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED JUNE 30, 2004 AND 2003
NET INCOME. We recorded net income of $2.5 million for the nine months
ended June 30, 2004, a decrease of $500,000, or 16.7% over the $3.0 million
reported in the nine months ended June 30, 2003. For the nine months ended June
30, 2004, basic and diluted earnings per share were $0.89 and $0.85,
respectively. The Company reported basic and diluted earnings per share for the
nine months ended June 30, 2003 of $1.06 and $1.01, respectively. The decrease
in net income resulted primarily from decreased net interest income and
decreased other income. These decreases in income were partially offset by
decreased operating expenses and decreased income taxes. The decrease in the net
interest income resulted from lower net interest margins. The average prime
interest rate for the nine months ended June 30, 2004 was 4.00%, a decrease of
32 basis points from 4.32% which was the average prime for the nine months ended
June 30, 2003. The rate decrease caused a greater reduction in the average yield
on earning assets than the average rate paid on interest-bearing liabilities.
NET INTEREST INCOME. Net interest income, the difference between interest
earned on loans and investments and interest paid on interest-bearing
liabilities, decreased by $248,000 or 2.8% for the nine months ended June 30,
2004, compared to the same nine months in the prior year. This decrease reflects
a $979,000 decrease in interest income that was partially offset by the $731,000
decrease in total interest expense. The average net interest rate spread
decreased 20 basis points from 3.17% for the nine months ended June 30, 2003 to
2.97% for the nine months ended June 30, 2004.
15
INTEREST INCOME. The decrease in interest income for the nine months ended
June, 2004 was due to a decrease in yield on interest-earning assets of 70 basis
points from 5.37% for the nine months ended June 30, 2003 to 4.67% for the nine
months ended June 30, 2004 that was partially offset by an increase of $20.7
million in average interest-earning assets compared to the same period in the
prior year. The increased volume of average interest-earning assets increased
interest income by approximately $1.1 million and the decreased yield decreased
interest income by approximately $2.1 million. Average investment securities
increased $30.1 million and average loans receivable increased $1.1 million
compared with the prior year. These increases were offset in part by a decrease
of $10.5 million in average interest bearing overnight funds.
INTEREST EXPENSE. Interest expense decreased in the nine months ended June
30, 2004 due to a decrease in the cost of interest-bearing liabilities of 50
basis points from 2.20% for the nine months ended June 30, 2003 to 1.70% for the
nine months ended June 30, 2004 that was partially offset by an increase of
$19.9 million in average interest-bearing liabilities. Average deposits
increased by $4.8 million and average FHLB advances increased $15.2 million for
the nine months ended June 30, 2004 compared to the same nine months in the
prior year. The increase in average interest-bearing liabilities increased
interest expense by approximately $673,000 and the decrease in the average cost
of interest-bearing liabilities decreased interest expense by approximately $1.4
million.
The following table presents average balances and average rates earned/paid
by the Company for the nine months ended June 30, 2004 compared to the nine
months ended June 30, 2003.
NINE MONTHS ENDED NINE MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2003
----------------------------------- -------------------------------------
(DOLLARS IN THOUSANDS)
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE INTEREST YIELD/COST BALANCE INTEREST YIELD/COST
------------ --------- ---------- ---------- ---------- ----------
Assets:
Loans receivable (5)......................... $ 228,827 $ 8,495 4.95% $ 227,694 $ 9,764 5.72%
Investment securities (6).................... 113,480 3,588 4.22 83,352 3,194 5.11
Interest-bearing overnight deposits ......... 3,556 24 0.89 14,088 128 1.21
------------ --------- ------ ---------- --------- ----
Total interest-earning assets (7).......... 345,863 12,107 4.67 325,134 13,086 5.37
Noninterest-earning assets................... 20,896 20,094
------------ ----------
Total assets............................... $ 366,759 $ 345,228
============ ==========
Liabilities and stockholders' equity:
Interest bearing checking.................... 36,148 57 0.21 33,686 101 0.40
Money market investment accounts............. 19,565 98 0.67 22,649 167 0.98
Passbook and statement savings............... 30,377 139 0.61 29,784 227 1.01
Certificates of deposit...................... 160,476 2,335 1.94 155,675 3,005 2.57
FHLB advances................................ 35,883 965 3.58 20,718 825 5.31
------------ --------- ------ ---------- --------- ----
Total interest-bearing liabilities......... 282,449 3,594 1.70 262,512 4,325 2.20
Non interest-bearing liabilities............. 21,060 20,517
------------ ----------
Total liabilities.......................... 303,509 283,029
Stockholders' equity......................... 63,250 62,199
------------ ----------
Total liabilities and stockholders' equity $ 366,759 $ 345,228
============ ==========
Net interest income.......................... $ 8,513 $ 8,761
========== =========
Interest rate spread......................... 2.97% 3.17%
====== ====
Net interest margin (8)...................... 3.28% 3.59%
====== ====
Ratio of average interest-earning assets to
average interest-bearing liabilities........ 122.45% 123.85%
====== ======
16
--------
(5) Includes nonaccrual loans and loans held for sale, net of discounts and
allowance for loan losses.
(6) Includes FHLB of Atlanta stock.
(7) Due to immateriality, the interest income and yields related to certain tax
exempt assets have not been adjusted to reflect a fully taxable equivalent
yield.
(8) Represents net interest income divided by the average balance of
interest-earning assets.
PROVISION FOR LOAN LOSSES. The provision for loan losses is charged to
earnings to maintain the total allowance for loan losses at a level considered
adequate to absorb estimated probable losses inherent in the loan portfolio
based on existing loan levels and types of loans outstanding, nonperforming
loans, prior loan loss experience, general economic conditions and other
factors. The provision for loan losses was $180,000 and net charge-offs were
$126,000 for the nine months ended June 30, 2004 compared with a provision of
$180,000, and net charge-offs of $10,000 for the nine months ended June 30,
2003. The provision for loan losses was impacted by the continued shift in the
portfolio to commercial loans which require a larger allocation of allowance for
loan losses. The effects of this continued shift in the portfolio were offset to
a certain degree in 2004 by a decrease in nonperforming loans. The Company has
completed the foreclosure on some of the nonperforming loans and has sold the
majority of its real estate owned.
OTHER INCOME. Other income decreased $700,000 from $2.5 million for the
nine months ended June 30, 2003 to $1.8 million for the nine months ended June
30, 2004. Mortgage banking income, net decreased $922,000 from $1.3 million for
the nine months ended June 30, 2003 to $337,000 for the nine months ended June
30, 2004. This decrease results from a decrease in volume of mortgage loan
originations and sales. We sold loans totaling $21.7 million in the nine months
ended June 30, 2004 compared with sales of $75.8 million in the previous year
for the comparable period. The increase in mortgage interest rates slowed the
volume of mortgage originations and sales. Given the current level of mortgage
interest rates, the Company believes that mortgage banking income will continue
to decrease in future quarters due to lower refinancing activity. Commissions
from sales of annuities and mutual funds decreased $83,000 from $346,000 for the
nine months ended June 30, 2003 to $263,000 for the nine months ended June 30,
2004. This decrease results from lower sales of annuities. Sales of annuities
and mutual funds totaled $150,000 and $4.9 million and $1.9 million and $4.6
million for the nine months ended June 30, 2004 and 2003, respectively. The
Company recorded gains on sales of investments of $185,000 in the nine months
ended June 30, 2004 compared to gains of $103,000 in the prior year. Other
income increased $135,000 from $183,000 for the nine months ended June 30, 2003
to $318,000 for the nine months ended June 30, 2004. The increase was the result
of the $143,000 gain on the sale of the Mebane real estate in the current
quarter.
OPERATING EXPENSES. Total operating expenses were $6.2 million and $6.4
million for the nine months ended June 30, 2004 and 2003, respectively. The
Company has been able to control expenses during this period of slower loan and
deposit growth.
INCOME TAX EXPENSE. Income tax expense decreased $300,000 from tax expense
of $1.7 million for the nine months ended June 30, 2003 to $1.4 million for the
nine months ended June 30, 2004. The effective tax rates were 35.7% and 36.7%
for the nine months ended June 30, 2004 and 2003, respectively. The decrease in
the effective rate was primarily due to an increase in the ratio of non-taxable
income as a percentage of net income before taxes.
COMMITMENTS, CONTINGENCIES AND OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk
including commitments to extend credit under existing lines of credit and
commitments to sell loans. These instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheets.
17
Off-balance sheet financial instruments whose contract amounts represent
credit and interest rate risk are summarized as follows:
JUNE 30, 2004 SEPTEMBER 30, 2003
------------- ------------------
(Dollars in thousands)
Commitments to originate new loans $ 4,563 $ 1,552
Commitments to originate new loans held for sale -- 278
Unfunded commitments to extend credit under existing
equity line and commercial lines of credit 56,172 57,237
Commercial letters of credit 1,994 326
Commitments to sell loans held for sale 1,532 1,630
Commitments to originate new loan include two unrelated commercial real
estate loans totaling $3.7 million. The Company does not have any special
purpose entities or other similar forms of off-balance sheet financing
arrangements.
Commitments to originate new loans or to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Loan commitments generally expire within 30 to 45 days. Most
equity line commitments are for a term of 15 years, and commercial lines of
credit are generally renewable on an annual basis. Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee. Since many of the commitments are expected to expire without being drawn
upon, the total commitment amounts do not necessarily represent future cash
requirements. The Company evaluates each customer's creditworthiness on a
case-by-case basis. The amounts of collateral obtained, if deemed necessary by
the Company upon extension of credit, is based on management's credit evaluation
of the borrower.
Commitments to sell loans held for sale are agreements to sell loans to a
third party at an agreed upon price. At June 30, 2004, the aggregate fair value
of these commitments exceeded the book value of the loans to be sold.
CONTRACTUAL OBLIGATIONS
As of June 30, 2004:
PAYMENTS DUE BY PERIOD
(DOLLARS IN THOUSANDS)
LESS THAN
1 YEAR 1-3 YEARS 4-5 YEARS OVER 5 YEARS TOTAL
----------- --------- --------- ------------ -----
Deposits $ 228,919 $ 23,112 $ 11,807 $ -- $263,838
Advances from FHLB 27,500 -- 20,000 -- 47,500
Lease obligations 18 41 42 26 127
---------- -------- -------- ------ --------
Total contractual cash
obligations $ 256,437 $ 23,153 $ 31,849 $ 26 $311,465
========== ======== ======== ====== ========
ASSET QUALITY
At June 30, 2004, the Company had approximately $4.0 million in
nonperforming assets (nonaccrual loans and real estate owned) or 1.06% of total
assets. At September 30, 2003, nonperforming assets were $4.2 million or 1.17%
of total assets. At June 30, 2004 and September 30, 2003, impaired loans totaled
$3.6 million and $3.8 million, respectively, as defined by Statement of
Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment
of a Loan." The impaired loans at June 30, 2004 and September 30, 2003 result
from two and three, respectively, unrelated commercial loan customers, each of
which have loans secured by commercial real estate and business assets in
Alamance County. At June 30, 2004, the entire $3.6 million of the impaired loans
are on non-accrual status, and their related reserve for loan losses totaled
$160,000. The average carrying value of impaired loans was $3.7 million during
the nine months ended June 30, 2004. Interest income of $148,000 has been
recorded on impaired loans in the nine months ended June 30, 2004. The Bank's
net chargeoffs for the nine months ended June 30, 2004 were $126,000. The Bank's
allowance for loan losses was $3.9 million at June 30, 2004 and September 30,
2003, and the
18
ratio of the allowance for loan losses to total loans, net of loans in process
and deferred loan fees was 1.67% and 1.68% at June 30, 2004 and September 30,
2003, respectively.
The following table presents an analysis of our nonperforming assets:
AT AT AT
JUNE 30, SEPTEMBER 30, JUNE 30,
2004 2003 2003
-------------------- ------------------- -------------
Nonperforming loans:
Nonaccrual loans $ 4,007 $ 4,153 $ 4,501
Loans 90 days past due and accruing -- -- --
Restructured loans -- -- --
------------- -------------- -----------
Total nonperforming loans 4,007 4,153 4,501
Other real estate 26 95 80
------------- -------------- -----------
Total nonperforming assets $ 4,033 $ 4,248 $ 4,581
============= ============== ===========
Nonperforming loans to loans receivable, net 1.74% 1.84% 2.01%
Nonperforming assets as a percentage
of loans and other real estate owned 1.75% 1.88% 2.05%
Nonperforming assets to total assets 1.06% 1.17% 1.29%
Regulations require that we classify our assets on a regular basis. There
are three classifications for problem assets: substandard, doubtful and loss. We
regularly review our assets to determine whether any assets require
classification or re-classification. At June 30, 2004, we had $4.8 million in
classified assets consisting of $4.8 million in substandard loans, $7,000 in
loss loans and $26,000 in real estate owned. At September 30, 2003, we had $4.9
million in substandard assets consisting of $4.8 million in loans and $95,000 in
real estate owned. At June 30, 2003, we had $4.9 million in substandard and loss
loans and $80,000 in real estate owned.
In addition to regulatory classifications, we also classify as "special
mention" and "watch" assets that are currently performing in accordance with
their contractual terms but may become classified or nonperforming assets in the
future. At June 30, 2004, we have identified approximately $4.8 million in
assets classified as special mention and $28.0 million as watch. At June 30,
2003, we had identified approximately $1.1 million in assets classified as
special mention and $36.5 million as watch.
Included in the total of special mention assets are five loans with an
aggregate outstanding balance of $4.0 million at June 30, 2004 to borrowers, of
which one of our directors along with family members, is a majority stockholder.
In addition, one of the borrowers has the ability to borrow an additional
$124,000 from us under a line of credit. All the loans are secured by a first
lien on all assets, including accounts receivable, inventory, equipment,
furniture and real property occupied by the borrower. In addition, the director
and his spouse have personally guaranteed repayment of the loans. At June 30,
2004, such loans were current with respect to their payment terms.
Subsequent to June 30, 2004, the borrowers sold a division and used the
proceeds from such sale to repay a significant portion of the outstanding
principal balance of such loans, reducing the aggregate outstanding balance of
the loans to $580,000 at August 12, 2004. However, the minority stockholders of
the borrower, Roger W. Overman, Jack D. Overman and Larry D. Overman, have
brought a lawsuit in the Superior Court of Guilford County, North Carolina,
against the majority stockholders, as well as others, including the Bank,
seeking money damages. Included in part of plaintiffs' complaint are allegations
related to loans made by the Bank to the borrowers. Although the time for the
Bank to formally respond in court to the complaint has not yet arrived, the
Bank's attorneys have asked that the plaintiffs' attorney drop the Bank as a
party to the lawsuit. If the plaintiffs do not do so, the Bank will vigorously
defend the lawsuit and seek its dismissal by the court. Management does not
anticipate that this lawsuit will have a material adverse impact on the
Company's financial condition or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
The Bank must meet certain liquidity requirements established by the State
of North Carolina Office of the Commissioner of Banks (the "Commissioner"). At
June 30, 2004, the Bank's liquidity ratio exceeded such requirements. Liquidity
generally refers to the Bank's ability to generate adequate amounts of funds to
meet its cash needs. Adequate liquidity guarantees that sufficient funds are
available to meet deposit withdrawals, fund loan commitments, maintain adequate
reserve requirements, pay operating expenses, provide funds for debt service,
pay dividends to stockholders and meet other general commitments.
19
Our primary sources of funds are deposits, principal and interest payments
on loans, proceeds from the sale of loans, and to a lesser extent, advances from
the FHLB of Atlanta. While maturities and scheduled amortization of loans are
predictable sources of funds, deposit flows and mortgage prepayments are greatly
influenced by general interest rates, economic conditions and local competition.
Our most liquid assets are cash and cash equivalents. The levels of these
assets are dependent on our operating, financing, lending and investing
activities during any given period. At June 30, 2004, cash and cash equivalents
totaled $10.7 million. We have other sources of liquidity should we need
additional funds. During the three and nine months ended June 30, 2004, we sold
loans totaling $7.5 million and $21.1 million, respectively. Additional sources
of funds include FHLB of Atlanta advances. Other sources of liquidity include
loans and investment securities designated as available for sale, which totaled
$97.6 million at June 30, 2004.
We anticipate that we will have sufficient funds available to meet our
current commitments. At June 30, 2004, we had $5.1 million in commitments to
originate new loans, $56.2 million in unfunded commitments to extend credit
under existing equity lines and commercial lines of credit and $2.0 million in
standby letters of credit. At June 30, 2004, certificates of deposit, which are
scheduled to mature within one year, totaled $124.9 million. We believe that a
significant portion of such deposits will remain with us.
The Federal Deposit Insurance Corporation ("FDIC") requires the Bank to
meet a minimum leverage capital requirement of Tier I capital to assets ratio of
4%. The FDIC also requires the Bank to meet a ratio of total capital to
risk-weighted assets of 8%, of which 4% must be in the form of Tier I capital.
The Commissioner requires the Bank at all times to maintain certain minimum
capital levels. The Bank was in compliance with all capital requirements of the
FDIC and the Commissioner at June 30, 2004 and is deemed to be "well
capitalized."
The Federal Reserve also mandates capital requirements on all bank holding
companies, including 1st State Bancorp, Inc. These capital requirements are
similar to those imposed by the FDIC on the Bank. At June 30, 2004, the Company
was in compliance with the capital requirements of the Federal Reserve.
The Company's equity to asset ratio at June 30, 2004 was 16.8%. The
Company's capital level is sufficient to support future growth.
The Company has declared cash dividends per common share of $0.10 for each
of the three months ended June 30, 2004, September 30, 2003 and June 30, 2003.
The Company's ability to pay dividends is dependent upon earnings. The Company's
dividend payout ratio for the three months ended June 30, 2004, September 30,
2003 and June 30, 2003 was 30.3%, 31.2% and 29.4%, respectively.
ACCOUNTING MATTERS
In March 2004, the SEC released Staff Accounting Bulletin No. 105 -
Application of Accounting Principles to Loan Commitments. This bulletin requires
all registrants to begin accounting for their issued loan commitments (including
interest rate lock commitments) subject to Statement 133 as written options.
Treatment as a written option would require those loan commitments to be
reported as liabilities until either they are exercised (and a loan is made) or
they expire unexercised. Staff Accounting Bulletin No. 105 must be applied to
loan commitments that are issued after March 31, 2004. The adoption of Staff
Accounting Bulletin No. 105 did not have a material impact on the consolidated
financial statements.
In January 2003, FASB Interpretation No. 46, "Consolidation of Variable
Interest Entities, an interpretation of ARB No. 51", (Interpretation 46) was
issued. Interpretation 46 addresses the consolidation by business enterprises of
variable interest entities as defined in the Interpretation. Interpretation 46
applies immediately to variable interests in variable interest entities created
after January 31, 2003, and to variable interests in variable interest entities
obtained after January 31, 2003. In December 2003, the FASB issued FASB
Interpretation No. 46 (revised December 2003), "Consolidation of Variable
Interest Entities", which addresses how a business enterprise should evaluate
whether it has a controlling financial interest in an entity through means other
than voting rights and accordingly should consolidate the entity. FIN 46R
replaces FASB Interpretation No. 46, "Consolidation of Variable Interest
Entities", which was issued in January 2003. The Company will be required to
apply FIN 46R to variable interests in VIEs created after December 31, 2003. The
application of this revised interpretation is not expected to have a material
effect on the consolidated financial statements.
20
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the possible chance of loss from unfavorable changes in
market prices and rates. These changes may result in a reduction of current and
future period net interest income, which is the favorable spread earned from the
excess of interest income on interest-earning assets over interest expense on
interest-bearing liabilities.
The Company considers interest rate risk to be its most significant market
risk, which could potentially have the greatest impact on operating earnings.
The structure of the Company's loan and deposit portfolios is such that a
significant decline in interest rates may adversely impact net market values and
net interest income.
The Company monitors whether material changes in market risk have occurred
since September 30, 2003. The Company does not believe that any material adverse
changes in market risk exposures have occurred since September 30, 2003.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management of the
Company carried out an evaluation, under the supervision and with the
participation of the Company's principal executive officer and principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures. Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and procedures are effective in ensuring that information required to be
disclosed by the Company in reports that it files or submits under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported, within the time periods specified in the Securities and Exchange
Commission's rules and forms. It should be noted that the design of the
Company's disclosure controls and procedures is based in part upon certain
reasonable assumptions about the likelihood of future events, and there can be
no reasonable assurance that any design of disclosure controls and procedures
will succeed in achieving its stated goals under all potential future
conditions, regardless of how remote, but the Company's principal executive and
financial officers have concluded that the Company's disclosure controls and
procedures are, in fact, effective at a reasonable assurance level.
In addition, there have been no changes in the Company's internal control
over financial reporting identified in connection with the evaluation described
in the above paragraph that occurred during the Company's last fiscal quarter,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
21
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time, we are a party to various legal proceedings incident to
our business. There currently are no legal proceedings to which we are a party,
or to which any of our property was subject, except as described in the
following paragraph, and none which are expected to result in a material loss.
There are no pending regulatory proceedings to which we are a party or to which
any of our properties is subject which are expected to result in a material
loss.
A civil action was filed against 1st State Bank and Brokers, Incorporated
by Michael Locklar in Davidson County Superior Court, in the State of North
Carolina on May 16, 2003. Mr. Locklar has alleged in the action that 1st State
Bank granted him an option to purchase certain real property located in Davidson
County, North Carolina, which 1st State Bank wrongfully sold to Brokers,
Incorporated for $150,000 in breach of the option granted to Mr. Locklar. Mr.
Locklar is seeking to set aside the conveyance of property to Brokers,
Incorporated and to purchase the property from 1st State Bank for the option
price. Brokers, Incorporated has filed a cross-claim against 1st State Bank
seeking indemnification in the form of return of the purchase price they paid
for the property, damages and attorneys fees should Locklar be successful in
setting aside the real estate conveyance. 1st State Bank intends to vigorously
contest Mr. Locklar's allegations.
The Bank has been named as a defendant in a lawsuit brought by minority
stockholders of a corporation against the majority stockholders of the
corporation. A director of the Company and the Bank, along with family members,
is the majority stockholder of the corporation, which has loans outstanding from
the Bank. For further information regarding this lawsuit, see "Part I Financial
Information -- Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Comparison of Operating Results for the
Nine Months Ended June 30, 2004 and 2003 -- Asset Quality."
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
SECURITIES
(a) Not applicable
(b) Not applicable
(c) Not applicable
(d) Not applicable
(e) The Company did not repurchase any of its Common Stock during the
quarter ended June 30, 2004.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS.
---------
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Section 1350 Certification
(b) REPORTS ON FORM 8-K.
The Registrant filed the following Current Reports on Form 8-K
during the quarter ended June 30, 2004:
Date of Report Item(s) Reported Financial Statements Filed
-------------- ---------------- --------------------------
April 26, 2004 7, 12 N/A
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
1st STATE BANCORP, INC.
Date: August 12, 2004 /s/ James C. McGill
----------------------------------------
James C. McGill
President and Chief Executive Officer
(Principal Executive Officer)
Date: August 12, 2004 /s/ A. Christine Baker
----------------------------------------
A. Christine Baker
Executive Vice President
Treasurer and Secretary
(Principal Financial and Accounting
Officer)