================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------------- FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2005 Commission File Number 0-15572 FIRST BANCORP -------------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) <TABLE> <S> <C> North Carolina 56-1421916 - ---------------------------------------- ------------------------------------------- (State of Incorporation) (I.R.S. Employer Identification Number) 341 North Main Street, Troy, North Carolina 27371-0508 - ------------------------------------------------ ------------------------------------------- (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code (910) 576-6171 ------------------------------------------- </TABLE> Securities Registered Pursuant to Section 12(b) of the Act: None Securities Registered Pursuant to Section 12(g) of the Act: COMMON STOCK, NO PAR VALUE (Title of each class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933. [ ] YES [ X ] NO Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934. [ ] YES [ X ] NO Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 filing requirements for the past 90 days. [ X ] YES [ ] 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 the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to the Form 10-K. [ X ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. [ ] Large Accelerated Filer [ X ] Accelerated Filer [ ] Non-Accelerated Filer Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X ] NO The aggregate market value of the Common Stock, no par value, held by non-affiliates of the registrant, based on the closing price of the Common Stock as of June 30, 2005 as reported on the NASDAQ National Market System, was approximately $252,329,000. The number of shares of the registrant's Common Stock outstanding on February 27, 2006 was 14,255,043. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's Proxy Statement to be filed pursuant to Regulation 14A are incorporated herein by reference into Part III. ================================================================================
<TABLE> <CAPTION> CROSS REFERENCE INDEX Begins on Page (s) -------- <S> <C> PART I Item 1 Business 4 Item 1A Risk Factors 12 Item 1B Unresolved Staff Comments 14 Item 2 Properties 14 Item 3 Legal Proceedings 14 Item 4 Submission of Matters to a Vote of Shareholders 14 PART II Item 5 Market for the Registrant's Common Stock, Related Shareholder Matters, and Issuer Purchases of Equity Securities 14 Item 6 Selected Consolidated Financial Data 15, 47 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Critical Accounting Policies 16 Merger and Acquisition Activity 18 Statistical Information Net Interest Income 22, 48 Provision for Loan Losses 24, 54 Noninterest Income 24, 49 Noninterest Expenses 27, 49 Income Taxes 27, 50 Stock-Based Compensation 28 Distribution of Assets and Liabilities 30, 50 Securities 31, 50 Loans 32, 52 Nonperforming Assets 33, 53 Allowance for Loan Losses and Loan Loss Experience 34, 53 Deposits and Securities Sold Under Agreements to Repurchase 36, 55 Borrowings 37 Liquidity, Commitments, and Contingencies 38, 56 Off-Balance Sheet Arrangements and Derivative Financial Instruments 40 Interest Rate Risk (Including Quantitative and Qualitative Disclosures About Market Risk) 40, 57 Return on Assets and Equity 41, 57 Capital Resources and Shareholders' Equity 42, 58 Inflation 43 Current Accounting and Regulatory Matters 44 Item 7A Quantitative and Qualitative Disclosures About Market Risk 46 Forward-Looking Statements 46 Item 8 Financial Statements and Supplementary Data: Consolidated Balance Sheets as of December 31, 2005 and 2004 60 Consolidated Statements of Income for each of the years in the three-year period ended December 31, 2005 61 Consolidated Statements of Comprehensive Income for each of the years in the three-year period ended December 31, 2005 62 </TABLE> 2
<TABLE> <CAPTION> Begins on Page (s) -------- <S> <C> Consolidated Statements of Shareholders' Equity for each of the years in the three-year period ended December 31, 2005 63 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2005 64 Notes to Consolidated Financial Statements 65 Report of Independent Registered Public Accounting Firm (Current Firm) 98 Report of Independent Registered Public Accounting Firm (Predecessor Firm) 100 Selected Consolidated Financial Data 47 Quarterly Financial Summary 59 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 101 Item 9A Controls and Procedures 101 Item 9B Other Information 102 PART III Item 10 Directors and Executive Officers of the Registrant 103* Item 11 Executive Compensation 103* Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters 103* Item 13 Certain Relationships and Related Transactions 104* Item 14 Principal Accountant Fees and Services 104* PART IV Item 15 Exhibits and Financial Statement Schedules 104 SIGNATURES 107 </TABLE> * Information called for by Part III (Items 10 through 14) is incorporated herein by reference to the Registrant's definitive Proxy Statement for the 2006 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission. 3
PART I Item 1. Business General Description The Company First Bancorp (the "Company") is a bank holding company. The principal activity of the Company is the ownership and operation of First Bank (the "Bank"), a state chartered bank with its main office in Troy, North Carolina. The Company also owns and operates two nonbank subsidiaries: Montgomery Data Services, Inc. ("Montgomery Data"), a data processing company, and First Bancorp Financial Services, Inc. ("First Bancorp Financial"), which owns and operates various real estate. Each of these subsidiaries is fully consolidated for financial reporting purposes. The Company is also the parent to three statutory business trusts created under the laws of the State of Delaware, which have issued a total of $41.2 million in trust preferred debt securities. Under current accounting requirements, these three statutory business trusts are not consolidated for financial reporting purposes - see discussion of FIN 46 in "Current Accounting and Regulatory Matters" under Item 7 below. The Company was incorporated in North Carolina on December 8, 1983, as Montgomery Bancorp, for the purpose of acquiring 100% of the outstanding common stock of the Bank through stock-for-stock exchanges. On December 31, 1986, the Company changed its name to First Bancorp to conform its name to the name of the Bank, which had changed its name from Bank of Montgomery to First Bank in 1985. The Bank was organized in 1934 and began banking operations in 1935 as the Bank of Montgomery, named for the county in which it operated. As of December 31, 2005, the Bank operated in a 24-county area centered in Troy, North Carolina. Troy, population 3,500, is located in the center of Montgomery County, approximately 60 miles east of Charlotte, 50 miles south of Greensboro, and 80 miles southwest of Raleigh. The Bank conducts business from 61 branches located within a 120-mile radius of Troy, covering principally a geographical area from Latta, South Carolina to the southeast, to Wallace, North Carolina to the east, to Radford, Virginia to the north, to Wytheville, Virginia to the northwest, and to Harmony, North Carolina to the west. The Bank also has a loan production office in Wilmington, which is on the coast of North Carolina and represents the Bank's furthest location to the east of Troy. Of the Bank's 61 full-service branches, 55 are in North Carolina, with three branches each in South Carolina and Virginia (where the Bank operates under the name "First Bank of Virginia"). Ranked by assets, the Bank was the 7th largest bank in North Carolina as of December 31, 2005. The Bank has two wholly owned subsidiaries, First Bank Insurance Services, Inc. ("First Bank Insurance") and First Montgomery Financial Services Corporation ("First Montgomery"). First Bank Insurance was acquired as an active insurance agency in 1994 in connection with the Company's acquisition of a bank that had an insurance subsidiary. On December 29, 1995, the insurance agency operations of First Bank Insurance were divested. From December 1995 until October 1999, First Bank Insurance was inactive. In October 1999, First Bank Insurance began operations again as a provider of non-FDIC insured investments and insurance products. Currently, First Bank Insurance's primary business activity is the placement of property and casualty insurance coverage. First Montgomery, a Virginia corporation incorporated on November 2, 2001, was formed to acquire real estate in Virginia and lease the property to the Bank. First Troy Realty Corporation ("First Troy") was incorporated on May 12, 1999 and is a subsidiary of First Montgomery. First Troy was formed for the purpose of allowing the Bank to centrally manage a portion of its residential, mortgage, and commercial real estate loan portfolio. The assets of First Montgomery and First Troy were liquidated during 2005, and these entities are no longer active. The Company's principal executive offices are located at 341 North Main Street, Troy, North Carolina 27371-0508, and its telephone number is (910) 576-6171. Unless the context requires otherwise, references to the "Company" in this annual report on Form 10-K shall mean collectively First Bancorp and its consolidated 4
subsidiaries. General Business The Bank engages in a full range of banking activities, providing such services as checking, savings, NOW and money market accounts and other time deposits of various types including certificates of deposits (CDs) and individual retirement accounts (IRAs); loans for business, agriculture, real estate, personal uses, home improvement and automobiles; credit cards; debit cards; letters of credit; safe deposit box rentals; bank money orders; and electronic funds transfer services, including wire transfers, automated teller machines, and bank-by-phone capabilities. In December 2004, the Bank also began offering its internet banking product, with on-line bill-pay and cash management features. Because the majority of the Bank's customers are individuals and small to medium-sized businesses located in the counties it serves, management does not believe that the loss of a single customer or group of customers would have a material adverse impact on the Bank. There are no seasonal factors that tend to have any material effect on the Bank's business, and the Bank does not rely on foreign sources of funds or income. Because the Bank operates primarily within the central Piedmont region of North Carolina, the economic conditions within that area could have a material impact on the Company. See additional discussion below in the section entitled "Territory Served and Competition." Beginning in 1999, First Bank Insurance began offering non-FDIC insured investment and insurance products, including mutual funds, annuities, long-term care insurance, life insurance, and company retirement plans, as well as financial planning services (the "investments division"). In May 2001, First Bank Insurance added to its product line when it acquired two insurance agencies that specialized in the placement of property and casualty insurance. In October 2003, the "investment division" of First Bank Insurance became a part the Bank. The primary activity of First Bank Insurance is now the placement of property and casualty insurance products. Montgomery Data's primary business is to provide electronic data processing services for the Bank. Ownership and operation of Montgomery Data allows the Company to do all of its electronic data processing without paying fees for such services to an independent provider. Maintaining its own data processing system also allows the Company to adapt the system to its individual needs and to the services and products it offers. Although not a significant source of income, Montgomery Data has historically made its excess data processing capabilities available to area financial institutions for a fee. For the years ended December 31, 2005, 2004 and 2003, external customers provided gross revenues of $279,000, $416,000 and $333,000, respectively. During 2005, three of the five customers terminated their services with Montgomery Data and switched to another provider, which left Montgomery Data with two outside customers as of December 31, 2005. Montgomery Data intends to continue to market this service to area banks, but does not currently have any near-term prospects for additional business. First Bancorp Financial was organized under the name of First Recovery in September of 1988 for the purpose of providing a back-up data processing site for Montgomery Data and other financial and non-financial clients. First Recovery's back-up data processing operations were divested in 1994. First Bancorp Financial now periodically purchases parcels of real estate from the Bank that were acquired through foreclosure or from branch closings. First Bancorp Financial actively pursues the sale of these properties. First Bancorp Capital Trust I was organized in October 2002 for the purpose of issuing $20.6 million in debt securities. These borrowings are due on November 7, 2032 and were structured as trust preferred capital securities, which qualify as capital for regulatory capital adequacy requirements. These debt securities are callable by the Company at par on any quarterly interest payment date beginning on November 7, 2007. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 3.45%. This rate may not exceed 12.50% through November 2007. First Bancorp Capital Trust II and First Bancorp Capital Trust III were organized in December 2003 for 5
the purpose of issuing $20.6 million in debt securities ($10.3 million were issued from each trust). These borrowings are due on December 19, 2033 and were also structured as trust preferred capital securities in order to qualify as regulatory capital. These debt securities are callable by the Company at par on any quarterly interest payment date beginning on January 23, 2009. The interest rate on these debt securities adjusts on a quarterly basis at a weighted average rate of three-month LIBOR plus 2.70%. First Montgomery was incorporated on November 2, 2001. First Montgomery was formed for the purpose of selecting and acquiring real estate in Virginia, which would then be leased to the Bank for use as bank branches. First Troy was incorporated on May 12, 1999 as a subsidiary of the Bank. Upon the formation of First Montgomery as a subsidiary of the Bank, the Bank contributed its interest in First Troy to First Montgomery, resulting in First Troy becoming a subsidiary of First Montgomery. First Troy was formed for the purpose of allowing the Bank to centrally manage a portion of its residential, mortgage, and commercial real estate loan portfolio. For tax years through December 31, 2004, First Troy elected to be treated as a real estate investment trust for tax purposes. During 2005, in response to evolving taxing authority developments (discussed in more detail in "Liquidity, Commitments, and Contingencies" under Item 7 below), the Company liquidated First Montgomery and First Troy by transferring the assets and liabilities of each of these subsidiaries to the Bank. It is the Company's intent to dissolve First Montgomery and First Troy in 2006. Territory Served and Competition The Company's headquarters are located in Troy, Montgomery County, North Carolina. The Company serves primarily the south central area of the Piedmont region of North Carolina. The following table presents, for each county where the Company operates, the number of bank branches operated by the Company within the county, the approximate amount of deposits with the Company in the county as of December 31, 2005, the Company's approximate market share, and the number of bank competitors located in the county. No. of Deposits Market Number County Branches (in millions) Share Competitors - ---------------- -------- ------------ ---------- ----------- Anson, NC 1 $ 11 4.9% 4 Cabarrus, NC 2 28 1.3% 9 Chatham, NC 2 52 9.6% 9 Davidson, NC 3 114 6.3% 9 Dillon, SC 3 62 24.7% 2 Duplin, NC 3 47 10.7% 7 Guilford, NC 1 30 0.6% 24 Harnett, NC 3 93 10.0% 7 Iredell, NC 1 21 1.2% 15 Lee, NC 4 136 19.2% 7 Montgomery, NC 5 87 39.2% 4 Montgomery, VA 1 11 0.1% 9 Moore, NC 10 337 25.0% 10 Randolph, NC 4 53 3.7% 14 Richmond, NC 1 30 6.1% 5 Robeson, NC 5 126 15.4% 9 Rockingham, NC 1 14 1.2% 9 Rowan, NC 2 42 3.5% 11 Scotland, NC 2 46 14.7% 5 Stanly, NC 4 82 10.1% 5 Wake, NC 1 15 0.1% 21 Washington, VA 1 25 2.6% 12 Wythe, VA 1 33 7.3% 9 --------- --------- Total 61 $ 1,495 ========= ========= ================================================================================ The Company's 61 branches and facilities are primarily located in small communities whose economies are based primarily on services, manufacturing and light industry. Although the Company's market is predominantly small communities and rural areas, the area is not dependent on agriculture. Textiles, furniture, mobile homes, 6
electronics, plastic and metal fabrication, forest products, food products and cigarettes are among the leading manufacturing industries in the trade area. Leading producers of lumber, socks, hosiery and area rugs are located in Montgomery County. The Pinehurst area within Moore County is a widely known golf resort and retirement area. The High Point area is widely known for its furniture market. Additionally, several of the communities served by the Company are "bedroom" communities serving large cities like Charlotte, Raleigh and Greensboro, while several branches serve medium-sized cities such as Albemarle, Asheboro, High Point, Southern Pines and Sanford. The Company also has branches in small communities such as Bennett, Polkton, Vass, and Harmony. Approximately 23% of the Company's deposit base is in Moore County, and, accordingly, material changes in competition, the economy or population of Moore County could materially impact the Company. No other county comprises more than 10% of the Company's deposit base. The Company competes in its various market areas with, among others, several large interstate bank holding companies that are headquartered in North Carolina. These large competitors have substantially greater resources than the Company, including broader geographic markets, higher lending limits and the ability to make greater use of large-scale advertising and promotions. A significant number of interstate banking acquisitions have taken place in the past decade, thus further increasing the size and financial resources of some of the Company's competitors, three of which are among the largest bank holding companies in the nation. In many of the Company's markets, the Company also competes against banks that have been organized within the past ten years. These new banks often focus on loan and deposit balance sheet growth, and not necessarily on earnings profitability. This strategy often allows them to offer more attractive terms on loans and deposits than the Company is able to offer because the Company must achieve an acceptable level of profitability. Moore County, which as noted above comprises a disproportionate share of the Company's deposits, is a particularly competitive market, with at least ten other financial institutions having a physical presence. See "Supervision and Regulation" below for a further discussion of regulations in the Company's industry that affect competition. The Company competes not only against banking organizations, but also against a wide range of financial service providers, including federally and state chartered savings and loan institutions, credit unions, investment and brokerage firms and small-loan or consumer finance companies. Competition among financial institutions of all types is virtually unlimited with respect to legal ability and authority to provide most financial services. The Company also experiences competition from internet banks, particularly in the area of time deposits. However, the Company believes it has certain advantages over its competition in the areas it serves. The Company seeks to maintain a distinct local identity in each of the communities it serves and actively sponsors and participates in local civic affairs. Most lending and other customer-related business decisions can be made without delays often associated with larger systems. Additionally, employment of local managers and personnel in various offices and low turnover of personnel enable the Company to establish and maintain long-term relationships with individual and corporate customers. Lending Policy and Procedures Conservative lending policies and procedures and appropriate underwriting standards are high priorities of the Bank. Loans are approved under the Bank's written loan policy, which provides that lending officers, principally branch managers, have authority to approve loans of various amounts up to $100,000. Each of the Bank's regional senior lending officers has discretion to approve secured loans in principal amounts up to $350,000 and together can approve loans up to $3,000,000. Lending limits may vary depending upon whether the loan is secured or unsecured. The Bank's board of directors reviews and approves loans that exceed management's lending authority, loans to executive officers, directors, and their affiliates and, in certain instances, other types of loans. New credit extensions are reviewed daily by the Bank's senior management and at least monthly by its board of directors. 7
The Bank continually monitors its loan portfolio to identify areas of concern and to enable management to take corrective action. Lending officers and the board of directors meet periodically to review past due loans and portfolio quality, while assuring that the Bank is appropriately meeting the credit needs of the communities it serves. Individual lending officers are responsible for pursuing collection of past-due amounts and monitoring any changes in the financial status of borrowers. The Bank also contracts with an independent consulting firm to review new loan originations meeting certain criteria, as well as to assign risk grades to existing credits meeting certain thresholds. The consulting firm's observations, comments, and risk grades, including variances with the Bank's risk grades, are shared with the audit committee of the Company's board of directors, and are considered by management in setting Bank policy, as well as in evaluating the adequacy of the allowance for loan losses. The consulting firm also provides on-going training on a periodic basis to the Company's loan officers to keep them updated on current developments in the marketplace. For additional information, see "Allowance for Loan Losses and Loan Loss Experience" under Item 7 below. Investment Policy and Procedures The Company has adopted an investment policy designed to optimize the Company's income from funds not needed to meet loan demand in a manner consistent with appropriate liquidity and risk objectives. Pursuant to this policy, the Company may invest in federal, state and municipal obligations, federal agency obligations, public housing authority bonds, industrial development revenue bonds, Fannie Mae, Government National Mortgage Association, Freddie Mac, and Student Loan Marketing Association securities, and, to a limited extent, corporate bonds. Except for corporate bonds, the Company's investments must be rated at least Baa by Moody's or BBB by Standard and Poor's. Securities rated below A are periodically reviewed for creditworthiness. The Company may purchase non-rated municipal bonds only if such bonds are in the Company's general market area and determined by the Company to have a credit risk no greater than the minimum ratings referred to above. Industrial development authority bonds, which normally are not rated, are purchased only if they are judged to possess a high degree of credit soundness to assure reasonably prompt sale at a fair value. The Company is also authorized by its board of directors to invest a portion of its security portfolio in high quality corporate bonds, with the amount of bonds related to any one issuer not to exceed the Company's legal lending limit. Prior to purchasing a corporate bond, the Company's management performs due diligence on the issuer of the bond, and the purchase is not made unless the Company believes that the purchase of the bond bears no more risk to the Company than would an unsecured loan to the same company. The Company's investment officer implements the investment policy, monitors the investment portfolio, recommends portfolio strategies and reports to the Company's investment committee. Reports of all purchases, sales, issuer calls, net profits or losses and market appreciation or depreciation of the bond portfolio are reviewed by the Company's board of directors each month. Once a quarter, the Company's interest rate risk exposure is evaluated by its board of directors. Once a year, the written investment policy is reviewed by the board of directors, and the Company's portfolio is compared with the portfolios of other companies of comparable size. Mergers and Acquisitions As part of its operations, the Company has pursued an acquisition strategy over the years to augment its internal growth. The Company regularly evaluates the potential acquisition of or merger with various financial institutions. The Company's acquisitions to date have generally fallen into one of three categories - 1) an acquisition of a financial institution or branch thereof within a market in which the Company operates, 2) an acquisition of a financial institution or branch thereof in a market contiguous to a market in which the Company operates, or 3) an acquisition of a company that has products or services that the Company does not currently offer. The Company believes that it can enhance its earnings by pursuing these types of acquisition opportunities 8
through any combination or all of the following: 1) achieving cost efficiencies, 2) enhancing the acquiree's earnings or gaining new customers by introducing a more successful banking model with more products and services to the acquiree's market base, 3) increasing customer satisfaction or gaining new customers by providing more locations for the convenience of customers, and 4) leveraging the Company's customer base by offering new products and services. In the last five years, the Company has made acquisitions in all three categories described above. In 2001, acquisitions resulted in the Company adding $116.2 million in loans and $204.6 million in deposits, expanding into four contiguous markets (Lumberton, Pembroke, St. Pauls, and Thomasville), providing another branch for customers in one of the Company's newer markets (Salisbury), and giving the Company the ability to offer property and casualty insurance coverage. In 2002, the Company completed the acquisition of a branch within its market area (Broadway, located in Lee County) with approximately $8.4 million in deposits and $3.1 million in loans. In 2003, the Company completed acquisitions that added approximately $72.5 million in loans and $160.8 million in deposits that were in the nearby markets of Dillon County SC, Duplin County NC, Harmony NC, and Fairmont NC. In 2003, the Company also purchased another property and casualty insurance agency that provided efficiencies of scale when combined with the agency purchased in 2001. The Company did not complete any acquisitions during 2004 or 2005, but in 2006 has agreed to purchase a branch in Dublin, Virginia (a contiguous market) with $20 million in deposits. The Company plans to continue to evaluate acquisition opportunities that could potentially benefit the Company and its shareholders. These opportunities may include acquisitions that do not fit the categories discussed above. For a further discussion of recent acquisition activity, see "Merger and Acquisition Activity" under Item 7 below. Employees As of December 31, 2005, the Company had 540 full-time and 76 part-time employees. The Company is not a party to any collective bargaining agreements and considers its employee relations to be good. Supervision and Regulation As a bank holding company, the Company is subject to supervision, examination and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") and the North Carolina Office of the Commissioner of Banks (the "Commissioner"). The Bank is subject to supervision and examination by the Federal Deposit Insurance Corporation (the "FDIC") and the Commissioner. For additional information, see also Note 15 to the consolidated financial statements. Supervision and Regulation of the Company The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is required to register as such with the Federal Reserve Board. The Company is also regulated by the Commissioner under the Bank Holding Company Act of 1984. A bank holding company is required to file quarterly reports and other information regarding its business operations and those of its subsidiaries with the Federal Reserve Board. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval prior to making certain acquisitions of other institutions or voting securities. The Commissioner is empowered to regulate certain acquisitions of North Carolina banks and bank holding companies, issue cease and desist orders for violations of North Carolina banking laws, and promulgate rules necessary to effectuate the purposes of the Bank Holding Company Act of 1984. Regulatory authorities have cease and desist powers over bank holding companies and their nonbank 9
subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. Those authorities may compel holding companies to invest additional capital into banking subsidiaries upon acquisitions or in the event of significant loan losses or rapid growth of loans or deposits. In 1999, the U.S. enacted legislation that allowed bank holding companies to engage in a wider range of non-banking activities, including greater authority to engage in securities and insurance activities. Under the Gramm-Leach-Bliley Act (the "Act"), a bank holding company that elects to become a financial holding company may engage in any activity that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines by regulation or order is (i) financial in nature, (ii) incidental to any such financial activity, or (iii) complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. The Act made significant changes in U.S. banking law, principally by repealing certain restrictive provisions of the 1933 Glass-Steagall Act. The Act lists certain activities that are deemed to be financial in nature, including lending, exchanging, transferring, investing for others, or safeguarding money or securities; underwriting and selling insurance; providing financial, investment, or economic advisory services; underwriting, dealing in or making a market in, securities; and any activity currently permitted for bank holding companies by the Federal Reserve Board under Section 4(c)(8) of the Bank Holding Company Act. The Act does not authorize banks or their affiliates to engage in commercial activities that are not financial in nature. A bank holding company may elect to be treated as a financial holding company only if all depository institution subsidiaries of the holding company are well-capitalized, well-managed and have at least a satisfactory rating under the Community Reinvestment Act. At the present time, the Company does not anticipate applying for status as a financial holding company under the Act. National and state banks are also authorized by the Act to engage, through "financial subsidiaries," in any activity that is permissible for a financial holding company (as described above) and any activity that the Secretary of the Treasury, in consultation with the Federal Reserve Board, determines is financial in nature or incidental to any such financial activity, except (i) insurance underwriting, (ii) real estate development or real estate investment activities (unless otherwise permitted by law), (iii) insurance company portfolio investments and (iv) merchant banking. The authority of a national or state bank to invest in a financial subsidiary is subject to a number of conditions, including, among other things, requirements that the bank be well-managed and well-capitalized (after deducting from the bank's capital outstanding investments in financial subsidiaries). The United States Congress and the North Carolina General Assembly have periodically considered and adopted legislation that has resulted in, and could result in further, deregulation of both banks and other financial institutions. Such legislation could modify or eliminate geographic restrictions on banks and bank holding companies and current restrictions on the ability of banks to engage in certain nonbanking activities. For example, the Riegle-Neal Interstate Banking Act, which was enacted several years ago, allows expansion of interstate acquisitions by bank holding companies and banks. This and other legislative and regulatory changes have increased the ability of financial institutions to expand the scope of their operations, both in terms of services offered and geographic coverage. Such legislative changes have placed the Company in more direct competition with other financial institutions, including mutual funds, securities brokerage firms, insurance companies, investment banking firms, and internet banks. The Company cannot predict what other legislation might be enacted or what other regulations might be adopted or, if enacted or adopted, the effect thereof on the Company's business. After the September 11, 2001 terrorist attacks in New York and Washington, D.C., the United States government acted in several ways to tighten control on activities perceived to be connected to money laundering and terrorist funding. A series of orders were issued that identify terrorists and terrorist organizations and require the blocking of property and assets of, as well as prohibiting all transactions or dealings with, such terrorists, terrorist organizations and those that assist or sponsor them. The USA Patriot Act substantially broadened existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States, imposed new compliance and due diligence obligations, created new crimes and penalties, compelled the production of documents located both inside and outside the United States, including those of foreign institutions that have a 10
correspondent relationship in the United States, and clarified the safe harbor from civil liability to customers. In addition, the United States Treasury Department issued regulations in cooperation with the federal banking agencies, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Department of Justice to require customer identification and verification, expand the money-laundering program requirement to the major financial services sectors, including insurance and unregistered investment companies, such as hedge funds, and facilitate and permit the sharing of information between law enforcement and financial institutions, as well as among financial institutions themselves. The United States Treasury Department also has created the Treasury USA Patriot Act Task Force to work with other financial regulators, the regulated community, law enforcement and consumers to continually improve the regulations. The Company has established policies and procedures to ensure compliance with the USA Patriot Act. In 2002, the Sarbanes-Oxley Act was signed into law. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity or debt securities registered under the Securities Exchange Act of 1934, as amended. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (v) new and increased civil and criminal penalties for violation of the securities laws. The most significant expense associated with compliance with the Sarbanes-Oxley Act has been the internal control documentation and attestation requirements of Section 404 of the Act. In 2004 and 2005, the Company's incremental external costs associated with complying with Section 404 of the Sarbanes-Oxley Act amounted to approximately $193,000 and $832,000, respectively. The incremental costs relate to higher external audit fees and outside consultant fees. These amounts do not include the value of the significant internal resources devoted to compliance. Supervision and Regulation of the Bank Federal banking regulations applicable to all depository financial institutions, among other things: (i) provide federal bank regulatory agencies with powers to prevent unsafe and unsound banking practices; (ii) restrict preferential loans by banks to "insiders" of banks; (iii) require banks to keep information on loans to major shareholders and executive officers; and (iv) bar certain director and officer interlocks between financial institutions. As a state chartered bank, the Bank is subject to the provisions of the North Carolina banking statutes and to regulation by the Commissioner. The Commissioner has a wide range of regulatory authority over the activities and operations of the Bank, and the Commissioner's staff conducts periodic examinations of the Bank and its affiliates to ensure compliance with state banking regulations. Among other things, the Commissioner regulates the merger and consolidation of state-chartered banks, the payment of dividends, loans to officers and directors, recordkeeping, types and amounts of loans and investments, and the establishment of branches. The Commissioner also has cease and desist powers over state-chartered banks for violations of state banking laws or regulations and for unsafe or unsound conduct that is likely to jeopardize the interest of depositors. The dividends that may be paid by the Bank to the Company are subject to legal limitations under North Carolina law. In addition, regulatory authorities may restrict dividends that may be paid by the Bank or the Company's other subsidiaries. The ability of the Company to pay dividends to its shareholders is largely dependent on the dividends paid to the Company by its subsidiaries. The Bank is a member of the FDIC, which currently insures the deposits of member banks. For this protection, each bank pays a quarterly statutory assessment, based on its level of deposits, and is subject to the rules and regulations of the FDIC. The FDIC also is authorized to approve conversions, mergers, consolidations and assumptions of deposit liability transactions between insured banks and uninsured banks or institutions, and 11
to prevent capital or surplus diminution in such transactions where the resulting, continuing, or assumed bank is an insured nonmember bank. In addition, the FDIC monitors the Bank's compliance with several banking statutes, such as the Depository Institution Management Interlocks Act and the Community Reinvestment Act of 1977. The FDIC also conducts periodic examinations of the Bank to assess its compliance with banking laws and regulations, and it has the power to implement changes in or restrictions on a bank's operations if it finds that a violation is occurring or is threatened. Neither the Company nor the Bank can predict what other legislation might be enacted or what other regulations might be adopted, or if enacted or adopted, the effect thereof on the Bank's operations. See "Capital Resources and Shareholders' Equity" under Item 7 below for a discussion of regulatory capital requirements. Available Information The Company maintains a corporate Internet site at www.firstbancorp.com, which contains a link within the "Investor Relations" section of the site to each of its filings with the Securities and Exchange Commission, including its annual reports on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These filings are available, free of charge, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission. These filings can also be accessed at the Securities and Exchange Commission's website located at www.sec.gov. Information included on the Company's Internet site is not incorporated by reference into this annual report. Item 1A. Risk Factors I. The Company is subject to interest rate risk, which could negatively impact earnings. Net interest income is the Company's most significant component of earnings. The Company's net interest income results from the difference between the yields the Company earns on its interest-earning assets, primarily loans and investments, and the rates that the Company pays on its interest-bearing liabilities, primarily deposits and borrowings. When interest rates change, the yields the Company earns on its interest-earning assets and the rates the Company pays on its interest-bearing liabilities do not necessarily move in tandem with each other because of the difference between their maturities and repricing characteristics. This mismatch can negatively impact net interest income if the margin between yields earned and rates paid narrows. Interest rate environment changes can occur at any time and are affected by many factors that are outside the control of the Company, including inflation, recession, unemployment trends, the Federal Reserve's monetary policy, domestic and international disorder and instability in domestic and foreign financial markets. As of December 31, 2005, interest rates in general have been steadily increasing for the past 18 months. During that period, the Company's interest-earning asset yields have increased by approximately the same amount as the Company's interest-bearing liability rates. However, our net interest income has benefited from the fact that the Company's interest-earnings assets generally reprice sooner upon a change in interest rates than do the Company's interest-bearing liabilities. Therefore, if interest rates do not change in 2006, the Company will likely have more interest-bearing liabilities than interest-earning assets that will reprice at higher rates. This will likely negatively impact the Company's net interest income. If interest rates were to decrease in 2006, the negative impact to the Company's net interest margin would be exacerbated as a result of the Company's interest-earning assets repricing downwards faster and by a greater amount than the Company's interest bearing liabilities. Growth that the Company expects to generate in loans and deposits would be expected to increase net interest income, and thus would lessen the negative impact of compressing spreads in a "no change" or declining interest rate environment. 12
II. The Company faces strong competition, which could hurt the Company's business. The Company's business operations are centered primarily in North Carolina, southwestern Virginia and northeastern South Carolina. Increased competition within this region may result in reduced loan originations and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. Many competitors offer the types of loans and banking services that the Company offers. These competitors include savings associations, national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including finance companies, internet banks, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. The Company competes in its market areas with several large interstate bank holding companies, including three of the largest in the nation that are headquartered in North Carolina. These large competitors have substantially greater resources than the Company, including broader geographic markets, more banking locations, higher lending limits and the ability to make greater use of large-scale advertising and promotions. Also, these institutions, particularly to the extent they are more diversified than the Company, may be able to offer the same products and services that the Company offers at more competitive rates and prices. The Company also competes in some of its market areas with many banks that have been organized within the past ten years. These new banks often focus on loan and deposit balance sheet growth, and not necessarily on earnings profitability. This strategy often allows them to offer more attractive terms on loans and deposits than the Company is able to offer because the Company must achieve an acceptable level of profitability. Moore County, which comprises a disproportionate share of the Company's deposits, is a particularly competitive market, with at least ten other financial institutions having a physical presence, including large interstate bank holding companies and recently organized banks. III. The Company's allowance for loan losses may not be adequate to cover actual losses. Like all financial institutions, the Company maintains an allowance for loan losses to provide for probable losses caused by customer loan defaults. The allowance for loan losses may not be adequate to cover actual loan losses, and in this case additional and larger provisions for loan losses would be required to replenish the allowance. Provisions for loan losses are a direct charge against income. The level of the allowance for loan losses set by the Company is dependent on the use of historical loss rates, as well as estimates and assumptions of future events. Because of the extensive use of estimates and assumptions, there is the possibility that they could be wrong and that the Company's actual loan losses could differ (and possibly significantly) from the Company's estimate. The Company believes that its allowance for loan losses is adequate to provide for probable losses, but it is possible that the allowance for loan losses will need to be increased for credit reasons or that regulators will require the Company to increase this allowance. Either of these occurrences could materially and adversely affect the Company's earnings and profitability. IV. The Company is vulnerable to the economic conditions within the fairly small geographic region in which it operates. Like most businesses, the Company's overall success is partially dependent on the economic conditions in the marketplace where it operates. The Company's marketplace is concentrated in the central Piedmont region of North Carolina and is therefore not particularly diversified. An economic downturn in this fairly small geographic region that negatively impacted the Company's customers would likely also have an adverse impact on the Company. For example, an economic downturn may result in higher loan default rates and reduce the value of real estate securing those loans, which would likely increase the Company's loan losses. At December 31, 2005, approximately 86% of the Company's loans were secured by real estate collateral, and thus the 13
Company could be adversely impacted if real estate values decreased. V. The Company is subject to extensive regulation, which could have an adverse effect. The Company is subject to extensive regulation and supervision from the North Carolina Commissioner of Banks, the FDIC, and the Federal Reserve Board. This regulation and supervision is intended primarily for the protection of the FDIC insurance fund and the Company's depositors and borrowers, and not for holders of the Company's common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of the Company's assets and determination of the level of the allowance for loan losses. Changes in the regulations that apply to the Company, or changes in the Company's compliance with regulations, could have a material impact on our operations. Item 1B. Unresolved Staff Comments None Item 2. Properties The main offices of the Company, the Bank and First Bancorp Financial are owned by the Bank and are located in a three-story building in the central business district of Troy, North Carolina. The building houses administrative and bank teller facilities. The Bank's Operations Division, including customer accounting functions, offices and operations of Montgomery Data, and offices for loan operations, are housed in two one-story steel frame buildings approximately one-half mile west of the main office. Both of these buildings are owned by the Bank. The Company operates 61 bank branches. The Company owns all its bank branch premises except nine branch offices for which the land and buildings are leased and four branch offices for which the land is leased but the building is owned. In addition, the Company leases three loan production offices. There are no other options to purchase or lease additional properties. The Company considers its facilities adequate to meet current needs and believes that lease renewals or replacement properties can be acquired as necessary to meet future needs. Item 3. Legal Proceedings Various legal proceedings may arise in the ordinary course of business and may be pending or threatened against the Company and/or its subsidiaries. However, neither the Company nor any of its subsidiaries is involved in any pending legal proceedings that management believes could have a material effect on the consolidated financial position of the Company. There were no tax shelter penalties assessed by the Internal Revenue Service against the Company during the year ended December 31, 2005. Item 4. Submission of Matters to a Vote of Shareholders No matters were submitted to a vote of shareholders during the fourth quarter of 2005. PART II Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters, and Issuer Purchases of Equity Securities The Company's common stock trades on the NASDAQ National Market System of the NASDAQ Stock Market under the symbol FBNC. Table 22, included in "Management's Discussion and Analysis" below, set 14
forth the high and low market prices of the Company's common stock as traded by the brokerage firms that maintain a market in the Company's common stock and the dividends declared for the periods indicated. See "Business - Supervision and Regulation" above and Note 15 to the consolidated financial statements for a discussion of regulatory restrictions on the payment of dividends. As of December 31, 2005, there were approximately 2,700 shareholders of record and another 3,250 shareholders whose stock is held in "street name." There were no sales of unregistered securities during the year ended December 31, 2005. It is the Company's current intention to continue to pay cash dividends in the future comparable to those in the recent past. Issuer Purchases of Equity Securities Pursuant to authorizations by the Company's board of directors, the Company has from time to time repurchased shares of common stock in private transactions and in open-market purchases. The most recent board of director authorization was announced on July 30, 2004 and authorized the repurchase of 375,000 shares of the Company's stock. During 2005, the Company did not repurchase any shares of its own stock. The following table sets forth information about the Company's stock repurchase plan for the three months ended December 31, 2005. <TABLE> <CAPTION> Issuer Purchases of Equity Securities - ----------------------------------------------------------------------------------------------------------------------------- Total Number of Shares Maximum Number of Purchased as Part of Shares that May Yet Be Total Number of Average Price Paid per Publicly Announced Purchased Under the Period Shares Purchased (2) Share Plans or Programs (1) Plans or Programs (1) - ---------------------------- -------------------- ---------------------- ----------------------- --------------------- <S> <C> <C> <C> <C> Month #1 (October 1, 2005 to October 31, 2005) -- -- -- 315,015 Month #2 (November 1, 2005 to November 30, 2005) -- -- -- 315,015 Month #3 (December 1, 2005 to December 31, 2005) -- -- -- 315,015 -------------------- ---------------------- ----------------------- --------------------- Total -- -- -- 315,015 ==================== ====================== ======================= ===================== </TABLE> Footnotes to the Above Table (1) Any shares repurchased would be pursuant to publicly announced share repurchase authorizations. On July 30, 2004, the Company announced that its Board of Directors had approved the repurchase of 375,000 shares of the Company's common stock. The repurchase authorization does not have an expiration date. There are no plans or programs the issuer has determined to terminate prior to expiration, or under which the issuer does not intend to make further purchases. (2) The above table above does not include shares that were used by option holders to satisfy the exercise price of the Company's call options issued by the Company to its employees and directors pursuant to the Company's stock option plans. In November 2005, 522 shares of the Company's common stock with a weighted average price of $22.00 were used to satisfy the exercise price of employee option exercises. In December 2005, 1,383 shares of the Company's common stock, with a weighted average market price of $22.07 were used to satisfy such exercises. Item 6. Selected Consolidated Financial Data Table 1 sets forth selected consolidated financial data for the Company. 15
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis is intended to assist readers in understanding the Company's results of operations and changes in financial position for the past three years. This review should be read in conjunction with the consolidated financial statements and accompanying notes beginning on page 60 of this report and the supplemental financial data contained in Tables 1 through 22 included with this discussion and analysis. All share data for periods prior to November 15, 2004 has been adjusted from its originally reported amounts to reflect the 3-for-2 stock split paid on November 15, 2004. CRITICAL ACCOUNTING POLICIES The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices followed by the banking industry. Certain of these principles involve a significant amount of judgment and/or use of estimates based on the Company's best assumptions at the time of the estimation. The Company has identified three policies as being more sensitive in terms of judgments and estimates, taking into account their overall potential impact to the Company's consolidated financial statements - 1) the allowance for loan losses, 2) tax uncertainties, and 3) intangible assets. Allowance for Loan Losses Due to the estimation process and the potential materiality of the amounts involved, the Company has identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to the Company's consolidated financial statements. The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio. Management's determination of the adequacy of the allowance is based primarily on a mathematical model that estimates the appropriate allowance for loan losses. This model has two components. The first component involves the estimation of losses on loans defined as "impaired loans." A loan is considered to be impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The estimated valuation allowance is the difference, if any, between the loan balance outstanding and the value of the impaired loan as determined by either 1) an estimate of the cash flows that the Company expects to receive from the borrower discounted at the loan's effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral. The second component of the allowance model is to estimate losses for all loans not considered to be impaired loans. First, loans that have been risk graded by the Company as having more than "standard" risk but are not considered to be impaired are assigned estimated loss percentages generally accepted in the banking industry. Loans that are classified by the Company as having normal credit risk are segregated by loan type, and estimated loss percentages are assigned to each loan type, based on the historical losses, current economic conditions, and operational conditions specific to each loan type. The reserve estimated for impaired loans is then added to the reserve estimated for all other loans. This becomes the Company's "allocated allowance." In addition to the allocated allowance derived from the model, management also evaluates other data such as the ratio of the allowance for loan losses to total loans, net loan growth information, nonperforming asset levels and trends in such data. Based on this additional analysis, the Company may determine that an additional amount of allowance for loan losses is necessary to reserve for probable losses. This additional amount, if any, is the Company's "unallocated allowance." The sum of the allocated allowance and the unallocated allowance is compared to the actual allowance for loan losses recorded on the books of the Company and any adjustment necessary for the recorded allowance to equal the computed allowance is recorded as a provision for loan losses. The provision for loan losses is a direct charge to earnings 16
in the period recorded. Although management uses the best information available to make evaluations, future adjustments may be necessary if economic, operational, or other conditions change. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on the examiners' judgment about information available to them at the time of their examinations. For further discussion including a review of the range of provisions for loan losses and its impact on reported results in recent periods, see "Nonperforming Assets" and "Allowance for Loan Losses and Loan Loss Experience" under "Analysis of Financial Condition and Changes in Financial Condition." Tax Uncertainties The Company reserves for tax uncertainties in instances when it has taken a position on a tax return that may differ from the opinion of the applicable taxing authority. In accounting for tax contingencies, the Company assesses the relative merits and risks of certain tax transactions, taking into account statutory, judicial and regulatory guidance in the context of the Company's tax position. For those matters where it is probable that the Company will have to pay additional taxes, interest or penalties and a loss or range of losses can be reasonably estimated, the Company records reserves in the consolidated financial statements. For those matters where it is reasonably possible but not probable that the Company will have to pay additional taxes, interest or penalties and the loss or range of losses can be reasonably estimated, the Company only makes disclosures in the notes and does not record reserves in the consolidated financial statements. The process of concluding that a loss is reasonably possible or probable and estimating the amount of loss or range of losses and related tax reserves is inherently subjective, and future changes to the reserve may be necessary based on changes in management's intent, tax law or related interpretations, or other functions. The sections below entitled "Income Taxes" and "Liquidity, Commitments, and Contingencies" and Notes 12 and 18 to the consolidated financial statements include information related to a tax loss contingency accrual that was recorded in 2005. For 2004, the Company had determined that this same tax uncertainty required disclosure, but not loss accrual. Intangible Assets Due to the estimation process and the potential materiality of the amounts involved, the Company has also identified the accounting for intangible assets as an accounting policy critical to the Company's consolidated financial statements. When the Company completes an acquisition transaction, the excess of the purchase price over the amount by which the fair market value of assets acquired exceeds the fair market value of liabilities assumed represents an intangible asset. The Company must then determine the identifiable portions of the intangible asset, with any remaining amount classified as goodwill. Identifiable intangible assets associated with these acquisitions are generally amortized over the estimated life of the related asset, whereas goodwill is tested annually for impairment, but not systematically amortized. Assuming no goodwill impairment, it is beneficial to the Company's future earnings to have a lower amount assigned to identifiable intangible assets and a higher amount to goodwill as opposed to having a higher amount considered to be identifiable intangible assets and a lower amount classified as goodwill. For the Company, the primary identifiable intangible asset typically recorded in connection with a whole bank or bank branch acquisition is the value of the core deposit intangible, whereas when the Company acquires an insurance agency, the primary identifiable intangible asset is the value of the acquired customer list. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions 17
and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all of the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. The Company typically engages a third party consultant to assist in each analysis. For the whole bank and bank branch transactions recorded to date, the core deposit intangible in each case has been estimated to have a ten year life, with an accelerated rate of amortization. For the 2003 insurance agency acquisition, the identifiable intangible asset related to the customer list was determined to have a ten year life, with amortization occurring on a straight-line basis. Subsequent to the initial recording of the identifiable intangible assets and goodwill, the Company amortizes the identifiable intangible assets over their estimated average lives, as discussed above. In addition, on at least an annual basis, goodwill is evaluated for impairment by comparing the fair value of the Company's reporting units to their related carrying value, including goodwill (the Company's community banking operation is its only material reporting unit). At its last evaluation, the fair value of the Company's community banking operation exceeded its carrying value, including goodwill. If the carrying value of a reporting unit were ever to exceed its fair value, the Company would determine whether the implied fair value of the goodwill, using a discounted cash flow analysis, exceeded the carrying value of the goodwill. If the carrying value of the goodwill exceeded the implied fair value of the goodwill, an impairment loss would be recorded in an amount equal to that excess. Performing such a discounted cash flow analysis would involve the significant use of estimates and assumptions. The Company reviews identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company's policy is that an impairment loss is recognized, equal to the difference between the asset's carrying amount and its fair value, if the sum of the expected undiscounted future cash flows is less than the carrying amount of the asset. Estimating future cash flows involves the use of multiple estimates and assumptions, such as those listed above. The foregoing accounting policy was adopted by the Company effective on January 1, 2002 in accordance with newly issued accounting standards for goodwill and other intangible assets. For acquisitions occurring prior to January 1, 2002, the Company generally did not separately identify its identifiable intangible assets from its goodwill, as all intangible assets were amortized under accounting standards then in effect. According to the transition provisions of the accounting standards that changed the Company's accounting policy to that described above, the entire amount of those combined intangible assets was accounted for entirely as non-amortizable goodwill. MERGER AND ACQUISITION ACTIVITY Over the past three fiscal years, the Company has completed several acquisitions, which have resulted in significant amounts of intangible assets being recorded by the Company, as detailed below. As noted above, the accounting for intangible assets changed significantly in 2002 with the Company being required under new accounting standards to cease the amortization of goodwill. See Note 2 and Note 6 to the consolidated financial statements for additional information regarding intangible assets. The Company did not announce or complete any acquisitions in 2004 or 2005. In January 2006, the Company announced an agreement to purchase a bank branch in Dublin, Virginia with approximately $20 million in deposits from another financial institution. The Company completed the following acquisitions during 2003: (a) On January 2, 2003, the Company completed the acquisition of Uwharrie Insurance Group, Inc. ("Uwharrie"), a Montgomery County based property and casualty insurance agency. Uwharrie was subsequently merged into First Bank Insurance. With eight employees, Uwharrie served approximately 5,000 customers, primarily from its Troy-based headquarters, and had annual commissions of approximately $500,000. The primary reason for the acquisition was to gain efficiencies of scale with the Company's existing property and casualty insurance business. The acquisition resulted in the Company recording an intangible asset of approximately $544,000. Based on an independent appraisal, $50,000 of the intangible asset recorded was 18
determined to be attributable to the value of the noncompete agreement signed as part of the transaction and is being amortized over its two year life, $151,000 was determined to be attributable to the value of the customer list and is being amortized on a straight-line basis over ten years, and the remaining $343,000 was determined to be goodwill and thus is not being systematically amortized, but rather is subject to an annual impairment test. (b) On January 15, 2003, the Company completed the acquisition of Carolina Community Bancshares, Inc. ("CCB"), the parent company of Carolina Community Bank, a South Carolina community bank with three branches in Dillon County, South Carolina. This represented the Company's first entry into South Carolina. Dillon County, South Carolina is contiguous to Robeson County, North Carolina, a county where the Company already operated four branches. The Company's primary reason for the acquisition was to expand into a contiguous market with facilities, operations and experienced staff in place. In this transaction, the shareholders of CCB received 1.2 shares of the Company's stock and $20.00 in cash for each share of CCB stock they owned at the time of closing. The transaction was completed on January 15, 2003, with the Company paying cash of $8.3 million, issuing 499,332 shares of common stock that were valued at approximately $8.4 million, and assuming employee stock options with an intrinsic value of approximately $0.9 million. As of the date of the acquisition, CCB had approximately $48 million in loans, $59 million in deposits and $70 million in total assets. In connection with the acquisition of CCB, the Company recorded total intangible assets of $10.2 million, of which $771,000 was determined to be the value of the core deposit base and is being amortized on an accelerated basis over ten years, and $9.4 million was determined to be goodwill and thus is not being systematically amortized, but rather is subject to an annual impairment test. (c) On October 24, 2003, the Company completed the acquisition of four branches of RBC Centura Bank located in Fairmont, Harmony, Kenansville, and Wallace, all in North Carolina. As of the date of the acquisition, the branches had a total of approximately $102 million in deposits and $25 million in loans. The primary reason for the acquisition was to expand into new markets and increase the Company's customer base. Subject to certain limitations, the Company paid a deposit premium of 14.1% for the branches, which resulted in the Company recording intangible assets relating to this purchase of $14.2 million. The identifiable intangible asset associated with the fair value of the core deposit base, as determined by an independent consulting firm, was valued at approximately $1.3 million and is being amortized as expense on an accelerated basis over a ten year period. The remaining intangible asset of $12.9 million has been classified as goodwill, and thus is not being systematically amortized, but rather is subject to an annual impairment test. The following table contains a condensed balance sheet that indicates the amount assigned to each major asset and liability as of the respective acquisition dates for the 2003 acquisitions described above. Uwharrie Carolina RBC Insurance Community Centura Assets acquired Group Bank Branches Total - ----------------------------- --------- --------- --------- --------- (in millions) Cash $ -- 7.0 62.4 69.4 Securities -- 13.1 -- 13.1 Loans, gross -- 47.7 24.8 72.5 Allowance for loan losses -- (0.8) (0.3) (1.1) Premises and equipment -- 0.8 1.0 1.8 Other -- 2.5 0.2 2.7 --------- --------- --------- --------- Total assets acquired -- 70.3 88.1 158.4 --------- --------- --------- --------- Liabilities assumed - ----------------------------- Deposits -- 58.9 102.0 160.9 Borrowings -- 2.1 -- 2.1 Other -- 0.6 0.3 0.9 --------- --------- --------- --------- Total liabilities assumed -- 61.6 102.3 163.9 --------- --------- --------- --------- Value of cash paid and/or stock issued to stock-holders of acquiree 0.5 18.9 n/a 19.4 --------- --------- --------- --------- Intangible assets recorded $ 0.5 10.2 14.2 24.9 ========= ========= ========= ========= 19
There are many factors that the Company considers when evaluating how much to offer for potential acquisition candidates - in the form of a purchase price comprised of cash and/or stock for a whole company purchase or a deposit premium in a branch purchase. Most significantly, the Company compares expectations of future earnings per share on a stand-alone basis with projected future earnings per share assuming completion of the acquisition under various pricing scenarios. Significant assumptions that affect this analysis include the estimated future earnings stream of the acquisition candidate, the amount of cost efficiencies that can be realized, and the interest rate earned/lost on the cash received/paid. In addition to the earnings per share comparison, the Company also considers other factors including (but not limited to): marketplace acquisition statistics, location of the candidate in relation to the Company's expansion strategy, market growth potential, management of the candidate, potential integration issues (including corporate culture), and the size of the acquisition candidate. ANALYSIS OF RESULTS OF OPERATIONS Net interest income, the "spread" between earnings on interest-earning assets and the interest paid on interest-bearing liabilities, constitutes the largest source of the Company's earnings. Other factors that significantly affect operating results are the provision for loan losses, noninterest income such as service fees and noninterest expenses such as salaries, occupancy expense, equipment expense and other overhead costs, as well as the effects of income taxes. Overview - 2005 Compared to 2004 Net income for the year ended December 31, 2005 amounted to $16,090,000, or $1.12 per diluted share, a 20.0% decrease from the net income of $20,114,000, or $1.40 per diluted share, reported for 2004. The annual earnings for 2005 were significantly impacted by a contingency loss accrual related to income tax exposure amounting to $4,338,000 (after-tax), or $0.30 per diluted share. The Company originally accrued $6,320,000, or $0.44 per diluted share, related to this loss exposure in the third quarter of 2005. In March 2006, prior to filing its financial statements, the Company reversed $1,982,000, or $0.14 per diluted share, of this accrual, effective for the fourth quarter of 2005, as a result of a change in the loss estimate. See additional discussion in the section entitled "Income Taxes" below. Total assets at December 31, 2005 amounted to $1.80 billion, 9.9% higher than a year earlier. Total loans at December 31, 2005 amounted to $1.48 billion, an increase of $116 million, or 8.5%, from a year earlier. Total deposits amounted to $1.49 billion at December 31, 2005, an increase of $106 million, or 7.6%, from a year earlier. Deposit growth would have been higher had the Company not paid off, without renewing, $50 million in brokered deposits that were outstanding at December 31, 2004 and matured during 2005. The Company had no brokered deposits outstanding at December 31, 2005. The growth in loans and deposits was the primary reason for the increase in the Company's net interest income when comparing 2004 to 2005. Net interest income for the year ended December 31, 2005 amounted to $68.6 million, an 11.9% increase over the $61.3 million recorded in 2004. The Company's net interest margin (tax-equivalent net interest income divided by average earning assets) realized for 2005 was 4.33% compared to 4.31% for 2004. The rising interest rate environment had a positive effect on the Company's net interest margin, but the positive effects were largely offset by the mix of the Company's deposit growth being more concentrated in the categories of time deposits and time deposits greater than $100,000. Time deposits are generally a high cost category of funds for the Company. However, their increased usage has been necessary in order to fund loan growth. The Company's provision for loan losses did not vary significantly in 2005 compared to 2004, amounting to $3,040,000 in 2005 compared to $2,905,000 in 2004. The ratio of net-charge offs to average loans for 2005 was 0.14%, which is the same as it was for 2004. At December 31, 2005, the Company's nonperforming assets to total assets ratio was 0.17% compared to 0.32% at the prior year end, and was the lowest it has been at any year 20
end since the Company became publicly held in 1985. Noninterest income for 2005 amounted to $15.0 million, a decrease of 5.4% from the $15.9 million recorded in 2004. The decrease in 2005 is partly a result of lower service charges on deposit accounts. Service charges on deposit accounts have decreased primarily as a result of the negative impact that higher short term interest rates have on the service charges that the Company earns from its commercial depositors - in the Company's commercial account service charge rate structure, commercial depositors are given "earnings credits" (negatively impacting service charges) on their average deposit balances that are tied to short term interest rates. Also, in 2005 the Company recorded significantly lower "securities gains" and "other gains" compared to 2004. In 2005, the Company recorded a combined net loss of $258,000 for these two line items compared to a net gain of $648,000 in 2004, a negative change of $906,000. Noninterest expenses in 2005 amounted to $47.6 million, a 9.0% increase from the $43.7 million recorded in 2004. The increase in noninterest expenses is primarily attributable to costs associated with the Company's overall growth in loans, deposits and branch network. Also, the Company's Sarbanes-Oxley compliance costs amounted to $832,000 in 2005 compared to $193,000 in 2004. The Company's income tax expense for 2005 of $16.8 million includes the previously discussed contingency tax loss accrual of $4.3 million. During periods that did not include this accrual, the Company's effective tax rate in 2005 was approximately 38%-39% compared to approximately 34%-35% in 2004. The higher effective tax rate in 2005 compared to 2004 is the result of the Company discontinuing, effective January 1, 2005, the operating structure involving a real estate investment trust (REIT) that gave rise to the 2005 contingency tax loss accrual. The Company expects its effective tax rate to continue to be in the 38%-39% range for the foreseeable future. See additional discussion in the section entitled "Income Taxes" below. Overview - 2004 Compared to 2003 Net income for the year ended December 31, 2004 amounted to $20,114,000, or $1.40 per diluted share, a 3.6% increase in net income and a 3.7% increase in diluted earnings per share over the net income of $19,417,000, or $1.35 per diluted share, reported for 2003. All per share amounts originally reported for periods prior to November 15, 2004 have been adjusted to reflect the 3-for-2 stock split paid on November 15, 2004. Total assets at December 31, 2004 amounted to $1.64 billion, 11.1% higher than a year earlier. Total loans at December 31, 2004 amounted to $1.37 billion, a 12.2% increase from a year earlier, and total deposits amounted to $1.39 billion at December 31, 2004, an 11.2% increase from a year earlier. Approximately $50 million of the total 2004 deposit increase of $139 million related to wholesale brokered deposits that the Company gathered in order to help fund the high loan growth experienced during 2004. The increase in loans and deposits during 2004 resulted in an increase in the Company's net interest income from 2003 to 2004. Net interest income for the year ended December 31, 2004 amounted to $61.3 million, a 9.9% increase over the $55.8 million recorded in 2003. The positive impact on net interest income from the increases in loans and deposits more than offset a lower net interest margin realized in 2004 compared to 2003. The Company's net interest margin (tax-equivalent net interest income divided by average earning assets) for 2004 was 4.31% compared to the 4.52% in 2003. The Company's net interest margin was negatively impacted by the thirteen interest rate cuts initiated by the Federal Reserve from 2001 to 2003 and the Company's shift toward originating more adjustable rate loans compared to fixed rate loans to protect the Company from anticipated increases in interest rates. The Federal Reserve increased interest rates by 125 basis points in the second half of 2004 which was responsible for the Company's net interest margin increasing during the third and fourth quarters of 2004 after having decreased for the immediately preceding five consecutive quarters. The Company's provision for loan losses did not vary significantly in 2004 compared to 2003, amounting to $2,905,000 in 2004 compared to $2,680,000 in 2003. The Company's asset quality ratios remained sound in 21
2004, with a net-charge off ratio (net charge-offs divided by average loans) of 0.14% in 2004 compared to 0.10% in 2003, and a December 31, 2004 nonperforming asset to total asset ratio of 0.32%, compared to 0.39% at the prior year end. For the year ended 2004, noninterest income amounted to $15.9 million, a 6.3% increase from $14.9 million in 2003. Except for fees from presold mortgages, most components of noninterest income increased for the year ended 2004 compared to 2003 as a result of the Company's overall growth, particularly the Company's October 2003 acquisition of four bank branches with $102 million in deposits, which impacted the Company's noninterest income for all twelve months of 2004 compared to only three months in 2003. Fees from presold mortgages decreased significantly in 2004 as a result of a decline in mortgage refinancing activity caused by higher mortgage interest rates. Fees from presold mortgages decreased from $2.3 million in 2003 to $1.0 million in 2004. The Company realized securities gains and other gains of $648,000 in 2004 compared to $306,000 in 2003. Noninterest expenses for 2004 amounted to $43.7 million, a 15.2% increase from the $38.0 million recorded in 2003. The increase in noninterest expenses was primarily attributable to growth in the Company's branch network, which increased by eight branches from October 2003 through the end of 2004. The Company's effective tax rates were slightly lower for 2004 compared to 2003, amounting to 34.1% in 2004 compared to 35.3% for 2003. The lower effective tax rate in 2004 was caused by several factors including higher amounts of state tax exempt income, higher amounts of low income housing investment tax credits, and the reversal of an $89,000 tax liability that was recorded in connection with a previous corporate acquisition. Net Interest Income Net interest income on a reported basis amounted to $68,591,000 in 2005, $61,290,000 in 2004, and $55,760,000 in 2003. For internal purposes and in the discussion that follows, the Company evaluates its net interest income on a tax-equivalent basis by adding the tax benefit realized from tax-exempt securities to reported interest income. Net interest income on a tax-equivalent basis amounted to $69,039,000 in 2005, $61,765,000 in 2004, and $56,278,000 in 2003. Management believes that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods. Table 2 analyzes net interest income on a tax-equivalent basis. The Company's net interest income on a taxable-equivalent basis increased by 11.8% in 2005 and 9.7% in 2004. There are two primary factors that cause changes in the amount of net interest income recorded by the Company - 1) growth in loans and deposits, and 2) the Company's net interest margin (tax-equivalent net interest income divided by average interest-earning assets). As illustrated in Table 3, in both 2005 and 2004, net interest income was positively impacted by both higher amounts of average loans and deposits outstanding. In 2005, the average amount of loans outstanding increased 9.8%, and the average amount of deposits outstanding increased 11.8%. In 2004, the average amount of loans outstanding increased 16.4%, and the average amount of deposits outstanding increased 13.3%. The growth in the volume of loans and deposits increased net interest income by $5.8 million in 2005 and $7.8 million in 2004. The higher amounts of average loans and deposits outstanding in 2005 were entirely a result of internal growth, as the Company did not complete any acquisitions in 2004 or 2005. The higher amounts of average loans and deposits outstanding in 2004 were a result of both internal growth, as well as growth achieved in corporate acquisitions. Although the Company did not complete any acquisitions in 2004, the increases in the Company's average loan and deposit amounts in 2004 compared to 2003 were impacted by acquisitions completed in 2003, as the loans and deposits assumed in the 2003 acquisitions were outstanding for the full year in 2004 compared to only a partial year in 2003 (from the date of the respective acquisitions). For analysis regarding the nature of the Company's loan and deposit growth, see "Analysis of Financial Condition and Changes in Financial Condition" below. 22
Table 3 also illustrates the impact that changes in the rates that the Company earned/paid had on the Company's net interest income in 2004 and 2005. In 2005, the Federal Reserve increased interest rates eight times totaling 200 basis points, which followed five rate increases totaling 125 basis points that occurred in the second half of 2004. This rising interest rate environment resulted in higher amounts of interest income earned and interest expense paid in 2005, with the net effect being a $1.5 million increase in net interest income. In 2004, although the average prime rate was slightly higher than in 2003, the average yields realized on earning assets and the average rates paid on interest-bearing liabilities for the year were both lower than in 2003. The average yield on earning assets was lower in 2004 than in 2003 due to a growing percentage of adjustable rate loans, which carry lower initial rates than fixed rate loans (see below for additional discussion), and lower renewal/reinvestment rates earned on fixed rate earning assets that matured during 2004 that had been originated during periods of higher interest rates. The average rate paid on interest-bearing liabilities was lower in 2004 than in 2003 due to the interest rates on deposits that are set by management not being increased at the same time, or by the full amount, as increases in the prime rate of interest that occurred in 2004. Also, interest expense on time deposits was otherwise lower as a result of time deposits that were originated prior to the increases in interest rates, with maturities subsequent to the dates of the rate changes. The reduction in interest income for 2004 was $2.4 million more than the reduction in interest expense, and thus changes in interest rates negatively impacted the Company's net interest income for 2004. The Company measures the spread between the yield on its earning assets and the cost of its funding primarily in terms of the ratio entitled "net interest margin" which is defined as tax-equivalent net interest income divided by average earning assets. The Company's net interest margin increased slightly in 2005 after decreasing in 2004, amounting to 4.33% in 2005, 4.31% in 2004, and 4.52% in 2003. In 2005, the Company's net interest margin was positively impacted by the rising interest rate environment, but the positive effects were largely offset by the mix of the Company's deposit growth being more concentrated in the categories of time deposits and time deposits greater than $100,000. As derived from Table 2, in 2005, the yield earned on loans, the Company's primary earning asset, increased by 75 basis points, from 5.87% to 6.62%, while the average rate paid on savings, NOW and money market accounts, the Company's largest deposit category, increased by only 32 basis points (from 0.54% to 0.86%). The difference in these increases positively impacted the Company's net interest margin. However, 82% of the Company's average deposit growth in 2005 was comprised of time deposits, which are a high cost category of funds for the Company and incrementally result in lower net interest margins for the Company. In addition to being a high cost of funds for the Company, this category of deposits is typically more price-sensitive than the Company's other deposit categories, repricing upward by a greater amount in a rising rate environment than the Company's other deposits. In 2005, the average rate paid on time deposits greater than $100,000 increased by 92 basis points in 2005, from 2.34% to 3.26%, while the average rate paid for all other time deposits increased by 82 basis points, from 2.04% to 2.86%. The higher growth in time deposits was necessary in order to fund the Company's loan growth. The positive and negative factors discussed above mostly offset each other, resulting in a two basis point increase in net interest margin for 2005 - from 4.31% in 2004 to 4.33% in 2005. In 2004, the Company's net interest margin was negatively impacted by the interest rate environment and a shift towards originating more adjustable rate loans compared to fixed rate loans to protect the Company from an expected rise in interest rates. The mostly declining interest rate environment in effect from 2001 until June 30, 2004, and the level to which interest rates dropped, resulted in the Company being unable to reset deposit rates by an amount that would offset the negative impact of the lower yields earned on the Company's interest earning assets. In the declining rate environment, the Company's interest-sensitive assets repriced sooner (most on the day following the interest rate cut) and by a larger percentage (generally by the same number of basis points that the Federal Reserve discount rate was decreased) than did the Company's interest-sensitive liabilities that were subject to repricing. Additionally, as fixed rate earning assets originated during periods of higher interest rates matured, they were generally replaced with lower yielding earning assets. The Company was unable to reset deposit rates by the full amount of the interest rate cuts because of their already near-zero rates and because of 23
competitive pricing pressures. Also, interest rates paid on time deposits are generally fixed and are not subject to automatic adjustment. When time deposits mature, the Company has the opportunity, at the customers' discretion, to renew the time deposit at a rate set by the Company. Because time deposits that are interest-sensitive in a twelve month horizon mature throughout the twelve month period, any change in the renewal rate will affect only a portion of the twelve month period. In addition, although changes in interest rates on renewing time deposits generally track rate changes in the interest rate environment, the Company found it especially difficult to decrease rates on renewing time deposits by the corresponding decreases in the Federal Reserve discount rate because of competitive pressures in the Company's market areas. Finally, in 2004 the Company increased its reliance on time deposits greater than $100,000 and borrowings in order to fund high loan growth that exceeded core retail deposit growth. The ratio of the average amount of time deposits greater than $100,000 and borrowings to total funding (total deposits plus borrowings) increased from 22.7% in 2003 to 25.6% in 2004. The impact of the factors just discussed resulted in a 21 basis point decrease in net interest margin for 2004 - from 4.52% in 2003 to 4.31% in 2004. As discussed above, from 2002 to 2004, the Company gradually positioned itself to be protected in a rising interest rate environment by originating more variable rate loans than fixed rate loans - a rising interest rate environment was forecasted by most economists after the steeply declining interest rate environment that began in 2001 and concluded with interest rates being at their lowest levels in 40 years during 2004. This initiative resulted in the Company's loan mix changing from 57% fixed rate and 43% variable rate at December 31, 2001 to 60% variable rate and 40% fixed rate at December 31, 2004. In 2005, most economists began to forecast that the steadily increasing interest rate environment in effect since mid-2004 would end in 2006. As a result, in 2005 the Company began originating a more even mix of fixed rate loans and variable rate loans, which resulted in the Company's fixed/variable mix shifting slightly to 58% variable rate and 42% fixed rate at December 31, 2005. See additional information regarding net interest income in the section entitled "Interest Rate Risk." Provision for Loan Losses The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered appropriate to absorb probable losses inherent in the portfolio. Management's determination of the adequacy of the allowance is based on the level of loan growth, an evaluation of the portfolio, current economic conditions, historical loan loss experience and other risk factors. The provision for loan losses recorded by the Company did not vary significantly over the past three years, amounting to $3,040,000 in 2005, compared to $2,905,000 in 2004 and $2,680,000 in 2003. Net internal loan growth was strong for each of those years, amounting to $116 million in 2005 and $148 million in both 2004 and 2003. There was no external/acquired loan growth in 2004 or 2005. In 2003, there was acquired growth of $72.5 million, for which a preexisting allocation for loan losses was already in place. Asset quality ratios were stable during each of the three years in the period ended December 31, 2005. See the section entitled "Allowance for Loan Losses and Loan Loss Experience" below for a more detailed discussion of the allowance for loan losses. The allowance is monitored and analyzed regularly in conjunction with the Company's loan analysis and grading program, and adjustments are made to maintain an adequate allowance for loan losses. Noninterest Income Noninterest income recorded by the Company amounted to $15,004,000 in 2005, $15,864,000 in 2004, and $14,918,000 in 2003. As shown in Table 4, core noninterest income, which excludes gains and losses from sales of securities, loans, and other assets, amounted to $15,262,000 in 2005, a 0.3% increase from $15,216,000 in 2004. The 2004 24
core noninterest income of $15,216,000 was 4.1% higher than the $14,612,000 recorded in 2003. See Table 4 and the following discussion for an understanding of the components of noninterest income. Service charges on deposit accounts in 2005 amounted to $8,537,000, a 5.8% decrease compared to $9,064,000 recorded in 2004. Service charges on deposit accounts have decreased primarily as a result of the negative impact that higher short term interest rates have on the service charges that the Company earns from its commercial depositors - in the Company's commercial account service charge rate structure, commercial depositors are given "earnings credits" (negatively impacting service charges) on their average deposit balances that are tied to short term interest rates. Beginning in February 2006, the Company changed the index that the earnings "credit rate" is tied to. The new index is based on a money market rate that is currently lower than the previous rate and is less susceptible to volatile changes, while still being competitive in the marketplace. The Company expects the new index to result in an increase in income earned from service charges on deposit accounts in 2006 as compared to the service charge income that would have been received using the old index. The 2004 amount of $9,064,000 in service charges on deposit accounts was 14.2% higher than the 2003 amount of $7,938,000. This increase can be attributed to the following primary factors: 1) periodic rate increases, 2) service charges earned from internally generated deposit growth, and 3) service charges earned from acquired deposits. Deposit service charge rates are generally increased 2%-4% per year, while internal growth among deposit transaction accounts was 4%-5% in both 2004 and 2003. The deposits assumed in the acquisition of four RBC Centura branches on October 24, 2003 generated approximately $720,000 in service charges for the full year of 2004 compared to $125,000 realized during the partial period in 2003 subsequent to the acquisition. This incremental income of $595,000 accounted for approximately half of the 14.2% increase in service charges on deposit accounts. The Company's income from service charges on deposit accounts in the fourth quarter of 2004 was essentially flat when compared to the fourth quarter of 2003, which was a result of a higher customer deposit base, the positive effects of which were offset by the negative impact that higher short term interest rates in the second half of 2004 had on service charges from commercial depositors - see discussion above. Other service charges, commissions and fees amounted to $3,963,000 in 2005, a 17.9% increase from the $3,361,000 earned in 2004. The 2004 amount of $3,361,000 was 24.0% higher than the $2,710,000 recorded in 2003. This category of noninterest income includes items such as credit card interchange income related to merchants and customers, debit card interchange income, ATM charges, safety deposit box rentals, fees from sales of personalized checks, and check cashing fees. This category of income grew primarily because of increases in these activity-related fee services as a result of the increased acceptance and popularity of debit cards, special credit and debit card promotions that increased their use, and the overall growth in the Company's total customer base, including growth achieved from corporate acquisitions. Fees from presold mortgages amounted to $1,176,000 in 2005, a 21.4% increase from the 2004 amount of $969,000. The 2004 amount was a 58.4% decrease from the $2,327,000 recorded in 2003. Fees from presold mortgages peaked in 2003 as a result of a high level of mortgage loan refinancings brought on by low mortgage interest rates. Since that time, the absence of the initial wave of refinancing activity and higher adjustable rate mortgage rates have resulted in the Company's fees from presold mortgages decreasing from the 2003 level and averaging approximately $200,000-$300,000 per quarter. Commissions from sales of insurance and financial products amounted to $1,307,000 in 2005, $1,406,000 in 2004, and $1,304,000 in 2003. This line item includes commissions the Company receives from three sources - 1) sales of credit insurance associated with new loans, 2) commissions from the sales of investment, annuity, and long-term care insurance products, and 3) commissions from the sale of property and casualty insurance. The following table presents the contribution of each of the three sources to the total amount recognized in this line item: 25
($ in thousands) 2005 2004 2003 ------ ------ ------ Commissions earned from: ------------------------ Sales of credit insurance $ 308 291 300 Sales of investments, annuities, and long term care insurance 193 291 299 Sales of property and casualty insurance 806 824 705 ------ ------ ------ Total $1,307 1,406 1,304 ====== ====== ====== As shown in the table above, lower "sales of investments, annuities, and long-term care insurance" is the primary cause for the decrease in recorded insurance and financial product commissions from 2004 to 2005. The decrease in this component is primarily due to two employees in this area being transferred to another division of the Company and not yet being replaced. Data processing fees amounted to $279,000 in 2005, $416,000 in 2004, and $333,000 in 2003. As noted earlier, Montgomery Data makes its excess data processing capabilities available to area financial institutions for a fee. The decrease in data processing fees in 2005 is a result of three of the five customers of Montgomery Data terminating their service and switching to another provider. Montgomery Data intends to continue to market this service to area banks, but does not currently have any near-term prospects for additional business. Noninterest income not considered to be "core" amounted to a net loss of $258,000 in 2005, a net gain of $648,000 in 2004, and a net gain of $306,000 in 2003. The 2005 net loss of $258,000 included $189,000 in losses due to normal write-downs of tax credit investments, and $83,000 in losses related to a change in the Company's methodology for reserving for overdrafts and overdraft loans. The 2004 net gain of $648,000 included securities gains of $299,000, which were effected primarily in order to realize current income. Also in 2004, the Company sold a former bank branch building that resulted in a gain of approximately $350,000. The 2003 net gain of $306,000 primarily related to securities gains of $218,000 effected primarily to realize current income and an $82,000 gain from a sale of vacant land located beside one of the Company's existing branches. The Company projects $196,000 of tax credit investment write-downs in 2006. Tax credit write-downs experienced in 2005 and projected for 2006 have increased from the $70,000 amounts recorded in 2004 and 2003 as a result of additional investments made in tax credit partnerships during 2005. To date, all tax credit write-downs have been exceeded, and are projected to continue to be exceeded, by the amount of tax credits realized and recorded as a reduction of income tax expense. 26
Noninterest Expenses Noninterest expenses for 2005 were $47,636,000, compared to $43,717,000 in 2004 and $37,964,000 in 2003. Table 5 presents the components of the Company's noninterest expense during the past three years. Based on the recorded amounts noted above, noninterest expenses increased 9.0% in 2005 and 15.2% in 2004. The increases in noninterest expenses over the past three years have occurred in nearly every line item of expense and have been primarily as a result of the significant growth experienced by the Company, both internally and by acquisition. Over the past three years, the number of the Company's branches has increased from 48 to 61, and the number of full time equivalent employees has increased from 447 at December 31, 2002 to 578 at December 31, 2005. Additionally, from December 31, 2002 to December 31, 2005, the amount of loans outstanding increased 48.5% and deposits increased 41.5%. The incremental expense associated with the acquisition of the four RBC Centura branches in October 2003 was approximately $380,000 in 2003 and $1,900,000 on an annual basis thereafter. The Company's noninterest expenses were also impacted by external costs associated with complying Section 404 of the Sarbanes-Oxley Act. These expenses amounted to approximately $193,000 in 2004 and increased to $832,000 in 2005. These amounts do not include the value of the significant internal resources devoted to compliance. The Company expects its Sarbanes-Oxley compliance costs to decline modestly in 2006 from the expense recorded in 2005. Income Taxes The provision for income taxes was $16,829,000 in 2005, $10,418,000 in 2004, and $10,617,000 in 2003. The Company's income tax expense for 2005 of $16.8 million includes a contingency accrual of $4.3 million. In 1999, in consultation with the Company's tax advisors, the Company established an operating structure involving a real estate investment trust ("REIT") that resulted in a reduction in the Company's state tax liability to the state of North Carolina. In late 2004, the North Carolina Department of Revenue indicated that it would challenge taxpayers engaged in activities deemed to be "income-shifting," and they indicated that they believed certain REIT operating structures were a type of "income-shifting." During 2005, the North Carolina Department of Revenue began an audit of the Company's tax returns for 2001-2004, which represented all years eligible for audit. In the third quarter of 2005, based on consultations with the Company's external auditor and legal counsel, the Company determined that it should record a $6.3 million loss accrual to reserve for this issue. In February 2006, the North Carolina Department of Revenue announced a "Settlement Initiative" that offered companies with certain transactions, including those with a REIT operating structure, the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative by June 15, 2006. Although the Company continues to believe that its tax returns complied with the relevant statutes, the board of directors of the Company has tentatively decided that it is in the best interests of the Company to settle this matter by participating in the initiative. Based on the terms of the initiative, the Company estimates that its total liability to settle the matter will be approximately $4.3 million, net of the federal tax benefit, or $2.0 million less than the amount that was originally accrued. Accordingly, in March 2006, prior to the filing of its financial statements, the Company retroactively recorded an adjustment to its fourth quarter of 2005 earnings to reverse $2.0 million of tax expense, as required by relevant accounting standards. The aspects of the REIT structure that gave rise to this issue were discontinued effective January 1, 2005, and thus the Company does not believe it has any additional exposure related to this item beyond the amount of the accrual other than ongoing interest on the unpaid taxes amounting to $65,000 per quarter (after-tax). Table 6 presents the components of tax expense and the related effective tax rates. The high effective tax rate of 55.1% in 2005 is primarily a result of the contingency loss accrual discussed above. During periods in 2005 that did not include contingency loss accrual matters, the Company's effective tax rate was approximately 38%-39% compared to approximately 34%-35% in 2004 and 2003. The higher effective tax rate in 2005 compared to 2004 is the result of the Company discontinuing, effective January 1, 2005, the operating structure involving a real estate investment trust (REIT) that gave rise to the contingency tax accrual. The Company 27
expects its effective tax rate to continue to be in the 38%-39% range for the foreseeable future. In 2004, the Company's effective tax rate of 34.1% was slightly lower than the 2003 effective tax rate of 35.3%. The lower effective tax rate in 2004 was caused by several factors including higher amounts of state tax exempt income, higher amounts of low income housing investment tax credits, and the reversal of an $89,000 tax liability that was recorded in connection with a previous corporate acquisition. Stock-Based Compensation For the three years ended December 31, 2005, the Company was not required to record any expense for the value of stock options granted to employees. As discussed in more detail below in the next to last paragraph of the section entitled "Current Accounting and Regulatory Matters," a new accounting standard ("Statement 123(R)", as defined below) will require the Company to record the value of stock options as an expense in the income statement beginning January 1, 2006. Note 1(k) to the consolidated financial statements contains pro forma net income and earnings per share information as if the Company applied the fair value recognition provisions required by the new standard. Note 1(k) indicates that the Company's stock-based employee compensation expense would have been $335,000, $1,291,000 and $319,000, for the three years ended December 31, 2005, 2004, and 2003, respectively. The significant increase in expense in 2004 compared to 2003 and 2005 is primarily due to the Company granting 128,000 employee options in April 2004 with immediate vesting (under the new standard, expense related to the fair market value of options is recognized when the options vest). Prior to that grant, all previous employee option grants had five year vesting periods (20% vesting each year), and thus the amount of expense related to options was generally spread over the five year vesting period. The Compensation Committee of the Board of Directors of the Company granted the April 2004 options without any vesting requirements for two reasons - 1) the options were granted primarily as a reward for past performance and therefore had already been "earned" in the view of the Committee, and 2) to potentially minimize the impact that any change in accounting standards for stock options could have on future years' reported net income. Employee stock option grants since the April 2004 grant have reverted to having five year vesting periods. As noted above, beginning on January 1, 2006, the Company will be required to expense, within its income statement, the value of stock option grants that vest from that date forward. In 2006, 2007, and 2008 the Company's stock-based compensation expense related to options currently outstanding will be approximately $126,000, $47,000, and $3,000 respectively. New stock option grants that are granted and vest after January 1, 2006 will increase the amount of stock-based compensation expense recorded by the Company. Except for grants to directors (see below), the Company cannot estimate the amount of future stock option grants at this time. In the past, stock option grants to employees have been irregular, generally falling into three categories - 1) to attract and retain new employees, 2) to recognize changes in responsibilities of existing employees, and 3) to periodically reward exemplary performance. The Company expects to continue to grant 2,250 stock options to each of the Company's non-employee directors in June of each year until the 2014 expiration of the current stock option plan. In 2005, the amount of pro forma expense associated with the June director grants was $127,000. 28
ANALYSIS OF FINANCIAL CONDITION AND CHANGES IN FINANCIAL CONDITION Overview Over the past two years, the Company has achieved steady increases in its levels of loans and deposits. All of this growth has been internally generated, as the Company did not complete any acquisitions in 2004 or 2005. The following table presents detailed information regarding the nature of the Company's growth in 2004 and 2005: <TABLE> <CAPTION> Internal growth, Balance at Change in Balance at Total excluding changes (in thousands) beginning Internal brokered end of percentage in brokered of period growth deposits period growth deposits ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> 2005 - ----------------------------- Loans $1,367,053 115,558 -- 1,482,611 8.5% 8.5% ========== ========== ========== ========== ========== ========== Deposits - Noninterest bearing 165,778 28,273 -- 194,051 17.1% 17.1% Deposits - Savings, NOW, and Money Market 472,811 (14,590) -- 458,221 (3.1%) (3.1%) Deposits - Time>$100,000 334,756 71,398 (49,873) 356,281 6.4% 21.3% Deposits - Time<$100,000 415,423 70,601 -- 486,024 17.0% 17.0% ---------- ---------- ---------- ---------- ---------- ---------- Total deposits $1,388,768 155,682 (49,873) 1,494,577 7.6% 11.2% ========== ========== ========== ========== ========== ========== 2004 - ----------------------------- Loans $1,218,895 148,158 -- 1,367,053 12.2% 12.2% ========== ========== ========== ========== ========== ========== Deposits - Noninterest bearing 146,499 19,279 -- 165,778 13.2% 13.2% Deposits - Savings, NOW, and Money Market 462,876 9,935 -- 472,811 2.1% 2.1% Deposits - Time>$100,000 238,535 46,348 49,873 334,756 40.3% 19.4% Deposits - Time<$100,000 401,454 13,969 -- 415,423 3.5% 3.5% ---------- ---------- ---------- ---------- ---------- ---------- Total deposits $1,249,364 89,531 49,873 1,388,768 11.2% 7.2% ========== ========== ========== ========== ========== ========== </TABLE> As shown in the table above, the Company experienced high internal growth in loans in 2004 and 2005 with internal growth of 12.2% and 8.5%, respectively. Deposits increased 11.2% in 2004 and 7.6% in 2005. In 2004, of the $96 million in growth in the category "Deposits - Time>$100,000," $50 million related to brokered deposits that the Company attracted in order to fund the strong loan growth experienced. Excluding the brokered deposits, the Company's deposit growth in 2004 was 7.2%. In 2005, the $50 million in brokered deposits gathered in 2004 matured and were paid off, without renewing. The Company's deposit growth rate in 2005, excluding the reduction in brokered deposits, was 11.2%. The Company had no brokered deposits outstanding at December 31, 2005. In both 2004 and 2005, the Company achieved its highest growth in time deposits, particularly time deposits in denominations greater than $100,000. Time deposits, especially time deposits greater than $100,000, are generally the easiest type of deposit to achieve growth in through the use of promotional interest rates. The Company offered promotional interest rates in 2004 and 2005 in order to help fund the strong loan growth experienced both years. Over the past few years, including 2004 and 2005, the Company's loan growth has exceeded its deposit growth and to a greater extent exceeded its retail deposit growth (excludes time deposits greater than $100,000). The Company believes the higher internal growth rates for loans compared to retail deposits over the past two years is largely attributable to the type of customers the Company has been able to attract. Most of the Company's loan growth has come from small-business customers that need loans in order to expand their business, and have few deposits. Additionally, the Company has found it difficult to compete for retail deposits in recent years. The Company frequently competes against banks in the marketplace that either 1) are so large 29
that they enjoy better economies of scale over the Company and can thus offer higher rates, or 2) are recently started banks that are focused on building market share, and not necessarily on positive earnings, by offering high deposit rates. The Company enjoys advantages in the loan marketplace by having seasoned lenders in place that have the experience necessary to oversee the completion of a loan and the autonomy to be able to make timely decisions. The Company's liquidity did not change significantly during 2004 or 2005. The Company's loan to deposit ratio increased has ranged from 97.6% to 99.2% at each of the past three year ends. The level of the Company's liquid assets (consisting of cash, due from banks, federal funds sold, presold mortgages in process of settlement and securities) as a percentage of deposits and borrowings has also remained consistent, ranging from 13.1% to 14.4% at each of the past three year ends. As discussed above, over the past two years, the Company has had to rely more on time deposits in order to maintain targeted liquidity levels. In 2004 and 2005, regulatory capital ratios declined as asset growth exceeded capital growth. Additionally, the $4.3 million contingency tax loss accrual negatively impacted the Company's capital ratios in 2005. However, all of the Company's capital ratios have significantly exceeded the minimum regulatory thresholds for all periods covered by this report. Although the Company's primary market area, the central Piedmont region of North Carolina, has experienced recessionary times in the past few years as a result of manufacturing job losses, the Company's asset quality ratios have remained fairly stable over the past three years with net charge-offs to average loans ranging from 10 basis points to 14 basis points and nonperforming assets to total assets ranging from 17 basis points to 39 basis points. Distribution of Assets and Liabilities Table 7 sets forth the percentage relationships of significant components of the Company's balance sheets at December 31, 2005, 2004, and 2003. The relative size of the components of the balance sheet has not varied significantly over the past two years with loans comprising 81%-82% of total assets and deposits comprising 83%-85%. The most significant variance in Table 7 is the 2004 increase in the percentage of time deposits of $100,000 or more, which increased from 16% at December 31, 2003 to 21% at December 31, 2004. The Company aggressively attracted large time deposits in 2004, including gathering the $50 million in brokered deposits, in order to help fund the strong loan growth experienced that was not able to be fully funded with core retail deposits. In 2005, these brokered deposits were paid off and were not renewed. Also shown in Table 7 is a decrease in the relative percentage of the Company's balance sheet comprised of Savings, NOW and Money Market accounts. The decrease in the percentage from 29% to 25% during 2005 is due partially to the high growth experienced in the other categories of deposits, and was also impacted by the introduction of a new product - Securities Sold Under Agreements to Repurchase ("repurchase agreements") - that resulted in a shift of customers' money from savings and money market accounts to repurchase agreements. Repurchase agreements are similar to interest-bearing deposits and allow the Company to pay interest to business customers without statutory limitations on the number of withdraws that these customers can make. Upon the introduction of this product in the second half of 2005, the growth in repurchase agreements to the year end balance of $33.5 million was comprised almost entirely of customer funds that had previously been held by the Company as savings or money market deposits. 30
Securities Information regarding the Company's securities portfolio as of December 31, 2005, 2004, and 2003 is presented in Tables 8 and 9. The composition of the investment securities portfolio reflects the Company's investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits. Total securities available for sale and held to maturity amounted to $127.8 million, $102.6 million, and $117.7 million at December 31, 2005, 2004, and 2003, respectively. The increase in securities from December 31, 2004 to December 31, 2005 was primarily due to security purchases, a decrease in the amount of called bonds and lower levels of principal repayments on mortgage-backed securities. The decrease in securities from December 31, 2003 to December 31, 2004 was primarily attributable to called and maturing bonds, as well as a high level of principal repayments on mortgage-backed securities due to the low interest rate environment. Instead of reinvesting the maturities/paydowns back into securities, the proceeds were used to fund loan growth. The security mix within the available for sale classification and the held to maturity classification remained relatively unchanged over the past three years. The majority of the Company's U.S. Government agency debt securities are issued by the Federal Home Loan Bank and carry one maturity date, often with an issuer call feature, while the mortgage-backed securities have been primarily issued by Freddie Mac and Fannie Mae and vary in their repayment in correlation with the underlying pools of home mortgage loans. The Company's investment in corporate bonds is primarily comprised of trust preferred securities issued by other North Carolina bank holding companies. Included in mortgage-backed securities at December 31, 2005 were collateralized mortgage obligations ("CMOs") with an amortized cost of $15,810,000 and a fair value of $15,399,000. Included in mortgage-backed securities at December 31, 2004 were CMOs with an amortized cost of $15,928,000 and a fair value of $15,831,000. Included in mortgage-backed securities at December 31, 2003 were CMOs with an amortized cost of $21,649,000 and a fair value of $21,458,000. The CMOs that the Company has invested in are substantially all "early tranche" portions of the CMOs, which minimizes long-term interest rate risk to the Company. At December 31, 2005, a net unrealized loss of $1,049,000 was included in the carrying value of securities classified as available for sale, compared to a net unrealized gain of $1,186,000 at December 31, 2004 and a net unrealized gain of $1,868,000 at December 31, 2003. The declining fair market value of securities available over the past two years was caused by a steadily rising interest rate environment. Higher interest rates negatively impact the value of fixed income securities. Another factor was the Company's 2004 sale of a portion of its bond portfolio that had unrealized gains at December 31, 2003. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates, not by concerns about the ability of the issuers to meet their obligations. Net unrealized gains (losses), net of applicable deferred income taxes, of ($639,000), $723,000, and $1,140,000 have been reported as part of a separate component of shareholders' equity (accumulated other comprehensive income) as of December 31, 2005, 2004, and 2003, respectively. The fair value of securities held to maturity, which the Company carries at amortized cost, was more than the carrying value at December 31, 2005 and 2004 by $149,000 and $426,000, respectively. Management evaluated any unrealized losses on individual securities at each year end and determined them to be of a temporary nature and caused by fluctuations in market interest rates, not by concerns about the ability of the issuers to meet their obligations. 31
Table 9 provides detail as to scheduled contractual maturities and book yields on securities available for sale and securities held to maturity at December 31, 2005. Mortgage-backed and other amortizing securities are shown maturing in the time periods consistent with their estimated lives based on expected prepayment speeds. The weighted average taxable-equivalent yield for the securities available for sale portfolio was 4.64% at December 31, 2005. The expected weighted average life of the available for sale portfolio using the call date for above-market callable bonds, the maturity date for all other non-mortgage-backed securities, and the expected life for mortgage-backed securities, was 4.0 years. The weighted average taxable-equivalent yield for the securities held to maturity portfolio was 5.76% at December 31, 2005. The expected weighted average life of the held to maturity portfolio using the call date for above-market callable bonds and the maturity date for all other securities, was 1.9 years. As of December 31, 2005 and 2004, the Company held no investment securities of any one issuer, other than U.S. Government agencies or corporations, in which aggregate book values and market values exceeded 10% of shareholders' equity. Loans Table 10 provides a summary of the loan portfolio composition at each of the past five year ends. The loan portfolio is the largest category of the Company's earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans, and consumer loans. The Company restricts virtually all of its lending to its 24 county market area, which is located in the central Piedmont region of North Carolina, three counties in Virginia and one county in South Carolina. The diversity of the region's economic base has historically provided a stable lending environment. In 2005, loans outstanding increased $115.6 million, or 8.5%, to $1.48 billion. In 2004, loans outstanding increased $148.2 million, or 12.2%, to $1.37 billion. All of the loan growth in 2005 and 2004 was internally generated, as the Company did not complete any acquisitions during those years. In 2003, loans outstanding increased $220.3 million, or 22.1%, to $1.22 billion. Approximately $148 million of the 2003 growth was from net internal loan growth, while $73 million was assumed in acquisitions. The majority of the 2005 and 2004 loan growth occurred in loans secured by real estate, with approximately $94.4 million, or 81.7%, in 2005, and $143.1 million, or 96.6%, in 2004 of the net loan growth occurring in real estate mortgage or real estate construction loans. Over the years, the Company's loan mix has remained fairly consistent, with real estate loans (mortgage and construction) comprising approximately 86% of the loan portfolio, commercial, financial, and agricultural loans not secured by real estate comprising 9%, and consumer installment loans comprising approximately 5% of the portfolio. The majority of the Company's "real estate" loans are primarily various personal and commercial loans where real estate provides additional security for the loan. At December 31, 2005, $1.275 billion, or 86.0%, of the Company's loan portfolio was secured by liens on real property. Included in this total are $707.9 million, or 47.7% of total loans, in loans secured by liens on 1-4 family residential properties and $567.1 million, or 38.3% of total loans, in loans secured by liens on other types of real estate. At December 31, 2004, $1.181 billion, or 86.4%, of the Company's loan portfolio was secured by liens on real property. Included in this total are $630.5 million, or 46.1% of total loans, in loans secured by liens on 1-4 family residential properties and $550.4 million, or 40.3% of total loans, in loans secured by liens on other types of real estate. The Company's $1.275 billion in real estate mortgage loans at December 31, 2005 can be further classified as follows - for comparison purposes, the classification of the Company's $1.181 billion real estate loan portfolio at December 31, 2004 is shown in parenthesis: 32
o $443.4 million, or 29.9% of total loans (vs. $411.7 million, or 30.1% of total loans), are traditional residential mortgage loans in which the borrower's personal income is the primary repayment source. o $410.1 million, or 27.7% of total loans (vs. $389.0 million, or 28.5% of total loans), are primarily dependent on cash flow from a commercial business for repayment. o $146.1 million, or 9.9% of total loans (vs. $120.6 million, or 8.8% of total loans), are home equity loans. o $125.2 million, or 8.4% of total loans (vs. $117.2 million, or 8.6% of total loans), are real estate construction loans. o $118.4 million, or 8.0% of total loans (vs. $110.6 million, or 8.1% of total loans), are personal consumer installment loans in which the borrower has provided residential real estate as collateral. o $31.9 million, or 2.2% of total loans (vs. $31.8 million, or 2.3% of total loans), are primarily dependent on cash flow from agricultural crop sales. Table 11 provides a summary of scheduled loan maturities over certain time periods, with fixed rate loans and adjustable rate loans shown separately. Approximately 23% of the Company's loans outstanding at December 31, 2005 mature within one year and 75% of total loans mature within five years. The percentages of variable rate loans and fixed rate loans as compared to total performing loans were 57.5% and 42.5%, respectively, as of December 31, 2005. The Company intentionally makes a blend of fixed and variable rate loans so as to reduce interest rate risk. See discussion regarding fluctuations in the Company's ratio of fixed rate loans to variable rate loans in the section above entitled "Net Interest Income." Nonperforming Assets Nonperforming assets include nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. As a matter of policy the Company places all loans that are past due 90 or more days on nonaccrual basis, and thus there were no loans at any of the past five year ends that were 90 days past due and still accruing interest. Table 12 summarizes the Company's nonperforming assets at the dates indicated. Nonaccrual loans are loans on which interest income is no longer being recognized or accrued because management has determined that the collection of interest is doubtful. Placing loans on nonaccrual status negatively impacts earnings because (i) interest accrued but unpaid as of the date a loan is placed on nonaccrual status is either deducted from interest income or is charged-off, (ii) future accruals of interest income are not recognized until it becomes probable that both principal and interest will be paid and (iii) principal charged-off, if appropriate, may necessitate additional provisions for loan losses that are charged against earnings. In some cases, where borrowers are experiencing financial difficulties, loans may be restructured to provide terms significantly different from the originally contracted terms. Nonperforming loans (which includes nonaccrual loans and restructured loans) as of December 31, 2005, 2004, and 2003 totaled $1,653,000, $3,724,000, and $4,295,000, respectively. Nonperforming loans as a percentage of total loans amounted to 0.11%, 0.27%, and 0.35%, at December 31, 2005, 2004, and 2003, respectively. The variances in nonperforming loans over the past two years have been primarily due to changes in nonaccrual loans, as restructured loans have not changed significantly. Nonaccrual loans have declined at each of the past two year ends. The decrease in nonaccrual loans from 2003 to 2004 was impacted by the resolution of the Company's largest nonaccrual loan relationship during 2004. This nonaccrual relationship amounted to $663,000 at December 31, 2003. In 2004, the loan was reduced to zero through a combination of payments received, property foreclosures, and charge-offs. In total, the Company received payments of $65,000, foreclosed on property with a value of $100,000, and charged-off the remaining balance of $498,000. The decrease in nonaccrual loans from 2004 to 2005 was primarily because during the fourth quarter of 2005, the collection process for several of the Company's large nonperforming loan relationships reached a conclusion. As a result, the Company's net charge-offs for the fourth quarter of 2005 were $1.1 million, or 0.29% of average loans (annualized), which is a higher ratio than the Company has historically experienced. The Company's largest 33
nonaccrual relationships at December 31, 2005 and 2004 amounted to $337,000 and $404,000, respectively. If the nonaccrual loans and restructured loans as of December 31, 2005, 2004 and 2003 had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period), gross interest income in the amounts of approximately $123,000, $247,000 and $319,000 for nonaccrual loans and $2,000, $2,000 and $2,000 for restructured loans would have been recorded for 2005, 2004 and 2003, respectively. Interest income on such loans that was actually collected and included in net income in 2005, 2004 and 2003 amounted to approximately $67,000, $120,000 and $102,000 for nonaccrual loans (prior to their being placed on nonaccrual status) and $2,000, $2,000 and $2,000 for restructured loans, respectively. At December 31, 2005 and 2004, the Company had no commitments to lend additional funds to debtors whose loans were nonperforming. Management routinely monitors the status of certain large loans that, in management's opinion, have credit weaknesses that could cause them to become nonperforming loans. In addition to the nonperforming loan amounts discussed above, management believes that an estimated $5.5-$6.0 million of loans that were performing in accordance with their contractual terms at December 31, 2005 have the potential to develop problems depending upon the particular financial situations of the borrowers and economic conditions in general. Management has taken these potential problem loans into consideration when evaluating the adequacy of the allowance for loan losses at December 31, 2005 (see discussion below). Loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed in the problem loan amounts and the potential problem loan amounts discussed above do not represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information that causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms. Other real estate includes foreclosed, repossessed, and idled properties. Other real estate has not varied materially at any of the past three year ends, amounting to $1,421,000 at December 31, 2005, $1,470,000 at December 31, 2004, and $1,398,000 at December 31, 2003. Other real estate represented approximately 0.10% of total assets at the end of 2005, 2004, and 2003. The Company's management believes that the fair values of the items of other real estate, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented. Allowance for Loan Losses and Loan Loss Experience The allowance for loan losses is created by direct charges to operations (known as a "provision for loan losses" for the period in which the charge is taken). Losses on loans are charged against the allowance in the period in which such loans, in management's opinion, become uncollectible. The recoveries realized during the period are credited to this allowance. The Company considers its procedures for recording the amount of the allowance for loan losses and the related provision for loan losses to be a critical accounting policy. See the heading "Critical Accounting Policies" above for further discussion. The factors that influence management's judgment in determining the amount charged to operating expense include past loan loss experience, composition of the loan portfolio, evaluation of probable inherent losses and current economic conditions. The Company uses a loan analysis and grading program to facilitate its evaluation of probable inherent loan losses and the adequacy of its allowance for loan losses. In this program, risk grades are assigned by management and tested by an independent third party consulting firm. The testing program includes an evaluation of a sample of new loans, loans that management identifies as having potential credit weaknesses, loans past due 90 days or more, loans originated by new loan officers, nonaccrual loans and any other loans 34
identified during previous regulatory and other examinations. The Company strives to maintain its loan portfolio in accordance with what management believes are conservative loan underwriting policies that result in loans specifically tailored to the needs of the Company's market areas. Every effort is made to identify and minimize the credit risks associated with such lending strategies. The Company has no foreign loans, few agricultural loans and does not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of loans captioned in the tables discussed below as "real estate" loans are primarily various personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within the Company's principal market area. The allowance for loan losses amounted to $15,716,000 at December 31, 2005 compared to $14,717,000 at December 31, 2004 and $13,569,000 at December 31, 2003. This represented 1.06%, 1.08%, and 1.11%, of loans outstanding as of December 31, 2005, 2004, and 2003, respectively. As noted in Table 12, the Company's allowance for loan losses as a percentage of nonperforming loans ("coverage ratio") amounted to 951% at December 31, 2005 compared to 395% at December 31, 2004 and 316% at December 31, 2003. Due to the secured nature of virtually all of the Company's loans that are on nonaccrual status, the variance in the coverage ratio is not necessarily indicative of the relative adequacy of the allowance for loan losses. Table 13 sets forth the allocation of the allowance for loan losses at the dates indicated. The portion of these reserves that was allocated to specific loan types in the loan portfolio increased to $15,692,000 at December 31, 2005 from $14,643,000 at December 31, 2004 and $13,416,000 at December 31, 2003. The 7.2% increase in the amount of the allocated allowance during 2005 is consistent with the 8.5% increase in total loans outstanding during the year. Similarly, the 9.1% increase in the amount of the allocated allowance during 2004 is consistent with the 12.2% increase in total loans outstanding during the year. In addition to the allocated portion of the allowance for loan losses, the Company maintains an unallocated portion that is not assigned to any specific category of loans, but rather is intended to reserve for the inherent risk in the overall portfolio and the intrinsic inaccuracies associated with the estimation of the allowance for loan losses and its allocation to specific loan categories. The amount of the unallocated portion of the allowance for loan losses did not vary materially at any of the past three year ends. Management considers the allowance for loan losses adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the allowance using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amount reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowances for loan losses and losses on foreclosed real estate. Such agencies may require the Company to recognize additions to the allowances based on the examiners' judgments about information available to them at the time of their examinations. For the years indicated, Table 14 summarizes the Company's balances of loans outstanding, average loans outstanding, and a detailed rollforward of the allowance for loan losses. In addition to the increases to the allowance for loan losses related to normal provisions, the increases in the dollar amounts of the allowance for loan losses in 2003 was also affected by amounts recorded to provide for loans assumed in corporate acquisitions. In 2003, the Company added $1,083,000 to the allowance for loan losses related to loans assumed in two corporate acquisitions. Approximately $333,000 of the $1,083,000 related to $24.8 million in loans assumed in the October 2003 RBC Centura branch acquisition, while $750,000 related to the CCB acquisition. The $750,000 addition related to CCB represented the book value of CCB's allowance for loan losses on the date of 35
the acquisition. The Company's net loan charge offs amounted to $2,041,000 in 2005, $1,757,000 in 2004, and $1,101,000 in 2003. This represents 0.14%, 0.14%, and 0.10% of average loans during 2005, 2004, and 2003 respectively. The increase in charge offs from 2003 to 2004 is largely attributable to the $498,000 charge off recorded in 2004 related to the disposition of a large nonaccrual relationship that is discussed above in the section entitled "Nonperforming Assets." As discussed in that same section, during the fourth quarter of 2005, the collection process for several of the Company's large nonperforming loan relationships reached a conclusion, which impacted the net charge off percentage in 2005. Deposits and Securities Sold Under Agreements to Repurchase At December 31, 2005, deposits outstanding amounted to $1.495 billion, an increase of $106 million, or 7.6%, from December 31, 2004. In 2004, deposits grew from $1.249 billion to $1.389 billion, an increase of $139 million, or 11.2% from December 31, 2003. All deposit growth in 2004 and 2005 was internally generated (the Company did not complete any acquisitions during those years). Approximately $50 million of the increase in 2004 related to wholesale brokered deposits that the Company gathered in order to help fund the high loan growth experienced during 2004, while the Company's deposit growth in 2005 was negatively impacted by paying back the $50 million in brokered deposits upon their maturity in 2005. Prior to 2004, the Company had never utilized brokered deposits. In 2003, $161 million of the $193 million increase in deposits was related to acquisitions - the Company's January 2003 acquisition of CCB with $59 million in deposits and the October 2003 acquisition of four RBC Centura branches with $102 million in deposits. The nature of the Company's deposit growth is illustrated in the table on page 29. The following table reflects the mix of the Company's deposits at each of the past three year ends: 2005 2004 2003 ------ ------ ------ Noninterest-bearing deposits 13% 12% 12% Savings, NOW and Money Market deposits 31% 34% 37% Time deposits > $100,000 24% 24% 19% Time deposits < $100,000 32% 30% 32% ------ ------ ------ Total deposits 100% 100% 100% ====== ====== ====== Securities sold under agreements to repurchase as a percent of total deposits 2% -- -- ====== ====== ====== In 2004, there was a significant increase in the percentage of time deposits greater than $100,000, which was largely a result of the Company offering competitive interest rates on this product and the $50 million in wholesale brokered deposits gathered by the Company. Both of the factors driving the increase in time deposits greater than $100,000 were necessitated by the combination of strong loan growth and modest core retail deposit growth experienced by the Company in 2004. As noted earlier, competition for deposits in the Company's market area is strong. The deposit mix remained relatively consistent from 2004 to 2005, despite the $50 million decrease in brokered deposits that were repaid in 2005, which impacted the time deposits greater than $100,000 category. In 2005, the $50 million repayment of brokered deposits was offset by growth in this category resulting from the Company competitively pricing this product in order to generate funds with which to repay the brokered deposit maturities, as well as to help fund loan growth. The percentage of savings, NOW and money market accounts to total deposits at December 31, 2005 was impacted by the introduction of a new product - securities sold under agreements to repurchase ("repurchase agreements") - that resulted in a shift of customer's money from savings and money market accounts to repurchase agreements. Repurchase agreements are similar to interest-bearing deposits and allow the Company to pay interest to business customers without statutory limitations on the number of withdraws that these customers can make. Upon the introduction of this product in the second half of 2005, the growth in repurchase agreements, which amounted to $33.5 million at year end, was comprised almost entirely of customer funds that 36
had previously been held by the Company as savings or money market deposits. Table 15 presents the average amounts of deposits of the Company and the average yield paid for those deposits for the years ended December 31, 2005, 2004, and 2003. As of December 31, 2005, the Company held approximately $356.3 million in time deposits of $100,000 or more. Table 16 is a maturity schedule of time deposits of $100,000 or more as of December 31, 2005. This table shows that 82.0% of the Company's time deposits greater than $100,000 mature within one year. At each of the past three year ends, the Company had no deposits issued through foreign offices, nor did the Company believe that it held any deposits by foreign depositors. Borrowings The Company had borrowings outstanding of $100.2 million at December 31, 2005 compared to $92.2 million at December 31, 2004. The slight increase in borrowings was due to normal fluctuations in cash needs and not to an overall increased dependence on borrowings. As shown in Table 2, average borrowings has fluctuated over the past two years, amounting to $42.1 million in 2003, rising to $84.9 million in 2004, and then declining slightly in 2005 to $77.1 million. The increase in average borrowing from 2003 to 2004 was necessary in order to fund loan growth that exceeded deposit growth. In 2005, growth in average deposits exceeded growth in average loans, which reduced the Company's dependency on borrowings. At December 31, 2005, the Company had three sources of readily available borrowing capacity - 1) an approximately $360 million line of credit with the Federal Home Loan Bank of Atlanta ("FHLB"), of which $59 million was outstanding at December 31, 2005 and $51 million was outstanding at December 31, 2004, 2) a $50 million overnight federal funds line of credit with a correspondent bank, none of which was outstanding at December 31, 2005 or 2004, and 3) an approximately $62 million line of credit through the Federal Reserve Bank of Richmond's (FRB) discount window, none of which was outstanding at December 31, 2005 or 2004. The Company's line of credit with the FHLB can be structured as either short-term or long-term borrowings, depending on the particular funding or liquidity need, and is secured by the Company's FHLB stock and a blanket lien on most of its real estate loan portfolio. In addition to the outstanding borrowings from the FHLB that reduce the available borrowing capacity of the line of credit, the borrowing capacity was further reduced by $40 million at December 31, 2005 and 2004 as a result of the Company pledging letters of credit for public deposits at each of those dates. The Company's correspondent bank relationship allows the Company to purchase up to $50 million in federal funds on an overnight, unsecured basis (federal funds purchased). The Company had no borrowings outstanding under this line at December 31, 2005 or 2004. This line of credit was not drawn upon during any of the past three years. The Company also has a line of credit with the FRB discount window. This line is secured by a blanket lien on a portion of the Company's commercial and consumer loan portfolio (excluding real estate loans). Based on the collateral owned by the Company as of December 31, 2005, the available line of credit is approximately $62 million. This line of credit was established primarily in connection with the Company's Y2K liquidity contingency plan and has not been drawn on since inception. The FRB has indicated that it would not expect lines of credit that have been granted to financial institutions to be a primary borrowing source. The Company plans to maintain this line of credit, although it is not expected that it will be drawn upon except in unusual circumstances. In addition to the lines of credit described above, in which the Company had $59 million outstanding as of December 31, 2005, the Company also had a total of $41.2 million in trust preferred security debt outstanding at 37
December 31, 2005. The Company issued $20.6 million of this debt on October 29, 2002 and an additional $20.6 million on December 19, 2003. These borrowings each have 30 year final maturities and were structured as trust preferred capital securities that qualify as Tier I capital for regulatory capital adequacy requirements. These debt securities are callable by the Company at par on any quarterly interest payment date five years after their issue date. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 3.45% for the securities issued in 2002 and three-month LIBOR plus 2.70% for the securities issued in 2003. The Company incurred approximately $1,195,000 in debt issuance costs related to the issuances that were recorded as prepaid expenses and are included in the "Other Assets" line item of the consolidated balance sheet. During the first quarter of 2006, the Company plans to issue an additional $25 million in trust preferred securities in order to improve regulatory capital ratios. The terms will be substantially the same as previous issuances except that the interest rate is expected to be based on three-month LIBOR plus 1.39%, and no debt issuance costs are expected. Average short-term borrowings for each of the past five years were less than 30% of total shareholders' equity at all times during each period. Liquidity, Commitments, and Contingencies The Company's liquidity is determined by its ability to convert assets to cash or to acquire alternative sources of funds to meet the needs of its customers who are withdrawing or borrowing funds, and its ability to maintain required reserve levels, pay expenses and operate the Company on an ongoing basis. The Company's primary liquidity sources are net income from operations, cash and due from banks, federal funds sold and other short-term investments. The Company's securities portfolio is comprised almost entirely of readily marketable securities which could also be sold to provide cash. As noted above, in addition to internally generated liquidity sources, the Company has the ability to obtain borrowings from the following three sources - 1) an approximately $360 million line of credit with the FHLB, 2) a $50 million overnight federal funds line of credit with a correspondent bank, and 3) an approximately $62 million line of credit through the FRB's discount window. The Company's liquidity did not change significantly during 2004 or 2005. The Company's loan to deposit ratio has ranged from 97.6% to 99.2% at each of the past three year ends. The level of the Company's liquid assets (consisting of cash, due from banks, federal funds sold, presold mortgages in process of settlement and securities) as a percentage of deposits and borrowings has also remained consistent, ranging from 13.1% to 14.4% at each of the past three year ends. As discussed above, over the past two years, the Company has had to rely more on time deposits in order to maintain targeted liquidity levels. The Company's management believes its liquidity sources, including unused lines of credit, are at an acceptable level and remain adequate to meet its operating needs in the foreseeable future. The Company will continue to monitor its liquidity position carefully and will explore and implement strategies to increase liquidity if deemed appropriate In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows. Table 18 reflects the contractual obligations and other commercial commitments of the Company outstanding as of December 31, 2005. Any of the Company's $59 million in outstanding borrowings with the FHLB may be accelerated immediately by the FHLB in certain circumstances, including material adverse changes in the condition of the Company or if the Company's qualifying collateral is less than the amount required under the terms of the borrowing agreement. 38
In the normal course of business there are various outstanding commitments and contingent liabilities such as commitments to extend credit, which are not reflected in the financial statements. As of December 31, 2005, the Company had outstanding loan commitments of $277,044,000, of which $236,047,000 were at variable rates and $40,997,000 were at fixed rates. Included in outstanding loan commitments were unfunded commitments of $157,257,000 on revolving credit plans, of which $132,796,000 were at variable rates and $24,461,000 were at fixed rates. At December 31, 2005 and 2004, the Company had $4,283,000 and $3,762,000, respectively, in standby letters of credit outstanding. The Company had no carrying amount for these standby letters of credit at either of those dates. The nature of the standby letters of credit is a guarantee made on behalf of the Company's customers to suppliers of the customers to guarantee payments owed to the supplier by the customer. The standby letters of credit are generally for terms for one year, at which time they may be renewed for another year if both parties agree. The payment of the guarantees would generally be triggered by a continued nonpayment of an obligation owed by the customer to the supplier. The maximum potential amount of future payments (undiscounted) the Company could be required to make under the guarantees in the event of nonperformance by the parties to whom credit or financial guarantees have been extended is represented by the contractual amount of the financial instruments discussed above. In the event that the Company is required to honor a standby letter of credit, a note, already executed with the customer, is triggered which provides repayment terms and any collateral. Over the past ten years, the Company has had to honor one standby letter of credit, which was repaid by the borrower without any loss to the Company. Management expects any draws under existing commitments to be funded through normal operations. It has been the experience of the Company that deposit withdrawals are generally replaced with new deposits, thus not requiring any net cash outflow. Based on that assumption, management believes that it can meet its contractual cash obligations and existing commitments from normal operations. The Company is not involved in any legal proceedings that, in management's opinion, could have a material effect on the consolidated financial position of the Company; however, the following paragraph describes a probable exposure related to taxes. In 1999, in consultation with the Company's tax advisors, the Company established an operating structure involving a real estate investment trust ("REIT") that resulted in a reduction in the Company's state tax liability to the state of North Carolina. In late 2004, the North Carolina Department of Revenue indicated that it would challenge taxpayers engaged in activities deemed to be "income-shifting," and they indicated that they believed certain REIT operating structures were a type of "income-shifting." During 2005, the North Carolina Department of Revenue began an audit of the Company's tax returns for 2001-2004, which represented all years eligible for audit. In the third quarter of 2005, based on consultations with the Company's external auditor and legal counsel, the Company determined that it should record a $6.3 million loss accrual to reserve for this issue. In February 2006, the North Carolina Department of Revenue announced a "Settlement Initiative" that offered companies with certain transactions, including those with a REIT operating structure, the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative by June 15, 2006. Although the Company continues to believe that its tax returns complied with the relevant statutes, the board of directors of the Company has tentatively decided that it is in the best interests of the Company to settle this matter by participating in the initiative. Based on the terms of the initiative, the Company estimates that its total liability to settle the matter will be approximately $4.3 million, net of the federal tax benefit, or $2.0 million less than the amount that was originally accrued. Accordingly, in March 2006, prior to the issuance of its financial statements, the Company retroactively recorded an adjustment to its fourth quarter of 2005 earnings to reverse $2.0 million of tax expense, as required by relevant accounting standards. The aspects of the REIT structure that gave rise to this issue were discontinued effective January 1, 2005, and thus the Company does not believe it has any additional exposure related to this item beyond the amount of the accrual other than ongoing interest on the unpaid taxes amounting to $65,000 per quarter (after-tax). 39
Off-Balance Sheet Arrangements and Derivative Financial Instruments Off-balance sheet arrangements include transactions, agreements, or other contractual arrangements in which the Company has obligations or provides guarantees on behalf of an unconsolidated entity. The Company has no off-balance sheet arrangements of this kind other than repayment guarantees associated with its trust preferred securities. Derivative financial instruments include futures, forwards, interest rate swaps, options contracts, and other financial instruments with similar characteristics. The Company has not engaged in derivatives activities through December 31, 2005 and has no current plans to do so. Interest Rate Risk (Including Quantitative and Qualitative Disclosures About Market Risk - Item 7A.) Net interest income is the Company's most significant component of earnings. Notwithstanding changes in volumes of loans and deposits, the Company's level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to the various categories of earning assets and interest-bearing liabilities. It is the Company's policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations. The Company's exposure to interest rate risk is analyzed on a regular basis by management using standard GAP reports, maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of "shock" interest rates. Over the years, the Company has been able to maintain a fairly consistent yield on average earning assets (net interest margin). Over the past five calendar years, the Company's net interest margin has ranged from a low of 4.23% (realized in 2001) to a high of 4.58% (realized in 2002). During that five year period, the prime rate of interest has ranged from a low of 4.00% to a high of 9.00%. Table 17 sets forth the Company's interest rate sensitivity analysis as of December 31, 2005, using stated maturities for all instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call). As illustrated by this table, at December 31, 2005, the Company had $282.4 million more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets. This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment. However, this method of analyzing interest sensitivity only measures the magnitude of the timing differences and does not address earnings, market value, or management actions. Also, interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. In addition to the effects of "when" various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products. For example, included in interest-bearing liabilities subject to interest rate changes within one year at December 31, 2005 are deposits totaling $458 million comprised of NOW, savings, and certain types of money market deposits with interest rates set by management. These types of deposits historically have not repriced with or in the same proportion as general market indicators. Thus, the Company believes that in the near term (twelve months), net interest income will not likely experience significant downward pressure from rising interest rates. Similarly, management would not expect a significant increase in near term net interest income from falling interest rates. Conversely, it was the Company's experience that each interest rate cut that occurred in the 2001-2003 period of declining rates negatively impacted (at least temporarily) the Company's net interest margin and that interest rate increases occurring since July 1, 2004 have positively impacted (at least temporarily) the Company's net interest margin. Generally, when rates change, the Company's interest-sensitive assets that are subject to adjustment reprice immediately at the full amount of the change, while the Company's interest-sensitive liabilities that are subject to adjustment reprice at a 40
lag to the rate change and typically not to the full extent of the rate change. The net effect is that in the twelve month horizon, as rates change, the impact of having a higher level of interest-sensitive liabilities is substantially negated by the later and typically lower proportionate change these liabilities experience compared to interest sensitive assets. However, the rate cuts totaling 75 basis points that occurred in late 2002 and mid-2003 had a more pronounced and a longer lasting negative impact on the Company's net interest margin than previous rate cuts because of the inability of the Company to reset deposit rates by an amount (because of their already near-zero rates) that would offset the negative impact of the rate cut on the yields earned on the Company's interest earning assets. Also, as previously discussed, over the past few years, the Company has originated more adjustable rate loans than fixed rate loans. Adjustable rate loans generally carry lower initial interest rates than fixed rate loans. For these reasons, the second quarter of 2004 marked the fifth consecutive quarter of declining net interest margins. Since July 1, 2004, the Federal Reserve has increased interest rates thirteen times totaling 325 basis points, which was largely responsible for the Company's net interest margin reversing its downward trend beginning in the third quarter of 2004 and increasing slightly for five out of the six consecutive quarters ending December 31, 2005. The net interest margin of 4.37% in the fourth quarter of 2005 was the highest since the first quarter of 2004. The immediate positive impact of the rising interest rate environment on the Company's net interest margin has been largely offset by the mix of the Company's deposit growth being more concentrated in the categories of time deposits and time deposits greater than $100,000, the Company's highest cost categories of deposits. Assuming no changes in interest rates in 2006, the Company would expect, as discussed above in the section titled "Net Interest Income," its net interest margin to be negatively impacted as a result of time deposits maturing and repricing in 2006 that were originated in periods when rates were lower. However, interest rates were increased 25 basis points by the Federal Reserve in February 2006, and most economists believe that the Federal Reserve will raise rates by at least 25 more basis points before the end of 2006. In a scenario that reflects the 25 basis point increase that has already occurred in 2006 and one more rate increase occurring in the second quarter of 2006, along with expected balance sheet growth rates, the Company anticipates that its net interest margin for the 2006 will continue to be in the recently realized range of 4.30%-4.40%. However in determining this range, the Company had to make certain assumptions about its ability to manage changes in rates paid on deposits, which will depend largely on actions taken by the Company's competitors and could be significantly different from the assumptions made. The Company has no market risk sensitive instruments held for trading purposes, nor does it maintain any foreign currency positions. Table 19 presents the expected maturities of the Company's other than trading market risk sensitive financial instruments. Table 19 also presents the estimated fair values of market risk sensitive instruments as estimated in accordance with Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments." The Company's assets and liabilities each have estimated fair values that are slightly less than their carrying values because of the rising interest rate environment. See additional discussion regarding net interest income, as well as discussion of the changes in the annual net interest margin in the section entitled "Net Interest Income" above. Return on Assets and Equity Table 20 shows return on assets (net income divided by average total assets), return on equity (net income divided by average shareholders' equity), dividend payout ratio (dividends per share divided by net income per share) and shareholders' equity to assets ratio (average shareholders' equity divided by average total assets) for each of the years in the three-year period ended December 31, 2005. The significant decrease in return on assets and return on equity and the increase in the dividend payout ratio from 2004 to 2005 were caused primarily by the large contingency tax loss accrual that is discussed in the sections entitled "Income Taxes" and "Liquidity, Commitments, and Contingencies" above. 41
Capital Resources and Shareholders' Equity Shareholders' equity at December 31, 2005 amounted to $155.7 million compared to $148.5 million at December 31, 2004. The two basic components that typically have the largest impact on the Company's shareholders' equity are net income, which increases shareholders' equity, and dividends declared, which decreases shareholders' equity. In 2005, net income of $16,090,000 increased equity, while dividends declared of $9,930,000 reduced equity. The Company made no stock repurchases during 2005. At December 31, 2005, the Company had a remaining authorization from its board of directors to repurchase 315,015 shares of stock. Other items affecting shareholders' equity in 2005 were 1) proceeds of $785,000 received from common stock issued as a result of stock option exercises, 2) proceeds of $1,604,000 received from the issuance of stock into the Company's dividend reinvestment plan, 3) a $118,000 increase to equity related to a tax benefit that the Company realized due to exercises of nonqualified stock options, and 4) other comprehensive loss of $1,417,000, which was comprised of the $1,362,000 decrease in the net unrealized gain, net of taxes, of the Company's available for sale securities and an adjustment to the Company's pension liability of $55,000, net of taxes. In 2004, net income of $20,114,000 increased equity, while dividends declared of $9,269,000 reduced equity. Also, the Company continued to actively manage its capital and number of common shares outstanding through stock repurchases. In 2004, the Company repurchased a total of 300,816 shares of its common stock at an average price of $21.65, which reduced shareholders' equity by $6.5 million. Other items affecting shareholders' equity in 2004 were 1) proceeds of $1,081,000 received from common stock issued as a result of stock option exercises, 2) proceeds of $1,466,000 received from the issuance of stock into the Company's dividend reinvestment plan, 3) a $203,000 increase to equity related to the tax benefit that the Company realized due to exercises of nonqualified stock options, and 4) other comprehensive loss of $445,000, which was comprised of the $417,000 decrease in the net unrealized gain, net of taxes, of the Company's available for sale securities and an adjustment to the Company's pension liability of $28,000, net of taxes. In 2003, net income of $19,417,000 increased equity, while dividends declared of $8,835,000 reduced equity. Two other items significantly impacted shareholders' equity in 2003. In connection with the Company's acquisition of CCB in January 2003, the Company issued 1.2 shares of stock for each share of CCB stock outstanding, which resulted in the Company issuing a total of 500,000 shares of stock valued at $9.3 million, which increased shareholders equity. Also in 2003, the Company repurchased a total of 315,000 shares of its common stock at an average price of $16.49, which reduced shareholders' equity by $5.2 million. Other items affecting shareholders' equity in 2003 were 1) proceeds of $1,167,000 received from common stock issued as a result of stock option exercises, 2) proceeds of $1,277,000 received from the issuance of stock into the Company's dividend reinvestment plan, 3) a $546,000 increase to equity related to the tax benefit that the Company realized due to exercises of nonqualified stock options, and 4) other comprehensive income of $210,000, which was comprised of the $287,000 increase in the net unrealized gain, net of taxes, of the Company's available for sale securities that was reduced by an adjustment to the Company's pension liability of $77,000, net of taxes. The Company is not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on its liquidity, capital resources, or operations. The Company and the Bank must comply with regulatory capital requirements established by the FRB and the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's 42
financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. These capital standards require the Company and the Bank to maintain minimum ratios of "Tier 1" capital to total risk-weighted assets ("Tier I Capital Ratio") and total capital to risk-weighted assets ("Total Capital Ratio") of 4.00% and 8.00%, respectively. Tier 1 capital is comprised of total shareholders' equity, excluding unrealized gains or losses from the securities available for sale, less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which for the Company and the Bank is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company and the Bank, adjusted for their related risk levels using formulas set forth in FRB and FDIC regulations. In addition to the risk-based capital requirements described above, the Company and the Bank are subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets ("Leverage Ratio) of 3.00% to 5.00%, depending upon the institution's composite ratings as determined by its regulators. The FRB has not advised the Company of any requirement specifically applicable to it. Table 21 presents the Company's regulatory capital ratios as of December 31, 2005, 2004, and 2003. In 2004 and 2005, regulatory capital ratios declined as asset growth exceeded capital growth. Additionally, the $4.3 million contingency tax loss accrual negatively impacted the Company's capital ratios in 2005. However, all of the Company's capital ratios have significantly exceeded the minimum regulatory thresholds for all periods covered by this report. In addition to the minimum capital requirements described above, the regulatory framework for prompt corrective action also contains specific capital guidelines for a bank's classification as "well capitalized." The specific guidelines are as follows - Tier I Capital Ratio of at least 6.00%, Total Capital Ratio of at least 10.00%, and a Leverage Ratio of at least 5.00%. The Bank's regulatory ratios exceeded the threshold for "well-capitalized" status at December 31, 2005, 2004 and 2003. The Company's goal is to maintain its "well-capitalized" status at all times. At December 31, 2005, the Company's total risk-based capital ratio was 11.51% compared to the 10.00% "well-capitalized" threshold. In order to improve this ratio, the Company plans to issue $25 million in additional trust preferred securities during the first quarter of 2006. The Company also believes that it has the ability to raise capital in a secondary stock offering should the need arise. See "Supervision and Regulation" under "Business" above and Note 15 to the consolidated financial statements for discussion of other matters that may affect the Company's capital resources. Inflation Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plant and inventories. During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans and deposits. Also, general increases in the price of goods and services will result in increased operating expenses. 43
Current Accounting and Regulatory Matters The Company prepares its consolidated financial statements and related disclosures in conformity with standards established by, among others, the Financial Accounting Standards Board (the "FASB"). Because the information needed by users of financial reports is dynamic, the FASB frequently issues new rules and proposes new rules for companies to apply in reporting their activities. The following paragraphs contain information regarding recently adopted accounting standards that affected the Company and new standards that have not yet been adopted that have the potential to affect the Company. In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities," which was subsequently revised in December 2003. FIN 46 addresses the consolidation by business enterprises of certain variable interest entities. The provisions of this interpretation became effective for the Company on January 31, 2003 as it relates to variable interest entities created or purchased after that date. In December 2003, the FASB issued a revision to FIN 46 (FIN 46R), which clarified and interpreted certain of the provisions of FIN 46, without changing the basic accounting model in FIN 46. The provisions of FIN 46R were effective no later than March 31, 2004. The adoption of FIN 46 did not have an impact on the Company's financial position or results of operations, as the Company had no investments in variable interest entities that required consolidation under FIN 46. The application of FIN 46R during 2004 resulted in the de-consolidation of three trusts that the Company established in order to issue $40 million in trust preferred capital securities. The de-consolidation of the trusts resulted in the Company recording the amount of the junior subordinated debentures between the Company and the trust subsidiary in the amount of $1,239,000. Previously, the junior subordinated debentures were eliminated in consolidation. The impact of this change was to increase both securities (held-to-maturity) and borrowings by $1,239,000 each. From November 2003 through November 2005, the FASB issued several sets of guidance relating to the concept of "other-than-temporary impairment" and its applicability to investments. The final guidance, as stated in Staff Position FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," requires the disclosure of information about unrealized losses associated with debt and equity securities, while affirming the existing requirements for determining whether impairment is other-than-temporary. The required disclosures are presented in Note 3 in the accompanying audited consolidated financial statements. In December 2003, the FASB issued Statement of Financial Accounting Standards No. 132 (revised 2003) (Statement 132(R)), "Employers' Disclosures about Pensions and Other Postretirement Benefits." Statement 132(R) revises employers' disclosures about pension plans and other postretirement plans, but does not change the measurement or recognition of those plans. Statement No. 132(R) requires additional disclosures about the assets, obligations, cash flows, and net periodic pension cost of defined benefit plans and other defined benefit postretirement plans. Most of the provisions of Statement 132(R) became effective for financial statements with fiscal years after December 15, 2003, with certain provisions becoming effective for fiscal years ending after June 15, 2004. The additional disclosures required for the Company are included in Note 11 in the accompanying audited consolidated financial statements. In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3 (SOP 03-3), "Accounting for Certain Loans or Debt Securities Acquired in a Transfer." SOP 03-3 provides guidance on the accounting for differences between contractual and expected cash flows from the purchaser's initial investment in loans or debt securities acquired in a transfer, if those differences are attributable, at least in part, to credit quality. The scope of SOP 03-3 includes loans that have shown evidence of deterioration of credit quality since origination, and includes loans acquired individually, in pools or as part of a business combination. Among other things, SOP 03-3: (1) prohibits the recognition of the excess of contractual cash flows over expected cash flows as an adjustment of yield, loss accrual or valuation allowance at the time of purchase; (2) requires that subsequent increases in expected cash flows be recognized prospectively through an adjustment of 44
yield; and (3) requires that subsequent decreases in expected cash flows be recognized as impairment. In addition, SOP 03-3 prohibits the creation or carrying over of a valuation allowance in the initial accounting of all loans within the scope that are acquired in a transfer. Under SOP 03-3, the difference between expected cash flows and the purchase price is accreted as an adjustment to yield over the life of the loans. For loans acquired in a business combination that have shown deterioration of credit quality since origination, SOP 03-3 represents a significant change from the previous purchase accounting practice whereby the acquiree's allowance for loan losses is typically added to the acquirer's allowance for loan losses. SOP 03-3 became effective for loans or debt securities acquired by the Company beginning on January 1, 2005. The adoption of this statement in the first quarter of 2005 did not have an impact on the Company's financial statements; however it will change, on a prospective basis, the way that the Company accounts for loans and debt securities that it acquires in the future. In March 2004, the Securities and Exchange Commission (the "SEC") issued Staff Accounting Bulletin Number 105 (SAB 105), "Application of Accounting Principles to Loan Commitments." SAB 105 summarizes the views of the SEC staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivatives, and its provisions were required for such loan commitments entered into subsequent to March 31, 2004. The adoption of SAB 105 did not have a material impact on the Company's consolidated financial statements. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) (Statement 123(R)), "Share-Based Payment." Statement 123(R) replaces FASB Statement No. 123 (Statement 123), "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25 (Opinion 25), "Accounting for Stock Issued to Employees." Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, Statement 123 permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Statement 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Currently, the only share-based compensation arrangement utilized by the Company is stock options. Under the original provisions of Statement 123(R), it was to have become effective as of the first interim or annual reporting period that began after June 15, 2005. However in April 2005, the Securities and Exchange Commission effectively delayed the adoption of Statement 123(R) for the Company until January 1, 2006. See "Stock-Based Compensation" above for further discussion, including the potential quantitative impact of adopting this statement. In March 2005, the FRB issued a final rule concerning the regulatory capital treatment of Trust Preferred Securities ("TPS") by bank holding companies. After a five-year transition period ending March 31, 2009, the aggregate amount of TPS and certain other capital elements will be limited to 25% of Tier I capital elements - net of goodwill, less any associated deferred tax liability. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The Company does not expect this rule to materially impact the Company's capital ratios. In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (Statement 154), "Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3." Statement 154 applies to all voluntary changes in accounting principle as well as to changes required by an accounting pronouncement that does not include specific transition provisions. Statement 154 eliminates the previous requirement that the cumulative effect of changes in accounting principle be reflected in the income statement in the period of change. Instead, to enhance the comparability of prior period financial statements, Statement 154 requires that changes in accounting principle be retrospectively applied. Under retrospective application, the new accounting principle is applied as of the beginning of the first period presented, as if that principle had always been used. Statement 154 carries forward the requirement that an error be reported by restating prior period financial statement as of the beginning of the first period. Statement 154 is effective for 45
accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not expect the initial adoption of Statement 154 to materially impact the Company's financial statements; however the adoption of this statement could result in a material change to the way the Company reflects future changes in accounting principles, depending on the nature of future changes in accounting principles and whether specific transition provisions are included. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. The information responsive to this Item is found in Item 7 under the caption "Interest Rate Risk." FORWARD-LOOKING STATEMENTS The discussion in Part I and Part II of this report contains statements that could be deemed forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act, which statements are inherently subject to risks and uncertainties. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words (and their derivatives) such as "expect," "believe," "estimate," "plan," "project," or other statements concerning opinions or judgment of the Company and its management about future events. Factors that could influence the accuracy of such forward-looking statements include, but are not limited to, the financial success or changing strategies of the Company's customers, the Company's level of success in integrating acquisitions, actions of government regulators, the level of market interest rates, and general economic conditions, and also include the matters discussed under "Risk Factors" in Item 1A of this report. 46
<TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------------------- Table 1 Selected Consolidated Financial Data - -------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ($ in thousands, except per share ------------------------------------------------------------------ and nonfinancial data) 2005 (1) 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Income Statement Data Interest income $ 101,429 81,593 74,667 73,261 76,773 Interest expense 32,838 20,303 18,907 23,871 35,720 Net interest income 68,591 61,290 55,760 49,390 41,053 Provision for loan losses 3,040 2,905 2,680 2,545 1,151 Net interest income after provision 65,551 58,385 53,080 46,845 39,902 Noninterest income 15,004 15,864 14,918 11,968 9,655 Noninterest expense 47,636 43,717 37,964 32,301 28,634 Income before income taxes 32,919 30,532 30,034 26,512 20,923 Income taxes 16,829 10,418 10,617 9,282 7,307 Net income 16,090 20,114 19,417 17,230 13,616 Earnings per share - basic 1.14 1.42 1.38 1.26 1.00 Earnings per share - diluted 1.12 1.40 1.35 1.23 0.98 - -------------------------------------------------------------------------------------------------------------------- Per Share Data (2) Cash dividends declared $ 0.70 0.66 0.63 0.60 0.59 Market Price High 27.88 29.73 21.49 18.35 18.72 Low 19.32 18.47 15.30 13.47 10.33 Close 20.16 27.17 20.80 15.67 15.03 Book value - stated 10.94 10.54 10.02 9.06 8.54 Tangible book value 7.48 7.04 6.44 7.22 6.75 - -------------------------------------------------------------------------------------------------------------------- Selected Balance Sheet Data (at year end) Total assets $1,801,050 1,638,913 1,475,769 1,218,146 1,144,691 Loans 1,482,611 1,367,053 1,218,895 998,547 890,310 Allowance for loan losses 15,716 14,717 13,569 10,907 9,388 Intangible assets 49,227 49,330 50,701 25,169 24,488 Deposits 1,494,577 1,388,768 1,249,364 1,055,957 1,000,281 Borrowings 100,239 92,239 76,000 30,000 15,000 Total shareholders' equity 155,728 148,478 141,856 123,985 116,726 - -------------------------------------------------------------------------------------------------------------------- Selected Average Balances Assets $1,709,380 1,545,332 1,339,823 1,162,708 1,046,030 Loans 1,422,419 1,295,682 1,113,426 954,885 831,817 Earning assets 1,593,554 1,434,425 1,245,679 1,090,666 983,628 Deposits 1,460,620 1,306,404 1,153,385 1,010,693 899,989 Interest-bearing liabilities 1,359,744 1,232,130 1,065,950 928,686 837,563 Shareholders' equity 154,871 146,683 137,293 120,943 115,620 - -------------------------------------------------------------------------------------------------------------------- Ratios Return on average assets 0.94% 1.30% 1.45% 1.48% 1.30% Return on average equity 10.39% 13.71% 14.14% 14.25% 11.78% Net interest margin (taxable-equivalent basis) 4.33% 4.31% 4.52% 4.58% 4.23% Shareholders' equity to assets at year end 8.65% 9.06% 9.61% 10.18% 10.20% Loans to deposits at year end 99.20% 98.44% 97.56% 94.56% 89.01% Allowance for loan losses to total loans 1.06% 1.08% 1.11% 1.09% 1.05% Nonperforming assets to total assets at year end 0.17% 0.32% 0.39% 0.36% 0.45% Net charge-offs to average loans 0.14% 0.14% 0.10% 0.11% 0.09% Efficiency ratio 56.68% 56.32% 53.32% 52.19% 55.82% - -------------------------------------------------------------------------------------------------------------------- Nonfinancial Data Number of branches 61 59 57 48 45 Number of employees - Full time equivalents 578 563 550 447 393 - -------------------------------------------------------------------------------------------------------------------- </TABLE> (1) Financial results for 2005 were significantly impacted by a contingency tax loss accrual amounting to $4.3 million, or $0.30 per diluted share, included above in the line item "Income Taxes." (2) Per share amounts for 2001, 2002, and 2003 have been restated from their originally reported amounts to reflect the 3-for-2 stock split paid on November 15, 2004. 47
<TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------------------------------- Table 2 Average Balances and Net Interest Income Analysis - --------------------------------------------------------------------------------------------------------------------------------- Year Ended December 31, ---------------------------------------------------------------------------------------------------- 2005 2004 2003 -------------------------------- ------------------------------- ------------------------------- Interest Interest Interest Average Avg. Earned Average Avg. Earned Average Avg. Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid Volume Rate or Paid ---------- ------ ---------- ---------- ------ ---------- ---------- ------ ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,422,419 6.62% $ 94,097 $1,295,682 5.87% $ 76,093 $1,113,426 6.23% $ 69,318 Taxable securities 114,223 4.54% 5,184 98,016 4.52% 4,428 81,211 4.80% 3,902 Non-taxable securities (2) 10,782 8.57% 924 12,082 8.30% 1,003 14,238 8.33% 1,186 Short-term investments, primarily federal funds 46,130 3.62% 1,672 28,645 1.90% 544 36,804 2.12% 779 ---------- ---------- ---------- ---------- ---------- ---------- Total interest- earning assets 1,593,554 6.39% 101,877 1,434,425 5.72% 82,068 1,245,679 6.04% 75,185 ---------- ---------- ---------- ---------- ---------- Cash and due from banks 34,574 32,594 31,189 Bank premises and equipment, net 32,179 25,915 23,371 Other assets 49,073 52,398 39,584 ---------- ---------- ---------- Total assets $1,709,380 $1,545,332 $1,339,823 ========== ========== ========== Liabilities and Equity Savings, NOW and money market deposits $ 470,648 0.86% 4,048 $ 468,177 0.54% 2,530 $ 414,525 0.53% 2,215 Time deposits >$100,000 350,240 3.26% 11,425 271,448 2.34% 6,362 229,758 2.56% 5,892 Other time deposits 455,557 2.86% 13,043 407,602 2.04% 8,334 379,603 2.37% 9,001 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,276,445 2.23% 28,516 1,147,227 1.50% 17,226 1,023,886 1.67% 17,108 Securities sold under agreements to repurchase 6,219 2.88% 179 -- -- -- -- -- -- Borrowings 77,080 5.37% 4,143 84,903 3.62% 3,077 42,064 4.28% 1,799 ---------- ---------- ---------- ---------- ---------- ---------- Total interest- bearing liabilities 1,359,744 2.42% 32,838 1,232,130 1.65% 20,303 1,065,950 1.77% 18,907 ---------- ---------- ---------- Non-interest- bearing deposits 184,175 159,177 129,499 Other liabilities 10,590 7,342 7,081 Shareholders' equity 154,871 146,683 137,293 ---------- ---------- ---------- Total liabilities and shareholders' equity $1,709,380 $1,545,332 $1,339,823 ========== ========== ========== Net yield on interest- earning assets and net interest income 4.33% $ 69,039 4.31% $ 61,765 4.52% $ 56,278 ========== ========== ========== Interest rate spread 3.97% 4.07% 4.26% Average prime rate 6.19% 4.34% 4.12% - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. Interest earned includes recognized loan fees in the amounts of $1,037,000, $1,244,000, and $1,235,000 for 2005, 2004, and 2003, respectively. (2) Includes tax-equivalent adjustments of $448,000, $475,000, and $518,000 in 2005, 2004, and 2003, respectively, to reflect the federal and state benefit of the tax-exempt securities (using a 39% combined tax rate), reduced by the related nondeductible portion of interest expense. ================================================================================ 48
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 3 Volume and Rate Variance Analysis - ------------------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, 2005 Year Ended December 31, 2004 ------------------------------------- --------------------------------------- Change Attributable to Change Attributable to ------------------------ ------------------------ Total Total Changes Changes Increase Changes Changes Increase (In thousands) in Volumes in Rates (Decrease) in Volumes in Rates (Decrease) ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Interest income (tax-equivalent): Loans $ 7,914 10,090 18,004 11,025 (4,250) 6,775 Taxable securities 734 22 756 783 (257) 526 Non-taxable securities (110) 31 (79) (179) (4) (183) Short-term investments, principally federal funds sold 483 645 1,128 (164) (71) (235) ---------- ---------- ---------- ---------- ---------- ---------- Total interest income 9,021 10,788 19,809 11,465 (4,582) 6,883 ---------- ---------- ---------- ---------- ---------- ---------- Interest expense: Savings, NOW and money market deposits 17 1,501 1,518 288 27 315 Time deposits>$100,000 2,208 2,855 5,063 1,023 (553) 470 Other time deposits 1,177 3,532 4,709 618 (1,285) (667) ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing deposits 3,402 7,888 11,290 1,929 (1,811) 118 Securities sold under agreements to repurchase 179 -- 179 -- -- -- Borrowings (352) 1,418 1,066 1,692 (414) 1,278 ---------- ---------- ---------- ---------- ---------- ---------- Total interest expense 3,229 9,306 12,535 3,621 (2,225) 1,396 ---------- ---------- ---------- ---------- ---------- ---------- Net interest income $ 5,792 1,482 7,274 7,844 (2,357) 5,487 ========== ========== ========== ========== ========== ========== Changes attributable to both volume and rate are allocated equally between rate and volume variances. </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 4 Noninterest Income - ------------------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, ------------------------------------------------- (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Service charges on deposit accounts $ 8,537 9,064 7,938 Other service charges, commissions, and fees 3,963 3,361 2,710 Fees from presold mortgages 1,176 969 2,327 Commissions from sales of insurance and financial products 1,307 1,406 1,304 Data processing fees 279 416 333 -------- -------- -------- Total core noninterest income 15,262 15,216 14,612 Loan sale gains 9 2 2 Securities gains, net 5 299 218 Other gains (losses), net (272) 347 86 -------- -------- -------- Total $ 15,004 15,864 14,918 ======== ======== ======== </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 5 Noninterest Expenses - ------------------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, ------------------------------------------ (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Salaries $ 21,921 20,116 17,756 Employee benefits 6,054 5,488 4,381 -------- -------- -------- Total personnel expense 27,975 25,604 22,137 Occupancy expense 3,037 2,754 2,366 Equipment related expenses 2,965 2,956 2,555 Amortization of intangible assets 290 378 224 Stationery and supplies 1,590 1,523 1,498 Telephone 1,260 1,345 1,229 Non-credit losses 110 187 198 Other operating expenses 10,409 8,970 7,757 -------- -------- -------- Total $ 47,636 43,717 37,964 ======== ======== ======== - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 49
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 6 Income Taxes - ------------------------------------------------------------------------------------------------------------------------------------ (In thousands) 2005 2004 2003 ---------- ---------- ---------- <S> <C> <C> <C> Current - Federal $ 8,285 10,407 9,578 - State 8,700 228 614 Deferred - Federal (124) (192) 425 - State (32) (25) -- ---------- ---------- ---------- Total $ 16,829 10,418 10,617 ========== ========== ========== Effective tax rate 51.1% 34.1% 35.3% ========== ========== ========== </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 7 Distribution of Assets and Liabilities - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, ---------------------------------------- 2005 2004 2003 ---------- ---------- ---------- <S> <C> <C> <C> Assets Interest-earning assets Net loans 81% 82% 82% Securities available for sale 6 5 7 Securities held to maturity 1 1 1 Short term investments 4 4 2 ---------- ---------- ---------- Total interest-earning assets 92 92 92 Noninterest-earning assets Cash and due from banks 2 2 2 Premises and equipment 2 2 2 Other assets 4 4 4 ---------- ---------- ---------- Total assets 100% 100% 100% ========== ========== ========== Liabilities and shareholders' equity Demand deposits - noninterest bearing 11% 10% 10% Savings, NOW, and money market deposits 25 29 31 Time deposits of $100,000 or more 20 21 16 Other time deposits 27 25 27 ---------- ---------- ---------- Total deposits 83 85 84 Securities sold under agreements to repurchase 2 -- -- Borrowings 5 5 5 Accrued expenses and other liabilities 1 1 1 ---------- ---------- ---------- Total liabilities 91 91 90 Shareholders' equity 9 9 10 ---------- ---------- ---------- Total liabilities and shareholders' equity 100% 100% 100% ========== ========== ========== </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 8 Securities Portfolio Composition - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, ---------------------------------------- (In thousands) 2005 2004 2003 ---------- ---------- ---------- <S> <C> <C> <C> Securities available for sale: U.S. Government agencies $ 44,481 29,810 35,808 Mortgage-backed securities 47,928 41,062 48,473 Corporate bonds 14,912 12,084 13,415 Equity securities 6,292 5,598 5,759 ---------- ---------- ---------- Total securities available for sale 113,613 88,554 103,455 ---------- ---------- ---------- Securities held to maturity: State and local governments 11,382 11,605 12,947 Other 2,790 2,420 1,259 ---------- ---------- ---------- Total securities held to maturity 14,172 14,025 14,206 ---------- ---------- ---------- Total securities $ 127,785 102,579 117,661 ========== ========== ========== Average total securities during year $ 125,005 110,098 95,449 ========== ========== ========== - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 50
- -------------------------------------------------------------------------------- Table 9 Securities Portfolio Maturity Schedule - -------------------------------------------------------------------------------- As of December 31, ------------------------------ 2005 ------------------------------ Book Fair Book Value Value Yield (1) -------- -------- -------- Securities available for sale: U.S. Government agencies Due within one year $ 2,300 2,268 3.10% Due after one but within five years 37,285 36,579 3.95% Due after five but within ten years 5,673 5,634 5.02% -------- -------- -------- Total 45,258 44,481 4.05% -------- -------- -------- Mortgage-backed securities Due within one year 1,498 1,468 4.21% Due after one but within five years 36,549 35,651 4.25% Due after five but within ten years 10,290 9,946 4.72% Due after ten years 898 863 5.07% -------- -------- -------- Total 49,235 47,928 4.36% -------- -------- -------- Corporate debt securities Due after five but within ten years 2,990 3,011 6.85% Due after ten years 10,939 11,901 7.74% -------- -------- -------- Total 13,929 14,912 7.55% -------- -------- -------- Equity securities 6,240 6,292 4.60% -------- -------- -------- Total securities available for sale Due within one year 3,798 3,736 3.54% Due after one but within five years 73,834 72,230 4.10% Due after five but within ten years 18,953 18,591 5.15% Due after ten years 11,837 12,764 7.54% Equity securities 6,240 6,292 4.60% -------- -------- -------- Total $114,662 113,613 4.64% ======== ======== ======== Securities held to maturity: State and local governments Due within one year $ 1,323 1,325 5.99% Due after one but within five years 6,712 6,799 7.30% Due after five but within ten years 3,061 3,121 7.34% Due after ten years 286 286 6.01% -------- -------- -------- Total 11,382 11,531 7.14% -------- -------- -------- Other Due after one but within five years 2,790 2,790 0.13% -------- -------- -------- Total 2,790 2,790 0.13% -------- -------- -------- Total securities held to maturity Due within one year 1,323 1,325 5.99% Due after one but within five years 9,502 9,589 5.20% Due after five but within ten years 3,061 3,121 7.34% Due after ten years 286 286 6.01% -------- -------- -------- Total $ 14,172 14,321 5.76% ======== ======== ======== (1) Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using a 39% tax rate. - -------------------------------------------------------------------------------- 51
<TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------------------------------- Table 10 Loan Portfolio Composition - -------------------------------------------------------------------------------------------------------------------------------- As of December 31, 2005 2004 2003 2002 2001 ------------------- -------------------- -------------------- -------------------- -------------------- % of % of % of % of % of ($ in Total Total Total Total Total thousands) Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ----------- ------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial, financial, & agricultural $ 135,942 9.17% $ 122,501 8.96% $ 117,287 9.62% $ 88,291 8.84% $ 79,695 8.94% Real estate - construction 125,158 8.44% 117,158 8.57% 98,189 8.05% 68,162 6.82% 66,304 7.44% Real estate - mortgage(1) 1,150,068 77.58% 1,063,694 77.80% 939,578 77.05% 795,148 79.57% 697,498 78.29% Installment loans to individuals 71,259 4.81% 63,913 4.67% 64,444 5.28% 47,648 4.77% 47,471 5.33% ----------- ------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ Loans, gross 1,482,427 100.00% 1,367,266 100.00% 1,219,498 100.00% 999,249 100.00% 890,968 100.00% ====== ====== ====== ====== ====== Unamortized net deferred loan costs/ (fees) 184 (213) (603) (702) (658) ----------- ----------- ----------- ----------- ----------- Total loans, net $ 1,482,611 $ 1,367,053 $ 1,218,895 $ 998,547 $ 890,310 =========== =========== =========== =========== =========== </TABLE> (1) The majority of these loans are various personal and commercial loans where real estate provides additional security for the loan. <TABLE> <CAPTION> - -------------------------------------------------------------------------------------------------------------------------------- Table 11 Loan Maturities - -------------------------------------------------------------------------------------------------------------------------------- As of December 31, 2005 --------------------------------------------------------------------------------- Due within Due after one year but Due after five one year within five years years Total ------------------ ------------------ ------------------ ------------------ ($ in thousands) Amount Yield Amount Yield Amount Yield Amount Yield ---------- ------ ---------- ------ ---------- ------ ---------- ------ <S> <C> <C> <C> <C> <C> <C> <C> <C> Variable Rate Loans: Commercial, financial, and agricultural $ 39,685 7.50% $ 27,391 7.40% $ 2,501 7.48% $ 69,577 7.46% Real estate - construction 96,892 7.78% 10,651 7.38% 2,554 7.29% 110,097 7.73% Real estate - mortgage 87,471 7.64% 269,297 7.25% 298,987 6.66% 655,755 7.03% Installment loans to individuals 6,789 7.46% 8,364 8.22% 1,579 8.00% 16,732 7.89% ---------- ---------- ---------- ---------- Total at variable rates 230,837 7.67% 315,703 7.29% 305,621 6.68% 852,161 7.17% ---------- ---------- ---------- ---------- Fixed Rate Loans: Commercial, financial, and 13,493 6.85% 41,240 6.45% 5,062 5.50% 59,795 6.46% agricultural Real estate - construction 16,348 6.32% 1,086 6.32% -- -- 17,434 6.32% Real estate - mortgage 67,663 6.71% 362,265 6.43% 53,642 6.86% 483,570 6.52% Installment loans to individuals 14,086 7.62% 51,975 8.49% 1,950 7.09% 68,011 8.27% ---------- ---------- ---------- ---------- Total at fixed rates 111,590 6.78% 456,566 6.67% 60,654 6.75% 628,810 6.70% ---------- ---------- ---------- ---------- Subtotal 342,427 7.38% 772,269 6.92% 366,275 6.69% 1,480,971 6.97% Nonaccrual loans 1,640 -- -- 1,640 ---------- ---------- ---------- ---------- Total Loans $ 344,067 $ 772,269 $ 366,275 $1,482,611 ========== ========== ========== ========== The above table is based on contractual scheduled maturities. Early repayment of loans or renewals at maturity are not considered in this table. - -------------------------------------------------------------------------------------------------------------------------------- </TABLE> 52
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 12 Nonperforming Assets - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, -------------------------------------------------------------- ($ in thousands) 2005 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Nonaccrual loans $ 1,640 3,707 4,274 2,976 3,808 Restructured loans 13 17 21 41 83 Accruing loans >90 days past due -- -- -- -- -- ---------- ---------- ---------- ---------- ---------- Total nonperforming loans 1,653 3,724 4,295 3,017 3,891 Other real estate (included in other assets) 1,421 1,470 1,398 1,384 1,253 ---------- ---------- ---------- ---------- ---------- Total nonperforming assets $ 3,074 5,194 5,693 4,401 5,144 ========== ========== ========== ========== ========== Nonperforming loans as a percentage of total loans 0.11% 0.27% 0.35% 0.30% 0.44% Nonperforming assets as a percentage of loans and other real estate 0.21% 0.38% 0.47% 0.44% 0.58% Nonperforming assets as a percentage of total assets 0.17% 0.32% 0.39% 0.36% 0.45% Allowance for loan losses as a percentage of nonperforming loans 950.76% 395.19% 315.93% 361.52% 241.27% </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 13 Allocation of the Allowance for Loan Losses - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, -------------------------------------------------------------- ($ in thousands) 2005 2004 2003 2002 2001 ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Commercial, financial, and agricultural $ 2,686 2,453 2,420 1,890 1,643 Real estate - construction 798 757 641 483 449 Real estate - mortgage 10,445 9,965 8,920 7,416 6,230 Installment loans to individuals 1,763 1,468 1,435 1,094 1,021 ---------- ---------- ---------- ---------- ---------- Total allocated 15,692 14,643 13,416 10,883 9,343 Unallocated 24 74 153 24 45 ---------- ---------- ---------- ---------- ---------- Total $ 15,716 14,717 13,569 10,907 9,388 ========== ========== ========== ========== ========== - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 53
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------ Table 14 Loan Loss and Recovery Experience - ------------------------------------------------------------------------------------------------------------------------------ As of December 31, --------------------------------------------------------------------------- ($ in thousands) 2005 2004 2003 2002 2001 ----------- ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> <C> Loans outstanding at end of year $ 1,482,611 1,367,053 1,218,895 998,547 890,310 =========== =========== =========== =========== =========== Average amount of loans outstanding $ 1,422,419 1,295,682 1,113,426 954,885 831,817 =========== =========== =========== =========== =========== Allowance for loan losses, at beginning of year $ 14,717 13,569 10,907 9,388 7,893 Provision for loan losses 3,040 2,905 2,680 2,545 1,151 Additions related to loans assumed in corporate acquisitions -- -- 1,083 50 1,125 ----------- ----------- ----------- ----------- ----------- 17,757 16,474 14,670 11,983 10,169 ----------- ----------- ----------- ----------- ----------- Loans charged off: Commercial, financial and agricultural (756) (247) (205) (598) (89) Real estate - mortgage (1,120) (1,143) (705) (230) (181) Installment loans to individuals (487) (548) (431) (383) (642) ----------- ----------- ----------- ----------- ----------- Total charge-offs (2,363) (1,938) (1,341) (1,211) (912) ----------- ----------- ----------- ----------- ----------- Recoveries of loans previously charged-off: Commercial, financial and agricultural 99 45 73 33 27 Real estate - mortgage 115 63 30 15 48 Installment loans to individuals 108 73 137 87 56 ----------- ----------- ----------- ----------- ----------- Total recoveries 322 181 240 135 131 ----------- ----------- ----------- ----------- ----------- Net charge-offs (2,041) (1,757) (1,101) (1,076) (781) ----------- ----------- ----------- ----------- ----------- Allowance for loan losses, at end of year $ 15,716 14,717 13,569 10,907 9,388 =========== =========== =========== =========== =========== Ratios: Net charge-offs as a percent of average loans 0.14% 0.14% 0.10% 0.11% 0.09% Allowance for loan losses as a percent of loans at end of year 1.06% 1.08% 1.11% 1.09% 1.05% Allowance for loan losses as a multiple of net charge-offs 7.70x 8.38x 12.32x 10.14x 12.02x Provision for loan losses as a percent of net charge-offs 148.95% 165.33% 243.42% 236.52% 147.38% Recoveries of loans previously charged-off as a percent of loans charged-off 13.63% 9.34% 17.90% 11.15% 14.36% - ------------------------------------------------------------------------------------------------------------------------------ </TABLE> 54
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 15 Average Deposits - ------------------------------------------------------------------------------------------------------------------------------------ Year Ended December 31, ------------------------------------------------------------------------------ 2005 2004 2003 ------------------------ ------------------------ ------------------------ Average Average Average Average Average Average Amount Rate Amount Rate Amount Rate ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Interest-bearing demand deposits $ 341,370 0.81% 338,831 0.47% 308,750 0.47% Savings deposits 129,278 1.00% 129,346 0.73% 105,775 0.72% Time deposits 455,557 2.86% 407,602 2.04% 379,603 2.37% Time deposits > $100,000 350,240 3.26% 271,448 2.34% 229,758 2.56% ---------- ---------- ---------- Total interest-bearing deposits 1,276,445 2.23% 1,147,227 1.50% 1,023,886 1.67% Noninterest-bearing deposits 184,175 -- 159,177 -- 129,499 -- ---------- ---------- ---------- Total deposits $1,460,620 1.95% 1,306,404 1.32% 1,153,385 1.48% ========== ========== ========== </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 16 Maturities of Time Deposits of $100,000 or More - ------------------------------------------------------------------------------------------------------------------------------------ As of December 31, 2005 ------------------------------------------------------------------ 3 Months Over 3 to 6 Over 6 to 12 Over 12 (In thousands) or Less Months Months Months Total ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Time deposits of $100,000 or more $ 106,804 78,207 107,061 64,209 356,281 ========== ========== ========== ========== ========== </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 17 Interest Rate Sensitivity Analysis - ------------------------------------------------------------------------------------------------------------------------------------ Repricing schedule for interest-earning assets and interest-bearing liabilities held as of December 31, 2005 -------------------------------------------------------------------- 3 Months Over 3 to 12 Total Within Over 12 ($ in thousands) or Less Months 12 Months Months Total ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Earning assets: Loans, net of deferred fees $ 772,795 116,541 889,336 593,275 1,482,611 Securities available for sale 4,947 16,994 21,941 91,672 113,613 Securities held to maturity 1,803 3,362 5,165 9,007 14,172 Short-term investments 73,885 -- 73,885 -- 73,885 ---------- ---------- ---------- ---------- ---------- Total earning assets $ 853,430 136,897 990,327 693,954 1,684,281 ========== ========== ========== ========== ========== Percent of total earning assets 50.67% 8.13% 58.80% 41.20% 100.00% Cumulative percent of total earning assets 50.67% 58.80% 58.80% 100.00% 100.00% Interest-bearing liabilities: Savings, NOW and money market deposits $ 458,221 -- 458,221 -- 458,221 Time deposits of $100,000 or more 106,804 185,268 292,072 64,209 356,281 Other time deposits 122,159 274,473 396,632 89,392 486,024 Securities sold under agreements to repurchase 33,530 -- 33,530 -- 33,530 Borrowings 79,739 12,500 92,239 8,000 100,239 ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities $ 800,453 472,241 1,272,694 161,601 1,434,295 ========== ========== ========== ========== ========== Percent of total interest-bearing liabilities 55.81% 32.92% 88.73% 11.27% 100.00% Cumulative percent of total interest- bearing liabilities 55.81% 88.73% 88.73% 100.00% 100.00% Interest sensitivity gap $ 52,977 (335,344) (282,367) 532,353 249,986 Cumulative interest sensitivity gap 52,977 (282,367) (282,367) 249,986 249,986 Cumulative interest sensitivity gap as a percent of total earning assets 3.15% -16.76% -16.76% 14.84% 14.84% Cumulative ratio of interest-sensitive assets to interest-sensitive liabilities 106.62% 77.81% 77.81% 117.43% 117.43% - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 55
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 18 Contractual Obligations and Other Commercial Commitments - ------------------------------------------------------------------------------------------------------------------------------------ Payments Due by Period (in thousands) Contractual -------------------------------------------------------------------------- Obligations On Demand or - ------------------------------------------------------- Less After As of December 31, 2005 Total than 1 Year 1-3 Years 4-5 Years 5 Years - ------------------------------------------------------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Securities sold under agreements to repurchase $ 33,530 33,530 -- -- -- Borrowings 100,239 51,000 3,000 5,000 41,239 Operating leases 2,572 435 581 450 1,106 ---------- ---------- ---------- ---------- ---------- Total contractual cash obligations, excluding deposits 136,341 84,965 3,581 5,450 42,345 Deposits 1,494,577 1,340,976 113,407 38,033 2,161 ---------- ---------- ---------- ---------- ---------- Total contractual cash obligations, including deposits $1,630,918 1,425,941 116,988 43,483 44,506 ========== ========== ========== ========== ========== </TABLE> <TABLE> <CAPTION> Amount of Commitment Expiration Per Period (in thousands) Other Commercial ------------------------------------------------------------------ Commitments Total - -------------------------------------------------------------- Amounts Less After As of December 31, 2005 Committed than 1 Year 1-3 Years 4-5 Years 5 Years - -------------------------------------------------------------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> Credit cards $ 18,494 9,247 9,247 -- -- Lines of credit and loan commitments 258,550 118,948 11,920 3,719 123,963 Standby letters of credit 4,283 4,139 93 51 -- ---------- ---------- ---------- ---------- ---------- Total commercial commitments $ 281,327 132,334 21,260 3,770 123,963 ========== ========== ========== ========== ========== - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 56
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 19 Market Risk Sensitive Instruments - ------------------------------------------------------------------------------------------------------------------------------------ Expected Maturities of Market Sensitive Instruments Held at December 31, 2005 Occurring in Indicated Year ---------------------------------------------------------------------------------- Average Estimated Interest Fair ($ in thousands) 2006 2007 2008 2009 2010 Beyond Total Rate Value ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---- ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Due from banks, interest-bearing $ 41,655 -- -- -- -- -- 41,655 4.15% $ 41,655 Federal funds sold 28,883 -- -- -- -- -- 28,883 4.15% 28,883 Presold mortgages in process of settlement 3,347 -- -- -- -- -- 3,347 5.75% 3,347 Debt Securities- at amortized cost (1) (2) 20,730 29,275 37,535 9,291 11,349 14,414 122,594 4.73% 121,642 Loans - fixed (3) (4) 123,119 91,386 147,682 113,292 105,077 48,255 628,811 6.70% 622,129 Loans - adjustable (3) (4) 272,320 91,761 125,766 121,387 99,529 141,397 852,160 7.17% 852,066 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---- ---------- Total $ 490,054 212,422 310,983 243,970 215,955 204,066 1,677,450 6.69% $1,669,722 ========== ========== ========== ========== ========== ========== ========== ==== ========== Savings, NOW, and money market deposits $ 458,221 -- -- -- -- -- 458,221 1.02% $ 458,221 Time deposits 688,704 77,846 35,561 16,210 21,823 2,161 842,305 2.36% 841,771 Securities sold under agreements to repurchase 33,530 -- -- -- -- -- 33,530 3.08% 33,530 Borrowings - fixed (2) 21,000 2,000 1,000 5,000 -- -- 29,000 3.77% 28,900 Borrowings - adjustable 30,000 -- -- -- -- 41,239 71,239 6.16% 72,771 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---- ---------- Total $1,231,455 79,846 36,561 21,210 21,823 43,400 1,434,295 2.92% $1,435,193 ========== ========== ========== ========== ========== ========== ========== ==== ========== </TABLE> (1) Tax-exempt securities are reflected at a tax-equivalent basis using a 35% tax rate. (2) Securities and borrowings with call dates within 12 months of December 31, 2005 that have above market interest rates are assumed to mature at their call date for purposes of this table. Mortgage securities are assumed to mature in the period of their expected repayment based on estimated prepayment speeds. (3) Excludes nonaccrual loans. (4) Single-family mortgage loans are assumed to mature in the period of their expected repayment based on estimated prepayment speeds. All other loans are shown in the period of their contractual maturity. <TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 20 Return on Assets and Equity - ------------------------------------------------------------------------------------------------------------------------------------ For the Year Ended December 31, ------------------------------------------ 2005 2004 2003 ---------- ---------- ---------- <S> <C> <C> <C> Return on assets 0.94% 1.30% 1.45% Return on equity 10.39% 13.71% 14.14% Dividend payout ratio 61.40% 46.48% 45.41% Average shareholders' equity to average assets 9.06% 9.49% 10.25% - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> 57
<TABLE> <CAPTION> - ---------------------------------------------------------------------------------------------- Table 21 Risk-Based and Leverage Capital Ratios - ---------------------------------------------------------------------------------------------- As of December 31, ------------------------------------------- ($ in thousands) 2005 2004 2003 ----------- ----------- ----------- <S> <C> <C> <C> Risk-Based and Leverage Capital Tier I capital: Common shareholders' equity $ 155,728 148,478 141,856 Trust preferred securities 40,000 40,000 40,000 Intangible assets (49,227) (49,330) (50,701) Accumulated other comprehensive income 900 (517) (962) ----------- ----------- ----------- Total Tier I leverage capital 147,401 138,631 130,193 ----------- ----------- ----------- Tier II capital: Allowable allowance for loan losses 15,716 14,717 13,569 ----------- ----------- ----------- Tier II capital additions 15,716 14,717 13,569 ----------- ----------- ----------- Total risk-based capital $ 163,117 153,348 143,762 =========== =========== =========== Risk adjusted assets $ 1,449,842 1,315,755 1,182,966 Tier I risk-adjusted assets (includes Tier I capital adjustments) 1,401,515 1,265,908 1,131,303 Tier II risk-adjusted assets (includes Tiers I and II capital adjustments) 1,417,231 1,280,625 1,144,872 Fourth quarter average assets 1,759,279 1,608,146 1,431,031 Adjusted fourth quarter average assets (includes Tier I capital adjustments) 1,710,952 1,558,299 1,379,368 Risk-based capital ratios: Tier I capital to Tier I risk adjusted assets 10.52% 10.95% 11.51% Minimum required Tier I capital 4.00% 4.00% 4.00% Total risk-based capital to Tier II risk-adjusted assets 11.51% 11.97% 12.56% Minimum required total risk-based capital 8.00% 8.00% 8.00% Leverage capital ratios: Tier I leverage capital to adjusted fourth quarter average assets 8.62% 8.90% 9.44% Minimum required Tier I leverage capital 4.00% 4.00% 4.00% - ---------------------------------------------------------------------------------------------- </TABLE> 58
<TABLE> <CAPTION> - ------------------------------------------------------------------------------------------------------------------------------------ Table 22 Quarterly Financial Summary - ------------------------------------------------------------------------------------------------------------------------------------ 2005 2004 -------------------------------------------------- -------------------------------------------------- ($ in thousands except Fourth Third Second First Fourth Third Second First per share data) Qtr (2) Qtr (2) Quarter Quarter Quarter Quarter Quarter Quarter ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Income Statement Data Interest income, taxable equivalent $ 27,853 26,178 24,818 23,028 22,026 20,852 19,684 19,507 Interest expense 9,793 8,715 7,700 6,630 5,793 5,193 4,706 4,611 Net interest income, taxable equivalent 18,060 17,463 17,118 16,398 16,233 15,659 14,978 14,896 Taxable equivalent, adjustment 113 111 111 113 116 118 119 123 Net interest income 17,947 17,352 17,007 16,285 16,117 15,541 14,859 14,773 Provision for loan losses 925 690 845 580 825 770 740 570 Net interest income after provision for losses 17,022 16,662 16,162 15,705 15,292 14,771 14,119 14,203 Noninterest income 3,803 3,779 3,712 3,710 3,844 4,296 3,912 3,812 Noninterest expense 12,175 11,486 12,260 11,715 11,271 11,092 10,622 10,732 Income before income taxes 8,650 8,955 7,614 7,700 7,865 7,975 7,409 7,283 Income taxes 1,237 9,646 2,962 2,984 2,554 2,778 2,523 2,563 Net income 7,413 (691) 4,652 4,716 5,311 5,197 4,886 4,720 - ------------------------------------------------------------------------------------------------------------------------------------ Per Share Data (1) Earnings per share - basic $ 0.52 (0.05) 0.33 0.33 0.37 0.34 0.33 0.38 Earnings per share - diluted 0.52 (0.05) 0.32 0.33 0.37 0.36 0.34 0.33 Cash dividends declared 0.18 0.18 0.17 0.17 0.17 0.17 0.16 0.16 Market Price High $ 22.89 22.54 23.16 27.88 22.65 22.77 23.26 29.73 Low 19.32 19.66 19.62 21.43 22.33 19.01 18.47 20.33 Close 20.16 20.04 22.13 22.64 27.17 22.48 22.29 20.99 Book value 10.94 10.63 10.88 10.66 10.54 10.36 10.13 10.15 Tangible book value 7.48 7.16 7.40 7.17 7.04 6.79 6.56 6.58 - ------------------------------------------------------------------------------------------------------------------------------------ Selected Average Balances Assets $1,759,279 1,720,505 1,707,112 1,650,624 1,608,146 1,563,548 1,524,169 1,482,987 Loans 1,463,468 1,433,874 1,409,118 1,383,216 1,352,589 1,320,391 1,273,672 1,236,076 Earning assets 1,639,823 1,604,383 1,592,845 1,537,165 1,495,139 1,453,879 1,414,095 1,372,109 Deposits 1,493,683 1,467,183 1,466,893 1,414,721 1,363,557 1,301,703 1,300,263 1,260,093 Interest-bearing liabilities 1,392,921 1,365,959 1,361,365 1,318,731 1,282,404 1,249,440 1,211,314 1,182,884 Shareholders' equity 154,562 158,220 154,540 152,162 150,163 145,757 145,776 145,036 - ------------------------------------------------------------------------------------------------------------------------------------ Ratios Return on average assets 1.67% (0.16%) 1.09% 1.16% 1.31% 1.32% 1.29% 1.28% Return on average equity 19.03% (1.73%) 12.07% 12.57% 14.07% 14.18% 13.48% 13.09% Equity to assets at end of period 8.65% 8.59% 8.87% 8.94% 9.06% 9.04% 9.19% 9.63% Tangible equity to tangible assets at end of period 6.08% 5.95% 6.21% 6.19% 6.24% 6.11% 6.15% 6.46% Average loans to average deposits 97.98% 97.73% 96.06% 97.77% 99.20% 101.44% 97.95% 98.09% Average earning assets to interest-bearing liabilities 117.73% 117.45% 117.00% 116.56% 116.59% 116.36% 116.74% 116.00% Net interest margin 4.37% 4.32% 4.31% 4.33% 4.32% 4.28% 4.26% 4.37% Allowance for loan losses to gross loans 1.06% 1.10% 1.10% 1.08% 1.08% 1.07% 1.10% 1.11% Nonperforming loans as a percent of total loans 0.11% 0.23% 0.27% 0.31% 0.27% 0.27% 0.26% 0.27% Nonperforming assets as a percent of total assets 0.17% 0.31% 0.36% 0.40% 0.32% 0.34% 0.33% 0.33% Net charge-offs as a percent of average loans 0.29% 0.12% 0.08% 0.07% 0.14% 0.22% 0.11% 0.07% - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> (1) Per share amounts for periods prior to the fourth quarter of 2004 have been restated from their originally reported amounts to reflect the 3-for-2 stock split paid on November 15, 2004. (2) The third-quarter of 2005 includes a contingency tax loss accrual of $6,320,000, or $0.44 per diluted share. The fourth quarter of 2005 includes a reversal of $1,982,000, or $0.14 per diluted share, related to this same accrual (which increased net income) that was recorded because the Company lowered its original estimate of this loss. 59
Item 8. Financial Statements and Supplementary Data First Bancorp and Subsidiaries Consolidated Balance Sheets December 31, 2005 and 2004 <TABLE> <CAPTION> ($ in thousands) 2005 2004 - ---------------------------------------------------------------------------------------- <S> <C> <C> ASSETS Cash and due from banks, noninterest-bearing $ 32,985 28,486 Due from banks, interest-bearing 41,655 45,135 Federal funds sold 28,883 15,780 ----------- ----------- Total cash and cash equivalents 103,523 89,401 ----------- ----------- Securities available for sale (costs of $114,662 in 2005 and $87,368 in 2004) 113,613 88,554 Securities held to maturity (fair values of $14,321 in 2005 and $14,451 in 2004) 14,172 14,025 Presold mortgages in process of settlement 3,347 1,771 Loans 1,482,611 1,367,053 Less: Allowance for loan losses (15,716) (14,717) ----------- ----------- Net loans 1,466,895 1,352,336 ----------- ----------- Premises and equipment 34,840 30,318 Accrued interest receivable 8,947 6,832 Intangible assets 49,227 49,330 Other assets 6,486 6,346 ----------- ----------- Total assets $ 1,801,050 1,638,913 =========== =========== LIABILITIES Deposits: Demand - noninterest-bearing $ 194,051 165,778 Savings, NOW, and money market 458,221 472,811 Time deposits of $100,000 or more 356,281 334,756 Other time deposits 486,024 415,423 ----------- ----------- Total deposits 1,494,577 1,388,768 Securities sold under agreements to repurchase 33,530 -- Borrowings 100,239 92,239 Accrued interest payable 3,835 2,677 Other liabilities 13,141 6,751 ----------- ----------- Total liabilities 1,645,322 1,490,435 ----------- ----------- SHAREHOLDERS' EQUITY Common stock, No par value per share Authorized: 20,000,000 shares Issued and outstanding: 14,229,148 shares in 2005 and 14,083,856 shares in 2004 54,121 51,614 Retained earnings 102,507 96,347 Accumulated other comprehensive income (loss) (900) 517 ----------- ----------- Total shareholders' equity 155,728 148,478 ----------- ----------- Total liabilities and shareholders' equity $ 1,801,050 1,638,913 =========== =========== </TABLE> See accompanying notes to consolidated financial statements. 60
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Income Years Ended December 31, 2005, 2004 and 2003 ($ in thousands, except per share data) 2005 2004 2003 - -------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 94,097 76,093 69,318 Interest on investment securities: Taxable interest income 5,184 4,428 3,902 Tax-exempt interest income 476 528 668 Other, principally overnight investments 1,672 544 779 ------------ ------------ ------------ Total interest income 101,429 81,593 74,667 ------------ ------------ ------------ INTEREST EXPENSE Savings, NOW and money market 4,048 2,530 2,215 Time deposits of $100,000 or more 11,425 6,362 5,892 Other time deposits 13,043 8,334 9,001 Securities sold under agreements to repurchase 179 -- -- Borrowings 4,143 3,077 1,799 ------------ ------------ ------------ Total interest expense 32,838 20,303 18,907 ------------ ------------ ------------ Net interest income 68,591 61,290 55,760 Provision for loan losses 3,040 2,905 2,680 ------------ ------------ ------------ Net interest income after provision for loan losses 65,551 58,385 53,080 ------------ ------------ ------------ NONINTEREST INCOME Service charges on deposit accounts 8,537 9,064 7,938 Other service charges, commissions and fees 3,963 3,361 2,710 Fees from presold mortgage loans 1,176 969 2,327 Commissions from sales of insurance and financial products 1,307 1,406 1,304 Data processing fees 279 416 333 Securities gains 5 299 218 Other gains (losses) (263) 349 88 ------------ ------------ ------------ Total noninterest income 15,004 15,864 14,918 ------------ ------------ ------------ NONINTEREST EXPENSES Salaries 21,921 20,116 17,756 Employee benefits 6,054 5,488 4,381 Total personnel expense 27,975 25,604 22,137 Occupancy expense 3,037 2,754 2,366 Equipment related expenses 2,965 2,956 2,555 Intangibles amortization 290 378 224 Other operating expenses 13,369 12,025 10,682 ------------ ------------ ------------ Total noninterest expenses 47,636 43,717 37,964 ------------ ------------ ------------ Income before income taxes 32,919 30,532 30,034 Income taxes 16,829 10,418 10,617 ------------ ------------ ------------ NET INCOME $ 16,090 20,114 19,417 ============ ============ ============ Earnings per share: Basic $ 1.14 1.42 1.38 Diluted 1.12 1.40 1.35 Weighted average common shares outstanding: Basic 14,165,992 14,138,513 14,076,471 Diluted 14,360,032 14,395,152 14,351,106 </TABLE> See accompanying notes to consolidated financial statements. 61
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Comprehensive Income Years Ended December 31, 2005, 2004 and 2003 ($ in thousands) 2005 2004 2003 - ------------------------------------------------------------------------------------- <S> <C> <C> <C> Net income $ 16,090 20,114 19,417 -------- -------- -------- Other comprehensive income (loss): Unrealized gains on securities available for sale: Unrealized holding gains (losses) arising during the period, pretax (2,229) (383) 688 Tax benefit (expense) 870 148 (268) Reclassification to realized gains (5) (299) (218) Tax expense 2 117 85 Adjustment to minimum pension liability: Additional pension charge related to unfunded pension liability (90) (46) (127) Tax benefit 35 18 50 -------- -------- -------- Other comprehensive income (loss) (1,417) (445) 210 -------- -------- -------- Comprehensive income $ 14,673 19,669 19,627 ======== ======== ======== </TABLE> See accompanying notes to consolidated financial statements. 62
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Shareholders' Equity Years Ended December 31, 2005, 2004 and 2003 Accumulated Total Common Stock Other Share- -------------------- Retained Comprehensive holders' (In thousands, except per share) Shares Amount Earnings Income (Loss) Equity - --------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Balances, January 1, 2003 13,683 $ 48,313 74,920 752 123,985 -------- -------- -------- -------- -------- Net income 19,417 19,417 Cash dividends declared ($0.63 per share) (8,835) (8,835) Common stock issued in acquisition 500 9,284 9,284 Common stock issued under stock option plans 211 1,167 1,167 Common stock issued into dividend reinvestment plan 74 1,277 1,277 Tax benefit realized from exercise of nonqualified stock options 546 546 Purchases and retirement of common stock (315) (5,195) (5,195) Other comprehensive income 210 210 -------- -------- -------- -------- -------- Balances, December 31, 2003 14,153 55,392 85,502 962 141,856 -------- -------- -------- -------- -------- Net income 20,114 20,114 Cash dividends declared ($0.66 per share) (9,269) (9,269) Common stock issued under stock option plans 165 1,081 1,081 Common stock issued into dividend reinvestment plan 67 1,466 1,466 Tax benefit realized from exercise of nonqualified stock options 203 203 Purchases and retirement of common stock (301) (6,528) (6,528) Other comprehensive loss (445) (445) -------- -------- -------- -------- -------- Balances, December 31, 2004 14,084 51,614 96,347 517 148,478 -------- -------- -------- -------- -------- Net income 16,090 16,090 Cash dividends declared ($0.70 per share) (9,930) (9,930) Common stock issued under stock option plans 71 785 785 Common stock issued into dividend reinvestment plan 74 1,604 1,604 Tax benefit realized from exercise of nonqualified stock options 118 118 Other comprehensive loss (1,417) (1,417) -------- -------- -------- -------- -------- Balances, December 31, 2005 14,229 $ 54,121 102,507 (900) 155,728 ======== ======== ======== ======== ======== </TABLE> See accompanying notes to consolidated financial statements. 63
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Cash Flows Years Ended December 31, 2005, 2004 and 2003 ($ in thousands) 2005 2004 2003 - ----------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Cash Flows From Operating Activities Net income $ 16,090 20,114 19,417 Reconciliation of net income to net cash provided by operating activities: Provision for loan losses 3,040 2,905 2,680 Net security premium amortization 120 152 362 Gains on sales of loans (9) (2) (2) Gains on sales of securities available for sale (5) (299) (218) Loss (gain) on sales of other real estate 82 (427) -- Other nonoperating losses (gains) 190 80 (86) Loan fees and costs deferred, net of amortization (397) (390) (99) Depreciation of premises and equipment 2,675 2,553 2,236 Tax benefit realized from exercise of nonqualified stock options 118 203 546 Amortization of intangible assets 290 378 224 Deferred income tax expense (benefit) (156) (217) 425 Decrease (increase) in presold mortgages in process of settlement (1,576) (464) 17,961 Decrease (increase) in accrued interest receivable (2,115) (745) 29 Decrease (increase) in other assets 3,447 2,331 (1,338) Increase (decrease) in accrued interest payable 1,158 539 (601) Increase (decrease) in other liabilities 5,945 1,175 (67) --------- --------- --------- Net cash provided by operating activities 28,897 27,886 41,469 --------- --------- --------- Cash Flows From Investing Activities Proceeds from sales of loans 276 49 41 Purchases of securities available for sale (54,130) (30,354) (73,663) Purchases of securities held to maturity (1,514) (707) (317) Proceeds from sales of securities available for sale 17 12,060 7,750 Proceeds from maturities/issuer calls of securities available for sale 26,710 32,673 38,908 Proceeds from maturities/issuer calls of securities held to maturity 1,176 2,033 3,850 Net increase in loans (120,065) (151,103) (149,877) Purchases of premises and equipment (7,212) (7,335) (3,666) Net cash received in purchase of branches -- -- 62,427 Net cash paid in insurance agency acquisitions -- -- (564) Net cash paid in bank acquisitions -- -- (2,256) --------- --------- --------- Net cash used by investing activities (154,742) (142,684) (117,367) --------- --------- --------- Cash Flows From Financing Activities Net increase in deposits and repurchase agreements 139,339 139,404 32,580 Proceeds from borrowings, net 8,000 15,000 44,000 Cash dividends paid (9,761) (9,138) (8,670) Proceeds from issuance of common stock 2,389 2,547 2,444 Purchases and retirement of common stock -- (6,528) (5,195) --------- --------- --------- Net cash provided by financing activities 139,967 141,285 65,159 --------- --------- --------- Increase (Decrease) in Cash and Cash Equivalents 14,122 26,487 (10,739) Cash and Cash Equivalents, Beginning of Year 89,401 62,914 73,653 --------- --------- --------- Cash and Cash Equivalents, End of Year $ 103,523 89,401 62,914 ========= ========= ========= Supplemental Disclosures of Cash Flow Information: Cash paid during the period for: Interest $ 31,680 19,764 19,508 Income taxes 11,925 9,738 9,858 Non-cash transactions: Foreclosed loans transferred to other real estate 2,596 1,531 537 Additions to held to maturity securities and borrowings related to deconsolidation of subsidiary trusts -- 1,239 -- Unrealized gain (loss) on securities available for sale, net of taxes (1,362) (417) 287 Other real estate transferred to premises and equipment -- 180 -- </TABLE> See accompanying notes to consolidated financial statements. 64
First Bancorp and Subsidiaries Notes to Consolidated Financial Statements December 31, 2005 Note 1. Summary of Significant Accounting Policies (a) Basis of Presentation - The consolidated financial statements include the accounts of First Bancorp (the Company) and its wholly owned subsidiaries: First Bank (the Bank); Montgomery Data Services, Inc. (Montgomery Data); and First Bancorp Financial Services, Inc. (First Bancorp Financial). The Bank has two wholly owned subsidiaries: First Bank Insurance Services, Inc. (First Bank Insurance), and First Montgomery Financial Services Corporation (First Montgomery). First Montgomery has one wholly owned subsidiary - First Troy Realty Corporation (First Troy). All significant intercompany accounts and transactions have been eliminated. The Company is a bank holding company. The principal activity of the Company is the ownership and operation of First Bank, a state chartered bank with its main office in Troy, North Carolina. Other subsidiaries include Montgomery Data, a data processing company whose primary client is First Bank, and First Bancorp Financial, a real estate investment subsidiary, both of which are headquartered in Troy. The Company is also the parent company for three statutory trusts that were formed in 2002 and 2003 for the purpose of issuing a total of $40 million in debt securities. These securities qualify as Tier I capital for regulatory capital adequacy requirements. First Bank Insurance is a provider of non-FDIC insured investment and insurance products. First Montgomery is a Virginia incorporated company that acquires real estate in Virginia and leases the property to the Bank. First Troy was formed in 1999 for the purpose of allowing the Bank to centrally manage a portion of its real estate loan portfolio. First Montgomery and First Troy were liquidated during 2005 and are no longer active. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates made by the Company in the preparation of its consolidated financial statements are the determination of the allowance for loan losses, the valuation of other real estate, and fair value estimates for financial instruments. (b) Cash and Cash Equivalents - The Company considers all highly liquid assets such as cash on hand, noninterest-bearing and interest-bearing amounts due from banks and federal funds sold to be "cash equivalents." (c) Securities - Debt securities that the Company has the positive intent and ability to hold to maturity are classified as "held-to-maturity" and carried at amortized cost. Securities not classified as held-to-maturity are classified as "available-for-sale" and carried at fair value, with unrealized gains and losses being reported as other comprehensive income and reported as a separate component of shareholders' equity. A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Any equity security that is in an unrealized loss position for twelve consecutive months is presumed to be permanently impaired and an impairment charge is recorded. Gains and losses on sales of securities are recognized at the time of sale based upon the specific identification method. Premiums and discounts are amortized into income on a level yield basis, with premiums 65
being amortized to the earliest call date and discounts being accreted to the stated maturity date. (d) Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation. Depreciation, computed by the straight-line method, is charged to operations over the estimated useful lives of the properties, which range from 5 to 40 years or, in the case of leasehold improvements, over the term of the lease, if shorter. Maintenance and repairs are charged to operations in the year incurred. Gains and losses on dispositions are included in current operations. (e) Loans - Loans are stated at the principal amount outstanding, less unearned income and deferred nonrefundable loan fees, net of certain origination costs. Interest on loans is accrued on the unpaid principal balance outstanding. Net deferred loan origination costs/fees are capitalized and recognized as a yield adjustment over the life of the related loan. Unearned income for each of the reporting periods was immaterial. A loan is placed on nonaccrual status when, in management's judgment, the collection of interest appears doubtful. The accrual of interest is discontinued on all loans that become 90 days or more past due with respect to principal or interest. The past due status of loans is based on the contractual payment terms. While a loan is on nonaccrual status, the Company's policy is that all cash receipts are applied to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to recoveries of any amounts previously charged off. Further cash receipts are recorded as interest income to the extent that any interest has been foregone. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectibility of principal or interest. In some cases, where borrowers are experiencing financial difficulties, loans may be restructured to provide terms significantly different from the originally contracted terms. Commercial loans greater than $100,000 that are on nonaccrual status are evaluated regularly for impairment. A loan is considered to be impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured using either 1) an estimate of the cash flows that the Company expects to receive from the borrower discounted at the loan's effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral is used to value the loan. While a loan is considered to be impaired, the Company's policy is that interest accrual is discontinued and all cash receipts are applied to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to recoveries of any amounts previously charged off. Further cash receipts are recorded as interest income to the extent that any interest has been foregone. (f) Presold Mortgages in Process of Settlement and Loans Held for Sale - As a part of normal business operations, the Company originates residential mortgage loans that have been pre-approved by secondary investors. The terms of the loans are set by the secondary investors, and the purchase price that the investor will pay for the loan is agreed to prior to the funding of the loan by the Company. Generally within three weeks after funding, the loans are transferred to the investor in accordance with the agreed-upon terms. The Company records gains from the sale of these loans on the settlement date of the sale equal to the difference between the proceeds received and the carrying amount of the loan. The gain generally represents the portion of the proceeds attributed to service release premiums received from the investors and the realization of origination fees received from borrowers which were deferred as part of the carrying amount of the loan. Between the initial funding of the loans by the Company and the subsequent reimbursement by the investors, the Company carries the loans on its balance sheet at the lower of cost or market. During 2005, the Company originated $74,569,000 and received proceeds from sales amounting to $72,993,000 related to these types of loans. Periodically, the Company originates commercial loans that are intended for resale. The Company carries these loans at the lower of cost or fair value at each reporting date. There were no such loans held for sale as of December 31, 2005 or 2004. (g) Allowance for Loan Losses - The allowance for loan losses is established through a provision for loan 66
losses charged to expense. Loans are charged-off against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, historical loan loss experience and other risk factors. While management uses the best information available to make evaluations, future adjustments may be necessary if economic and other conditions differ substantially from the assumptions used. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on the examiners' judgment about information available to them at the time of their examinations. (h) Other Real Estate - Other real estate owned consists primarily of real estate acquired by the Company through legal foreclosure or deed in lieu of foreclosure. The property is initially carried at the lower of cost (generally the loan balance plus additional costs incurred for improvements to the property) or estimated fair value of the property less estimated selling costs. If there are subsequent declines in fair value, the property is written down to its fair value through a charge to expense. Capital expenditures made to improve the property are capitalized. Costs of holding real estate, such as property taxes, insurance and maintenance, less related revenues during the holding period, are charged to operations. (i) Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based upon available evidence. The Company's investment tax credits, which for the Company are low income housing tax credits and state historic tax credits, are recorded in the period that they are affirmed by the tax credit fund. (j) Intangible Assets - Business combinations are accounted for using the purchase method of accounting. Identifiable intangible assets are recognized separately and are amortized over their estimated useful lives, which for the Company has generally been ten years and at an accelerated rate. Goodwill is recognized in business combinations to the extent that the price paid exceeds the fair value of the net assets acquired, including any identifiable intangible assets. As discussed in Note 1(n), goodwill is not amortized, but is subject to fair value impairment tests on at least an annual basis. In accordance with applicable accounting standards, the Company records an intangible asset in connection with a defined benefit pension plan to fully accrue for its liability. This intangible asset is adjusted annually in accordance with actuarially determined amounts. The amount of this intangible asset was $273,000 and $84,000 at December 31, 2005 and 2004, respectively. (k) Stock Option Plan - At December 31, 2005, the Company had six stock-based employee compensation plans, which are described more fully in Note 14. The Company accounts for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (APB Opinion No. 25), "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the 67
fair value recognition provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation. For options with vesting requirements, the amount of compensation expense recognized in each period is on a straight-line basis over the vesting period. <TABLE> <CAPTION> Year Ended December 31, -------------------------------------- (In thousands except per share data) 2005 2004 2003 ---------- ---------- ---------- <S> <C> <C> <C> Net income, as reported $ 16,090 20,114 19,417 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (335) (1,291) (319) ---------- ---------- ---------- Pro forma net income $ 15,755 18,823 19,098 ========== ========== ========== Earnings per share: Basic - As reported $ 1.14 1.42 1.38 Basic - Pro forma 1.11 1.33 1.36 Diluted - As reported 1.12 1.40 1.35 Diluted - Pro forma 1.10 1.31 1.33 </TABLE> (l) Per Share Amounts - Basic Earnings Per Share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted Earnings Per Share is computed by assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period. Currently, the Company's only potential dilutive common stock issuances relate to options that have been issued under the Company's stock option plans. In computing Diluted Earnings Per Share, it is assumed that all such dilutive stock options are exercised during the reporting period at their respective exercise prices, with the proceeds from the exercises used by the Company to buy back stock in the open market at the average market price in effect during the reporting period. The difference between the number of shares assumed to be exercised and the number of shares bought back is added to the number of weighted average common shares outstanding during the period. The sum is used as the denominator to calculate Diluted Earnings Per Share for the Company. The following is a reconciliation of the numerators and denominators used in computing Basic and Diluted Earnings Per Share: <TABLE> <CAPTION> For the Years Ended December 31, ---------------------------------------------------------------------------------------------------------------- 2005 2004 2003 ------------------------------------ ------------------------------------ ----------------------------------- ($ in thousands, Income Shares Per Income Shares Per Income Shares Per except per share (Numer- (Denom- Share (Numer- (Denom- Share (Numer- (Denom- Share amounts) ator inator) Amount ator) inator) Amount ator inator) Amount ---------- ----------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> Basic EPS $ 16,090 14,165,992 $ 1.14 $ 20,114 14,138,513 $ 1.42 $ 19,417 14,076,471 $ 1.38 ========== ========== ========== Effect of dilutive securities -- 194,040 -- 256,639 -- 274,635 ---------- ---------- ---------- ---------- ---------- ---------- Diluted EPS $ 16,090 14,360,032 $ 1.12 $ 20,114 14,395,152 $ 1.40 $ 19,417 14,351,106 $ 1.35 ========== ========== ========== ========== ========== ========== ========== ========== ========== </TABLE> For the year ended December 31, 2005, there were 34,000 options that were anti-dilutive because the exercise price exceeded the average market price for the period. For the years ended December 31, 2004 and 2003, there were no anti-dilutive options since the exercise price for each option outstanding was less that the average market price for the year. (m) Fair Value of Financial Instruments - Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments," requires that the Company disclose estimated fair values for its financial instruments. Fair value methods and assumptions are set forth below for the Company's 68
financial instruments. Cash and Due from Banks, Federal Funds Sold, Presold Mortgages in Process of Settlement, Accrued Interest Receivable, and Accrued Interest Payable - The carrying amounts approximate their fair value because of the short maturity of these financial instruments. Available for Sale and Held to Maturity Securities - Fair values are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, financial and agricultural, real estate construction, real estate mortgages and installment loans to individuals. Each loan category is further segmented into fixed and variable interest rate terms. For variable rate loans, the carrying value is a reasonable estimate of the fair value. For fixed rate loans, fair value is determined by discounting scheduled future cash flows using current interest rates offered on loans with similar risk characteristics. Fair values for impaired loans are estimated based on discounted cash flows or underlying collateral values, where applicable. Deposits and Securities Sold Under Agreements to Repurchase - The fair value of securities sold under agreements to repurchase and deposits with no stated maturity, such as non-interest-bearing demand deposits, savings, NOW, and money market accounts, is equal to the amount payable on demand as of the valuation date. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. Borrowings - The fair value of borrowings is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered by the Company's lenders for debt of similar remaining maturities. Commitments to Extend Credit and Standby Letters of Credit - At December 31, 2005 and 2004, the Company's off-balance sheet financial instruments had no carrying value. The large majority of commitments to extend credit and standby letters of credit are at variable rates and/or have relatively short terms to maturity. Therefore, the fair value for these financial instruments is considered to be immaterial. (n) Impairment - Goodwill is evaluated for impairment on at least an annual basis by comparing the fair value of its reporting units to their related carrying value. If the carrying value of a reporting unit exceeds its fair value, the Company determines whether the implied fair value of the goodwill, using a discounted cash flow analysis, exceeds the carrying value of the goodwill. If the carrying value of the goodwill exceeds the implied fair value of the goodwill, an impairment loss is recorded in an amount equal to that excess. For all other long-lived assets, including identifiable intangible assets, the Company reviews them for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company's policy is that an impairment loss is recognized if the sum of the undiscounted future cash flows is less than the carrying amount of the asset. Any of long-lived assets to be disposed of are reported at the lower of the carrying amount or fair value, less costs to sell. To date, the Company has not had to record any impairment write-downs of its long-lived assets or goodwill. (o) Comprehensive Income - Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income. Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards. The components of accumulated other comprehensive income for the Company are as follows: 69
December 31, December 31, December 31, 2005 2004 2003 ---------- ---------- ---------- Unrealized gain (loss) on securities available for sale $ (1,049) 1,186 1,868 Deferred tax asset (liability) 410 (463) (728) ---------- ---------- ---------- Net unrealized gain (loss) on securities available for sale (639) 723 1,140 ---------- ---------- ---------- Additional minimum pension liability (428) (338) (292) Deferred tax asset 167 132 114 ---------- ---------- ---------- Net additional minimum pension liability (261) (206) (178) ---------- ---------- ---------- Total accumulated other comprehensive income (loss) $ (900) 517 962 ========== ========== ========== (p) Segment Reporting - SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" requires management to report selected financial and descriptive information about reportable operating segments. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. Generally, disclosures are required for segments internally identified to evaluate performance and resource allocation. The Company's operations are primarily within the banking segment, and the financial statements presented herein reflect the results of that segment. Also, the Company has no foreign operations or customers. (q) Reclassifications - Certain amounts for prior years have been reclassified to conform to the 2005 presentation. The reclassifications had no effect on net income or shareholders' equity as previously presented, nor did they materially impact trends in financial information. (r) Stock Split - The Company paid a 3-for-2 stock split on November 15, 2004. All previously reported share totals and per share amounts have been adjusted to retroactively reflect the effect of the split. (s) Recent Accounting Pronouncements - In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities," which was subsequently revised in December 2003. FIN 46 addresses the consolidation by business enterprises of certain variable interest entities. The provisions of this interpretation became effective for the Company on January 31, 2003 as it relates to variable interest entities created or purchased after that date. In December 2003, the FASB issued a revision to FIN 46 (FIN 46R), which clarified and interpreted certain of the provisions of FIN 46, without changing the basic accounting model in FIN 46. The provisions of FIN 46R were effective no later than March 31, 2004. The adoption of FIN 46 did not have an impact on the Company's financial position or results of operations, as the Company had no investments in variable interest entities that required consolidation under FIN 46. The application of FIN 46R during 2004 resulted in the de-consolidation of three trusts that the Company established in order to issue $40 million in trust preferred capital securities. The de-consolidation of the trusts resulted in the Company recording the amount of the junior subordinated debentures between the Company and the trust subsidiary in the amount of $1,239,000. Previously, the junior subordinated debentures were eliminated in consolidation. The impact of this change was to increase both securities (held-to-maturity) and borrowings by $1,239,000 each. Additional information regarding the Company's trust preferred securities is included in Note 9. From November 2003 through November 2005, the FASB issued several sets of guidance relating to the concept of "other-than-temporary impairment" and its applicability to investments. The final guidance, as stated in Staff Position FAS 115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," requires the disclosure of information about unrealized losses associated with debt and equity securities, while affirming the existing requirements for determining whether impairment is 70
other-than-temporary. The required disclosures are presented in Note 3. In December 2003, the FASB issued Statement of Financial Accounting Standards No. 132 (revised 2003) (Statement 132(R)), "Employers' Disclosures about Pensions and Other Postretirement Benefits." Statement 132(R) revises employers' disclosures about pension plans and other postretirement plans, but does not change the measurement or recognition of those plans. Statement No. 132(R) requires additional disclosures about the assets, obligations, cash flows, and net periodic pension cost of defined benefit plans and other defined benefit postretirement plans. Most of the provisions of Statement 132(R) became effective for financial statements with fiscal years after December 15, 2003, with certain provisions becoming effective for fiscal years ending after June 15, 2004. The additional disclosures required for the Company are included in Note 11. In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3 (SOP 03-3), "Accounting for Certain Loans or Debt Securities Acquired in a Transfer." SOP 03-3 provides guidance on the accounting for differences between contractual and expected cash flows from the purchaser's initial investment in loans or debt securities acquired in a transfer, if those differences are attributable, at least in part, to credit quality. The scope of SOP 03-3 includes loans that have shown evidence of deterioration of credit quality since origination, and includes loans acquired individually, in pools or as part of a business combination. Among other things, SOP 03-3: (1) prohibits the recognition of the excess of contractual cash flows over expected cash flows as an adjustment of yield, loss accrual or valuation allowance at the time of purchase; (2) requires that subsequent increases in expected cash flows be recognized prospectively through an adjustment of yield; and (3) requires that subsequent decreases in expected cash flows be recognized as impairment. In addition, SOP 03-3 prohibits the creation or carrying over of a valuation allowance in the initial accounting of all loans within the scope that are acquired in a transfer. Under SOP 03-3, the difference between expected cash flows and the purchase price is accreted as an adjustment to yield over the life of the loans. For loans acquired in a business combination that have shown deterioration of credit quality since origination, SOP 03-3 represents a significant change from the previous purchase accounting practice whereby the acquiree's allowance for loan losses is typically added to the acquirer's allowance for loan losses. SOP 03-3 became effective for loans or debt securities acquired by the Company beginning on January 1, 2005. The adoption of this statement in the first quarter of 2005 did not have an impact on the Company's financial statements; however it will change, on a prospective basis, the way that the Company accounts for loans and debt securities that it acquires in the future. In March 2004, the Securities and Exchange Commission (the "SEC") issued Staff Accounting Bulletin Number 105 (SAB 105), "Application of Accounting Principles to Loan Commitments." SAB 105 summarizes the views of the SEC staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivatives, and its provisions were required for such loan commitments entered into subsequent to March 31, 2004. The adoption of SAB 105 did not have a material impact on the Company's consolidated financial statements. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) (Statement 123(R)), "Share-Based Payment." Statement 123(R) replaces FASB Statement No. 123 (Statement 123), "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25 (Opinion 25), "Accounting for Stock Issued to Employees." Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, Statement 123 permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Statement 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Currently, the only share-based compensation arrangement utilized by the Company is stock options. Under the original provisions of Statement 123(R), it was to have become effective as of the first interim or annual reporting period that began after June 15, 2005. However in April 2005, 71
the Securities and Exchange Commission effectively delayed the adoption of Statement 123(R) for the Company until January 1, 2006. In 2006, 2007, and 2008 the Company's stock-based compensation expense related to options currently outstanding will be approximately $126,000, $47,000, and $3,000 respectively. In addition, the Company expects to continue to grant 2,250 stock options to each of the Company's non-employee directors in June of each year until the 2014 expiration of the current stock option plan. In 2005, the amount of pro forma expense associated with the June director grants was $127,000. In December 2005, the FASB issued Staff Position SOP 94-6-1, "Terms of Loan Products that May Give Rise to a Concentration of Credit Risk" ("FSP SOP 94-6-1"). FSP SOP 94-6-1 addresses 1) the circumstances under which the terms of loan products give rise to a concentration of credit risk, and 2) the disclosures or other accounting considerations that apply for entities that originate, hold guarantee, service, or invest in loan products with terms that may give rise to a concentration of credit risk. The disclosures required by FSB SOP 94-6-1 are required for interim and annual periods ending after December 19, 2005. See Note 12 for this discussion as it relates to the Company. Note 2. Completed Acquisitions There were no acquisitions during 2004 or 2005. The Company completed the following acquisitions during 2003. The results of each acquired company are included in First Bancorp's results for the period ended December 31, 2003 beginning on their respective acquisition dates. (a) On January 2, 2003, the Company completed the acquisition of Uwharrie Insurance Group, a Montgomery County based property and casualty insurance agency. With eight employees, Uwharrie Insurance Group, Inc. serves approximately 5,000 customers, primarily from its Troy-based headquarters, and has annual commissions of approximately $500,000. The primary reason for the acquisition was to gain efficiencies of scale with the Company's existing property and casualty insurance business. In accordance with the terms of the merger agreement, the Company paid cash in the amount of $546,000 to complete the acquisition. In addition, the Company incurred $18,000 in other direct costs to complete the acquisition. As of the date of the acquisition, the value of the assets of Uwharrie Insurance Group amounted to $20,000 (consisting primarily of premises and equipment), which resulted in the Company recording an intangible asset of approximately $544,000. Based on an independent appraisal, the allocation among types of intangible assets and related amortization periods are: Type of Intangible Asset Allocated Amount Amortization Period - ----------------------------- ---------------- -------------------------- Value of Noncompete Agreement $ 50,000 Two years - straight-line Value of Customer List 151,000 Ten years - straight-line Goodwill 343,000 Not applicable ---------------- Total Intangible Assets $ 544,000 ================ For tax purposes, each of the intangible assets recorded will result in tax-deductible amortization expense. No pro forma earnings information has been presented due to the immateriality of the acquisition. (b) On January 15, 2003, the Company completed the acquisition of Carolina Community Bancshares, Inc. (CCB), the parent company of Carolina Community Bank, a South Carolina community bank with three branches in Dillon County, South Carolina. This represented the Company's first entry into South Carolina. Dillon County, South Carolina is contiguous to Robeson County, North Carolina, a county where the Company operates four branches. The Company's primary reason for the acquisition was to expand into a contiguous market with facilities, operations and experienced staff in place. The terms of the agreement called for shareholders of Carolina Community to receive 1.2 shares of First Bancorp stock and $20.00 in cash for each share of Carolina Community stock they own. The transaction was completed on January 15, 2003 with the Company paying cash of $8.3 million, issuing 499,332 shares of common stock that were valued at approximately $8.4 million, and assuming employee stock options with an intrinsic value of approximately $0.9 million. The value of the stock issued was determined using a Company stock price of $16.81, which was the average price of Company stock 72
during the five day period beginning two days before the acquisition announcement and ending two days after the acquisition announcement (as adjusted for the November 15, 2004 3-for-2 stock split). The value of the employee stock options assumed was determined using the Black-Scholes option-pricing model. This acquisition has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of CCB were recorded based on estimates of fair values as of January 15, 2003. Except as noted beginning in the next sentence, the table below is a condensed balance sheet disclosing the amount assigned to each major asset and liability caption of CCB on January 15, 2003, and the related fair value adjustments recorded by the Company to reflect the acquisition. The "Other" category in the table below amounting to $755,000 consists solely of the net tax asset recorded in connection with the acquisition and was originally a liability of $243,000. In 2004, the Company recorded three adjustments to the purchase price allocation totaling $998,000, each of which related to taxes, as explained in the following sentences. It was determined in 2004 that $895,000 of the amount originally recorded as goodwill at the acquisition date was deductible for tax purposes, with all other goodwill associated with this transaction being nondeductible. The tax impact of these deductions was approximately $353,000. It was also determined in 2004 that a deferred tax valuation allowance that had been recorded by CCB in the amount of $224,000 was no longer necessary. Additionally the Company has realized $421,000 in tax benefits related to the exercise of nonqualified stock options that were assumed in the merger. Accordingly, in 2004, the Company reduced its tax liability by $998,000, with a corresponding decrease to goodwill. The table below includes the impact of the 2004 adjustments. <TABLE> <CAPTION> As Fair As ($ in thousands) Recorded by Value Recorded by CCB Adjustments First Bancorp -------- -------- -------- <S> <C> <C> <C> Assets - ------------------------------------------ Cash and cash equivalents $ 7,048 -- 7,048 Securities 12,995 99 (a) 13,094 Loans, gross 47,716 -- 47,716 Allowance for loan losses (751) -- (751) Premises and equipment 799 (45)(b) 754 Other - Identifiable intangible asset -- 771 (c) 771 Other 1,697 755 (d) 2,452 -------- -------- -------- Total 69,504 1,580 71,084 -------- -------- -------- Liabilities - ------------------------------------------ Deposits $ 58,861 -- 58,861 Borrowings 2,000 115 (e) 2,115 Other 722 (88)(f) 634 -------- -------- -------- Total 61,583 27 61,610 -------- -------- -------- Net identifiable assets acquired 9,474 Total cost of acquisition Cash $ 8,322 Value of stock issued 8,395 Value of assumed options 889 Direct costs of acquisition 1,270 -------- Total cost of acquisition 18,876 -------- Goodwill recorded related to acquisition of CCB $ 9,402 ======== </TABLE> 73
Explanation of Fair Value Adjustments - ------------------------------------- (a) This fair value adjustment represents the net unrealized gain of CCB's held-to-maturity securities portfolio. This fair value adjustment was recorded by the Company as a premium on securities and will be amortized as a reduction of investment interest income over the life of the related securities, which have an average life of approximately four years. (b) This fair value adjustment represents the book value of certain equipment owned by CCB that became obsolete upon the acquisition. (c) This fair value adjustment represents the value of the core deposit base assumed in the acquisition based on a study performed by an independent consulting firm. This amount was recorded by the Company as an identifiable intangible asset and will be amortized as expense on an accelerated basis over a ten year period based on an amortization schedule provided by the consulting firm. (d) This fair value adjustment represents the net tax asset recorded related to the accounting for the acquisition. (e) This fair value adjustment was recorded because the interest rates of CCB's borrowings exceeded current interest rates on similar borrowings. This amount will be amortized to reduce interest expense over the remaining lives of the related borrowings, which have a weighted average life of approximately 3.7 years. (f) This fair value adjustment represents the carrying value of a retirement plan liability that was terminated in accordance with the terms of the merger agreement. The following unaudited pro forma financial information presents the combined results of the Company and CCB as if the acquisition had occurred as of January 1, 2002, after giving effect to certain adjustments, including amortization of the core deposit intangible, an assumed cost of funds related to the cash paid of 6%, and related income tax effects. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company and CCB constituted a single entity during such period. Because the acquisition took place on January 15, 2003, pro forma results for 2003 are not provided. ($ in thousands, except share data) Year Ended December 31, 2002 ----------------- Net interest income $ 52,200 Noninterest income 12,717 Net income 17,748 Earnings per share Basic 1.25 Diluted 1.22 The above pro forma results include charges recorded by CCB in the fourth quarter of 2002 related to the impending merger with the Company. These expenses amounted to $255,375 on a pretax basis and $198,432 on an after-tax basis. (c) On October 24, 2003, the Company completed the acquisition of four branches of RBC Centura Bank located in Fairmont, Harmony, Kenansville, and Wallace, all in North Carolina. As of the date of the acquisition, the branches had a total of approximately $102 million in deposits and $25 million in loans. The primary reason for the acquisition was to expand into new markets and increase the Company's customer base. Subject to certain limitations, the Company paid a deposit premium of 14.1% for the branches, which resulted in the Company recording intangible assets relating to this purchase of $14.2 million, all of which is deductible for tax purposes. The identifiable intangible asset associated with the fair value of the core deposit base, as determined 74
by an independent consulting firm, was determined to be approximately $1.3 million and is being amortized as expense on an accelerated basis over a ten year period based on an amortization schedule provided by the consulting firm. The remaining intangible asset of $12.9 million has been classified as goodwill, and thus is not being systematically amortized, but rather is subject to an annual impairment test. The primary factors that contributed to a purchase price that resulted in recognition of goodwill were the Company's desire to expand in four new markets with facilities, operations and experienced staff in place. These four branches' operations are included in the accompanying Consolidated Statements of Income beginning on the acquisition date of October 24, 2003. Historical financial information related to the four branches while owned by RBC Centura Bank is not available, and thus pro forma results of operations have not been presented. The following table contains a condensed balance sheet that indicates the amount assigned to each major asset and liability as of the respective acquisition dates for the 2003 acquisitions described above. Uwharrie Carolina RBC Insurance Community Centura Assets acquired Group Bank Branches Total ----------------------------- -------- -------- -------- -------- (in millions) Cash $ -- 7.0 62.4 69.4 Securities -- 13.1 -- 13.1 Loans, gross -- 47.7 24.8 72.5 Allowance for loan losses -- (0.8) (0.3) (1.1) Premises and equipment -- 0.8 1.0 1.8 Other -- 2.5 0.2 2.7 -------- -------- -------- -------- Total assets acquired -- 70.3 88.1 158.4 -------- -------- -------- -------- Liabilities assumed ----------------------------- Deposits -- 58.9 102.0 160.9 Borrowings -- 2.1 -- 2.1 Other -- 0.6 0.3 0.9 -------- -------- -------- -------- Total liabilities assumed -- 61.6 102.3 163.9 -------- -------- -------- -------- Value of cash paid and/or stock issued to stock-holders of acquiree 0.5 18.9 n/a 19.4 -------- -------- -------- -------- Intangible assets recorded $ 0.5 10.2 14.2 24.9 ======== ======== ======== ======== 75
Note 3. Securities The book values and approximate fair values of investment securities at December 31, 2005 and 2004 are summarized as follows: <TABLE> <CAPTION> 2005 2004 --------------------------------------------- ---------------------------------------------- Amortized Fair Unrealized Amortized Fair Unrealized Cost Value Gains (Losses) Cost Value Gains (Losses) --------- --------- --------- --------- --------- --------- --------- --------- <S> <C> <C> <C> <C> <C> <C> <C> <C> (In thousands) Securities available for sale: U.S. Government agencies $ 45,258 44,481 -- (777) 29,778 29,810 169 (137) Mortgage-backed securities 49,235 47,928 13 (1,320) 41,116 41,062 240 (294) Corporate bonds 13,929 14,912 1,067 (84) 10,909 12,084 1,194 (19) Equity securities 6,240 6,292 56 (4) 5,565 5,598 39 (6) --------- --------- --------- --------- --------- --------- --------- --------- Total available for sale $ 114,662 113,613 1,136 (2,185) 87,368 88,554 1,642 (456) ========= ========= ========= ========= ========= ========= ========= ========= Securities held to maturity: State and local governments $ 11,382 11,531 181 (32) 11,605 12,031 435 (9) Other 2,790 2,790 -- -- 2,420 2,420 -- -- --------- --------- --------- --------- --------- --------- --------- --------- Total held to maturity $ 14,172 14,321 181 (32) 14,025 14,451 435 (9) ========= ========= ========= ========= ========= ========= ========= ========= </TABLE> Included in mortgage-backed securities at December 31, 2005 were collateralized mortgage obligations with an amortized cost of $15,810,000 and a fair value of $15,399,000. Included in mortgage-backed securities at December 31, 2004 were collateralized mortgage obligations with an amortized cost of $15,928,000 and a fair value of $15,831,000. The Company owned Federal Home Loan Bank stock with a cost and fair value of $5,930,000 at December 31, 2005 and $5,247,000 at December 31, 2004, which is included in equity securities above and serves as part of the collateral for the Company's line of credit with the Federal Home Loan Bank (see Note 9 for additional discussion). The investment in this stock is a requirement for membership in the Federal Home Loan Bank system. The following table presents information regarding securities with unrealized losses at December 31, 2005: <TABLE> <CAPTION> Securities in an Unrealized Securities in an Unrealized Loss Position for Loss Position for Less than 12 Months More than 12 Months Total ----------------------- ----------------------- ----------------------- Unrealized Unrealized Unrealized Fair Value Losses Fair Value Losses Fair Value Losses ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> U.S. Government agencies $ 25,004 380 16,477 397 41,481 777 Mortgage-backed securities 30,729 667 15,955 653 46,684 1,320 Corporate bonds -- -- 3,016 84 3,016 84 Equity securities 38 4 -- -- 38 4 State and local governments 1,921 15 417 17 2,338 32 ---------- ---------- ---------- ---------- ---------- ---------- Total temporarily impaired securities $ 57,692 1,066 35,865 1,151 93,557 2,217 ========== ========== ========== ========== ========== ========== </TABLE> 76
The following table presents information regarding securities with unrealized losses at December 31, 2004: <TABLE> <CAPTION> Securities in an Unrealized Securities in an Unrealized Loss Position for Loss Position for Less than 12 Months More than 12 Months Total ----------------------- ----------------------- ----------------------- Unrealized Unrealized Unrealized Fair Value Losses Fair Value Losses Fair Value Losses ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> U.S. Government agencies $ 16,731 137 -- -- 16,731 137 Mortgage-backed securities 4,533 30 16,361 264 20,894 294 Corporate bonds 3,081 19 -- -- 3,081 19 Equity securities 53 6 -- -- 53 6 State and local governments 925 9 -- -- 925 9 ---------- ---------- ---------- ---------- ---------- ---------- Total temporarily impaired securities $ 25,323 201 16,361 264 41,684 465 ========== ========== ========== ========== ========== ========== </TABLE> In the above tables, all of the non-equity securities that are in an unrealized loss position at December 31, 2005 and 2004 are bonds that the company has determined are in a loss position due to interest rate factors, and not because of credit quality concerns. Therefore, the Company expects to collect the full par value of each bond upon maturity with no accounting loss. The Company has concluded that each of the equity securities in an unrealized loss position at December 31, 2005 and 2004 is due to minor temporary fluctuations in the market prices of the securities. The Company's policy is to record an impairment charge for any of these equity securities that remains in an unrealized loss position for twelve consecutive months. The aggregate carrying amount of cost-method investments was $8,803,000 and $6,508,000 at December 31, 2005 and 2004, respectively, which included the Federal Home Loan Bank stock discussed above. The Company determined that none of its cost-method investments were impaired at either year end. The book values and approximate fair values of investment securities at December 31, 2005, by contractual maturity, are summarized in the table below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. <TABLE> <CAPTION> Securities Available for Sale Securities Held to Maturity ----------------------------- ---------------------------- Amortized Fair Amortized Fair (In thousands) Cost Value Cost Value ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Debt securities Due within one year $ 2,300 2,268 $ 1,323 1,325 Due after one year but within five years 37,285 36,579 9,502 9,589 Due after five years but within ten years 8,663 8,645 3,061 3,121 Due after ten years 10,939 11,901 286 286 Mortgage-backed securities 49,235 47,928 -- -- ---------- ---------- ---------- ---------- Total debt securities 108,422 107,321 14,172 14,321 Equity securities 6,240 6,292 -- -- ---------- ---------- ---------- ---------- Total securities $ 114,662 113,613 $ 14,172 14,321 ========== ========== ========== ========== </TABLE> At December 31, 2005 and 2004, investment securities with book values of $88,581,000 and $43,315,000, respectively, were pledged as collateral for public and private deposits and securities sold under agreements to repurchase. Sales of securities available for sale with aggregate proceeds of $17,000 in 2005, $12,060,000 in 2004, and $7,750,000 in 2003 resulted in gross gains of $5,000 and no gross losses in 2005, resulted in gross gains of $299,000 and no gross losses in 2004, and gross gains of $218,000 and no gross losses in 2003. 77
Note 4. Loans and Allowance for Loan Losses Loans at December 31, 2005 and 2004 are summarized as follows: (In thousands) 2005 2004 ---------- ---------- Commercial, financial, and agricultural $ 135,942 122,501 Real estate - construction 125,158 117,158 Real estate - mortgage 1,150,068 1,063,694 Installment loans to individuals 71,259 63,913 ---------- ---------- Subtotal 1,482,427 1,367,266 Unamortized net deferred loan costs (fees) 184 (213) ---------- ---------- Loans, net of deferred fees $1,482,611 1,367,053 ========== ========== Loans described above as "Real estate - mortgage" included loans in the amounts of $1,050,191,000 and $999,384,000 as of December 31, 2005 and 2004, respectively, which are being pledged as collateral for certain borrowings (see Note 9). The loans above also include loans to executive officers and directors and to their associates totaling approximately $12,857,000 and $13,764,000 at December 31, 2005 and 2004, respectively. During 2005, additions to such loans were approximately $930,000 and repayments totaled approximately $1,837,000. These loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other non-related borrowers. Management does not believe these loans involve more than the normal risk of collectibility or present other unfavorable features. Nonperforming assets at December 31, 2005 and 2004 are as follows: (In thousands) 2005 2004 ---------- ---------- Loans: Nonaccrual loans $ 1,640 3,707 Restructured loans 13 17 Accruing loans greater than 90 days past due -- -- ---------- ---------- Total nonperforming loans 1,653 3,724 Other real estate (included in other assets) 1,421 1,470 ---------- ---------- Total nonperforming assets $ 3,074 5,194 ========== ========== If the nonaccrual loans and restructured loans as of December 31, 2005, 2004 and 2003 had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period), gross interest income in the amounts of approximately $123,000, $247,000 and $319,000 for nonaccrual loans and $2,000, $2,000 and $2,000 for restructured loans would have been recorded for 2005, 2004 and 2003, respectively. Interest income on such loans that was actually collected and included in net income in 2005, 2004 and 2003 amounted to approximately $67,000, $120,000 and $102,000 for nonaccrual loans (prior to their being placed on nonaccrual status) and $2,000, $2,000 and $2,000 for restructured loans, respectively. At December 31, 2005 and 2004, the Company had no commitments to lend additional funds to debtors whose loans were nonperforming. 78
Activity in the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003 is as follows: (In thousands) 2005 2004 2003 -------- -------- -------- Balance, beginning of year $ 14,717 13,569 10,907 Provision for loan losses 3,040 2,905 2,680 Recoveries of loans charged-off 322 181 240 Loans charged-off (2,363) (1,938) (1,341) Allowance recorded related to loans assumed in corporate acquisitions -- -- 1,083 -------- -------- -------- Balance, end of year $ 15,716 14,717 13,569 ======== ====== ====== At December 31, 2005 and 2004, the recorded investment in loans considered to be impaired was $338,000 and $1,578,000, respectively, of which all were on a nonaccrual basis at each year end. The related allowance for loan losses for the impaired loans at December 31, 2005 and 2004 was $100,000 and $370,000, respectively. At December 31, 2005, there were no impaired loans that did not have a related allowance. At December 31, 2004, there was $532,000 in impaired loans for which there was no related allowance. The average recorded investments in impaired loans during the years ended December 31, 2005, 2004, and 2003 were approximately $1,474,000, $1,317,000, and $1,590,000, respectively. For the years ended December 31, 2005, 2004, and 2003, the Company recognized no interest income on those impaired loans during the period that they were considered to be impaired. Note 5. Premises and Equipment Premises and equipment at December 31, 2005 and 2004 consist of the following: (In thousands) 2005 2004 -------- -------- Land $ 7,819 7,812 Buildings 27,097 21,725 Furniture and equipment 19,118 17,388 Leasehold improvements 1,204 1,236 -------- -------- Total cost 55,238 48,161 Less accumulated depreciation and amortization (20,398) (17,843) -------- -------- Net book value of premises and equipment $ 34,840 30,318 ======== ======== 79
Note 6. Goodwill and Other Intangible Assets The following is a summary of the gross carrying amount and accumulated amortization of amortized intangible assets as of December 31, 2005 and December 31, 2004 and the carrying amount of unamortized intangible assets as of December 31, 2005 and December 31, 2004. <TABLE> <CAPTION> December 31, 2005 December 31, 2004 ---------------------------- ---------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Amount Amortization Amount Amortization - ------------------------------- ------------- ------------ ------------- ------------ <S> <C> <C> <C> <C> (In thousands) Amortized intangible assets: Customer lists $ 394 115 394 85 Noncompete agreements 50 50 50 50 Core deposit premiums 2,441 1,011 2,441 751 ------------ ------------ ------------ ------------ Total $ 2,885 1,176 2,885 886 ============ ============ ============ ============ Unamortized intangible assets: Goodwill $ 47,247 47,247 ============ ============ Pension $ 273 84 ============ ============ </TABLE> The following table presents the estimated amortization expense for intangible assets for each of the five calendar years ending December 31, 2010 and the estimated amount amortizable thereafter. These estimates are subject to change in future periods to the extent management determines it is necessary to make adjustments to the carrying value or estimated useful lives of amortized intangible assets. Estimated Amortization Expense -------------------- -------------------- (In thousands) 2006 $ 242 2007 220 2008 219 2009 218 2010 218 Thereafter 592 ------------- Total 1,709 ============= 80
Note 7. Income Taxes Total income taxes for the years ended December 31, 2005, 2004 and 2003 were allocated as follows: <TABLE> <CAPTION> (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Allocated to net income $ 16,829 10,418 10,617 Allocated to stockholders' equity, for unrealized holding gain/loss on debt and equity securities for financial reporting purposes (872) (265) 183 Allocated to stockholders' equity, for tax benefit of additional pension charge (35) (18) (50) -------- -------- -------- Total income taxes $ 15,922 10,135 10,750 ======== ======== ======== </TABLE> The components of income tax expense (benefit) for the years ended December 31, 2005, 2004 and 2003 are as follows: (In thousands) 2005 2004 2003 -------- -------- -------- Current - Federal $ 8,285 10,407 9,578 - State 8,700 228 614 Deferred - Federal (124) (192) 425 - State (32) (25) -- -------- -------- -------- Total $ 16,829 10,418 10,617 ======== ======== ======== The sources and tax effects of temporary differences that give rise to significant portions of the deferred tax assets (liabilities) at December 31, 2005 and 2004 are presented below: <TABLE> <CAPTION> (In thousands) 2005 2004 ------- ------- <S> <C> <C> Deferred tax assets: Allowance for loan losses $ 6,075 5,456 Excess book over tax SERP retirement plan cost 739 550 Basis of investment in subsidiary 69 69 Net loan fees recognized for tax reporting purposes -- 55 Reserve for employee medical expense for financial reporting purposes 20 20 Deferred compensation 180 156 State net operating loss carryforwards 282 352 Trust preferred security issuance costs 206 128 Accruals, book versus tax 154 160 Minimum pension liability adjustment 167 132 Unrealized loss on securities available for sale 409 -- All other 27 35 ------- ------- Gross deferred tax assets 8,328 7,113 Less: Valuation allowance (275) (367) ------- ------- Net deferred tax assets 8,053 6,746 ------- ------- Deferred tax liabilities: Loan fees (1,115) (1,050) Excess tax over book pension cost (603) (559) Depreciable basis of fixed assets (1,689) (1,906) Amortizable basis of intangible assets (3,166) (2,378) Unrealized gain on securities available for sale -- (464) Net loan fees recognized for tax reporting purposes (69) -- FHLB stock dividends (436) (439) Book versus tax basis difference - securities (7) (46) ------- ------- Gross deferred tax liabilities (7,085) (6,842) ------- ------- Net deferred tax asset (liability) - included in other assets $ 968 (96) ======= ======= </TABLE> A portion of the annual change in the net deferred tax liability relates to unrealized gains and losses on securities available for sale. The related 2005 and 2004 deferred tax (benefit) of approximately ($872,000) and 81
($265,000), respectively, has been recorded directly to shareholders' equity. Additionally, a portion of the annual change in the net deferred tax liability relates to an additional pension charge. The related 2005 and 2004 deferred tax (benefit) of ($35,000) and ($18,000), respectively, has been recorded directly to shareholders' equity. The balance of the 2005 and 2004 increase (decrease) in the net deferred tax asset (liability) of ($156,000) and ($217,000), respectively, is reflected as a deferred income tax expense (benefit) in the consolidated statement of income. The valuation allowances for 2005 and 2004 relate primarily to state net operating loss carryforwards. It is management's belief that the realization of the remaining net deferred tax assets is more likely than not. See Note 12 for discussion regarding state taxing authority exposure. Retained earnings at December 31, 2005 and 2004 includes approximately $6,869,000 representing pre-1988 tax bad debt reserve base year amounts for which no deferred income tax liability has been provided since these reserves are not expected to reverse or may never reverse. Circumstances that would require an accrual of a portion or all of this unrecorded tax liability are a reduction in qualifying loan levels relative to the end of 1987, failure to meet the definition of a bank, dividend payments in excess of accumulated tax earnings and profits, or other distributions in dissolution, liquidation or redemption of the Bank's stock. The following is a reconcilement of federal income tax expense at the statutory rate of 35% to the income tax provision reported in the financial statements. <TABLE> <CAPTION> (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Tax provision at statutory rate $ 11,522 10,686 10,512 Increase (decrease) in income taxes resulting from: Tax-exempt interest income (251) (263) (286) Low income housing tax credits (109) (98) (20) Non-deductible interest expense 20 14 16 State income taxes, net of federal benefit 5,634 132 361 Change in valuation allowance (92) 153 78 Non-deductible penalty 50 -- -- Other, net 55 (206) (44) -------- -------- -------- Total $ 16,829 10,418 10,617 ======== ======== ======== </TABLE> Note 8. Time Deposits and Securities Sold Under Agreements to Repurchase At December 31, 2005, the scheduled maturities of time deposits are as follows: (In thousands) 2006 $ 688,704 2007 77,846 2008 35,561 2009 16,210 2010 21,823 Thereafter 2,161 ------------ $ 842,305 ============ Securities sold under agreement to repurchase represent short term borrowings by the Company with maturities less than one year and are collateralized by a portion of the Company's United States government agency obligations, which have been delivered to a third party custodian for safekeeping. At December 31, 2005, securities with an amortized cost of $48,830,000 and a market value of $47,835,000 were pledged to secure securities sold under agreements to repurchase. 82
The following table presents certain information for securities sold under agreements to repurchase: 2005 2004 ------- ------- Balance at December 31 $33,530 -- Weighted average interest rate at December 31 3.08% -- Maximum amount outstanding at an month-end during the year $33,530 -- Average daily balance outstanding during the year $ 6,219 -- Average annual interest rate paid during the year 2.88% -- Note 9. Borrowings and Borrowings Availability The following table presents information regarding the Company's outstanding borrowings at December 31, 2005 and 2004: <TABLE> <CAPTION> Description Due date Call Feature Amount Interest Rate - -------------------- -------------------------- ------------------------ ------------- ------------------------ 2005 - -------------------- <S> <C> <C> <C> <C> FHLB Overnight January 1, 2006, renewable None $30,000,000 4.49% subject to change daily FHLB Term Note Due February 15, 2006 None 6,500,000 3.47% fixed FHLB Term Note Due March 13, 2006 None 2,000,000 2.44% fixed FHLB Term Note Due May 15, 2006 None 7,500,000 3.51% fixed FHLB Term Note Due August 10, 2006 None 5,000,000 3.60% fixed FHLB Term Note Due March 13, 2007 None 2,000,000 2.91% fixed FHLB Term Note Due June 23, 2008 None 1,000,000 5.51% fixed FHLB Term Note Due on April 21, 2009 Expired (One time call 5,000,000 5.26% fixed option in 2004 not exercised by FHLB) Trust Preferred Due on November 7, 2032 By Company on a quarterly 20,619,000 7.79% at Dec. 31, 2005 Securities basis beginning on adjustable rate November 7, 2007 3 month LIBOR + 3.45% Trust Preferred Due on January 23, 2034 By Company on a 20,620,000 6.94% at Dec. 31, 2005 Securities quarterly basis beginning adjustable rate on January 23, 2009 3 month LIBOR + 2.70% ------------ ------------------------- Total borrowings/ 5.47% (5.88% excluding weighted average $100,239,000 overnight borrowings) rate ============ ========================= </TABLE> 83
<TABLE> <CAPTION> Description Due date Call Feature Amount Interest Rate - -------------------- -------------------------- ------------------------ ------------- ------------------------ 2004 - -------------------- <S> <C> <C> <C> <C> FHLB Overnight January 1, 2005, renewable None $40,000,000 2.55% subject to Borrowings daily change daily FHLB Term Note Due January 16, 2005 None 1,000,000 4.01% fixed FHLB Term Note Due March 13, 2006 None 2,000,000 2.44% fixed FHLB Term Note Due March 13, 2007 None 2,000,000 2.91% fixed FHLB Term Note Due June 23, 2008 None 1,000,000 5.51% fixed FHLB Term Note Due on April 21, 2009 Expired (One time call 5,000,000 5.26% fixed option in 2004 not exercised by FHLB) Trust Preferred Due on November 7, 2032 By Company on a quarterly 20,619,000 5.73% at Dec. 31, 2004 Securities basis beginning on adjustable rate November 7, 2007 3 month LIBOR + 3.45% Trust Preferred Due on January 23, 2034 By Company on a 20,620,000 4.86% at Dec. 31, 2004 Securities quarterly basis beginning adjustable rate on January 23, 2009 3 month LIBOR + 2.70% ----------- ------------------------ Total borrowings/ weighted 3.98% (5.07% excluding average rate $92,239,000 overnight borrowings) =========== ========================= </TABLE> In the tables above, only the $5 million due to the FHLB on April 21, 2009 had a lender call provision, which allowed the FHLB, at their option, to call the bond on April 21, 2004. The call provision provided interest rate protection to the FHLB in the event that prevailing market interest rates were higher than the note rate on the date of the call. This call option was not exercised by the FHLB at the April 21, 2004 call date. In addition to the call option, all outstanding FHLB borrowings may be accelerated immediately by the FHLB in certain circumstances including material adverse changes in the condition of the Company or if the Company's qualifying collateral amounts to less than that required under the terms of the borrowing agreement. In the above table, the $20.6 million in borrowings due on November 7, 2032 relate to borrowings structured as trust preferred capital securities that were issued by First Bancorp Capital Trust I, an unconsolidated subsidiary of the Company, on October 29, 2002 and qualify as Tier I capital for regulatory capital adequacy requirements. These debt securities are callable by the Company at par on any quarterly interest payment date beginning on November 7, 2007. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 3.45%. This rate may not exceed 12.50% through November 2007. The Company incurred approximately $615,000 in debt issuance costs related to the issuance that were recorded as prepaid expenses and are included in the "Other Assets" line item of the consolidated balance sheet. These debt issuance costs are being amortized as interest expense until the earliest possible call date of November 7, 2007. In the above table, the $20.6 million in borrowings due on January 23, 2034 relate to borrowings structured as trust preferred capital securities that were issued by First Bancorp Capital Trusts II and III ($10.3 million by each trust), unconsolidated subsidiaries of the Company, on December 19, 2003 and qualify as Tier I capital for regulatory capital adequacy requirements. These debt securities are callable by the Company at par on any quarterly interest payment date beginning on January 23, 2009. The interest rate on these debt securities adjusts on a quarterly basis at a rate of three-month LIBOR plus 2.70%. The Company incurred approximately $580,000 of debt issuance costs related to the issuance that were recorded as prepaid expenses and are included in the "Other Assets" line item of the consolidated balance sheet. These debt issuance costs are being amortized as interest expense until the earliest possible call date of January 23, 2009. At December 31, 2005, the Company has three sources of readily available borrowing capacity - 1) an approximately $360 million line of credit with the FHLB, of which $59 million was outstanding at December 31, 84
2005 and $51 million was outstanding at December 31, 2004, 2) a $50 million overnight federal funds line of credit with a correspondent bank, none of which was outstanding at December 31, 2005 or 2004, and 3) an approximately $62 million line of credit through the Federal Reserve Bank of Richmond's (FRB) discount window, none of which was outstanding at December 31, 2005 or 2004. The Company's line of credit with the FHLB totaling approximately $360 million can be structured as either short-term or long-term borrowings, depending on the particular funding or liquidity need and is secured by the Company's FHLB stock and a blanket lien on most of its real estate loan portfolio. In addition to the outstanding borrowings from the FHLB that reduce the available borrowing capacity of the line of credit, the borrowing capacity was further reduced by $40 million at December 31, 2005 and 2004 as a result of the Company pledging letters of credit for public deposits at each of those dates. The Company's correspondent bank relationship allows the Company to purchase up to $50 million in federal funds on an overnight, unsecured basis (federal funds purchased). The Company had no borrowings outstanding under this line at December 31, 2005 or 2004. This line of credit was not drawn upon during any of the past three years. The Company also has a line of credit with the FRB discount window. This line is secured by a blanket lien on a portion of the Company's commercial and consumer loan portfolio (excluding real estate). Based on the collateral owned by the Company as of December 31, 2005, the available line of credit is approximately $62 million. This line of credit was established primarily in connection with the Company's Y2K liquidity contingency plan and has not been drawn on since inception. The FRB has indicated that it would not expect lines of credit that have been granted to financial institutions to be a primary borrowing source. The Company plans to maintain this line of credit, although it is not expected that it will be drawn upon except in unusual circumstances. Note 10. Leases Certain bank premises are leased under operating lease agreements. Generally, operating leases contain renewal options on substantially the same basis as current rental terms. Rent expense charged to operations under all operating lease agreements was $510,000 in 2005, $452,000 in 2004, and $324,000 in 2003. Future obligations for minimum rentals under noncancelable operating leases at December 31, 2005 are as follows: (In thousands) Year ending December 31: 2006 $ 435 2007 314 2008 267 2009 237 2010 213 Later years 1,106 ------ Total $2,572 ====== Note 11. Employee Benefit Plans 401(k) Plan. The Company sponsors a retirement savings plan pursuant to ----------- Section 401(k) of the Internal Revenue Code. Employees who have completed one year of service are eligible to participate in the plan. An eligible employee may contribute up to 15% of annual salary to the plan. The Company contributes an amount equal to 75% of the first 6% of the employee's salary contributed. Participants vest in Company contributions at the rate of 20% after one year of service, and 20% for each additional year of service, with 100% vesting after five years of service. The Company's matching contribution expense was $700,000, $607,000, and $528,000, for the years ended December 31, 2005, 2004 and 2003, respectively. Additionally, the Company made additional 85
discretionary matching contributions to the plan of $225,000 in 2005, $175,000 in 2004, and $175,000 in 2003. The Company's matching and discretionary contributions are made in the form of Company stock. Employees are not permitted to invest their own contributions in Company stock. Pension Plan. The Company sponsors a noncontributory defined benefit ------------- retirement plan (the "Pension Plan"), which is intended to qualify under Section 401(a) of the Internal Revenue Code. Employees who have attained age 21 and completed one year of service are eligible to participate in the Pension Plan. The Pension Plan provides for a monthly payment, at normal retirement age of 65, equal to one-twelfth of the sum of (i) 0.75% of Final Average Annual Compensation (5 highest consecutive calendar years' earnings out of the last 10 years of employment) multiplied by the employee's years of service not in excess of 40 years, and (ii) 0.65% of Final Average Annual Compensation in excess of "covered compensation" multiplied by years of service not in excess of 35 years. "Covered compensation" means the average of the social security taxable wage base during the 35 year period ending with the year the employee attains social security retirement age. Early retirement, with reduced monthly benefits, is available at age 55 after 15 years of service. The Pension Plan provides for 100% vesting after 5 years of service, and provides for a death benefit to a vested participant's surviving spouse. The costs of benefits under the Pension Plan, which are borne by First Bancorp and/or its subsidiaries, are computed actuarially and defrayed by earnings from the Pension Plan's investments. The compensation covered by the Pension Plan includes total earnings before reduction for contributions to a cash or deferred profit-sharing plan (such as the 401(k) plan described above) and amounts used to pay group health insurance premiums and includes bonuses (such as amounts paid under the incentive compensation plan). Compensation for the purposes of the Pension Plan may not exceed statutory limits; such limits were $210,000 in 2005, $205,000 in 2004 and $200,000 in 2003. The Company's contributions to the Pension Plan are based on computations by independent actuarial consultants and are intended to provide the Company with the maximum deduction for income tax purposes. The contributions are invested to provide for benefits under the Pension Plan. The Company estimates that its contribution to the Pension Plan will be $945,000 in 2006. Funds in the Pension Plan are invested in a mix of investment types in accordance with the Pension Plan's investment policy, which is intended to provide a reasonable return while maintaining proper diversification. Except for Company stock, all of the Pension Plan's assets are invested in an unaffiliated bank money market account or mutual funds. The investment policy of the Pension Plan does not permit the use of derivatives, except to the extent that derivatives are used by any of the mutual funds invested in by the Pension Plan. The following table presents information regarding the mix of investments of the Pension Plan's assets at December 31, 2005 and its targeted mix, as set out by the Plan's investment policy: <TABLE> <CAPTION> Balance at % of Total Assets at Targeted % Investment type December 31, 2005 December 31, 2005 of Total Assets - ----------------------------- ----------------- ----------------- ----------------- <S> <C> <C> <C> (Dollars in thousands) Fixed income investments Money market account $ 301 2% 1%-5% US government bond fund 1,669 14% 10%-20% US corporate bond fund 1,111 10% 5%-15% Equity investments Large cap value fund 2,572 22% 20%-30% Large cap growth fund 3,086 27% 20%-30% Mid-small cap growth fund 2,302 20% 15%-25% Company stock 527 5% 0%-10% ------------ ------------ Total $ 11,568 100% ============ ============ </TABLE> For the three years ended December 31, 2005, the Company used an expected long-term rate-of-return-on-assets assumption of 9.00%. The Company arrived at this rate based primarily on a third-party investment consulting firm's historical analysis of investment returns, which indicated that the mix of the Pension Plan's 86
assets (generally 75% equities and 25% fixed income) can be expected to return approximately 9% on a long term basis. The following table reconciles the beginning and ending balances of the Pension Plan's projected benefit obligation, as computed by the Company's independent actuarial consultants. The Pension Plan's accumulated benefit obligation is also presented: <TABLE> <CAPTION> (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Projected benefit obligation at beginning of year $ 12,445 9,892 7,475 Service cost 1,137 955 690 Interest cost 766 642 527 Actuarial loss 1,829 1,013 1,175 Effect of amendments -- -- 85 Benefits paid (84) (57) (60) -------- -------- -------- Projected benefit obligation at end of year $ 16,093 12,445 9,892 ======== ======== ======== Accumulated benefit obligation at end of year $ 10,284 7,817 6,164 ======== ======== ======== </TABLE> The following table reconciles the beginning and ending balances of the Pension Plan's assets: (In thousands) 2005 2004 2003 -------- -------- -------- Plan assets at beginning of year $ 9,907 8,498 5,126 Actual return on plan assets 361 816 1,387 Employer contributions 1,419 650 2,045 Benefits paid (84) (57) (60) -------- -------- -------- Plan assets at end of year $ 11,603 9,907 8,498 ======== ======== ======== The following table presents information regarding the funded status of the Pension Plan, the amounts not recognized in the consolidated balance sheets, and the amounts recognized in the consolidated balance sheets: (In thousands) 2005 2004 ------- ------- Funded status $(4,490) (2,538) Unrecognized net actuarial loss 5,955 3,764 Unrecognized prior service cost 132 249 Unrecognized transition obligation 45 47 ------- ------- Prepaid pension cost $ 1,642 1,522 ======= ======= Net pension cost for the Pension Plan included the following components for the years ended December 31, 2005, 2004 and 2003: (In thousands) 2005 2004 2003 ------- ------- ------- Service cost - benefits earned during the period $ 1,137 955 690 Interest cost on projected benefit obligation 766 642 527 Expected return on plan assets (947) (759) (507) Net amortization and deferral 344 307 301 ------- ------- ------- Net periodic pension cost $ 1,300 1,145 1,011 ======= ======= ======= 87
The following table is an estimate of the benefits that will be paid in accordance with the Pension Plan during the indicated time periods: Estimated (In thousands) benefit payments ---------- Year ending December 31, 2006 $ 200 Year ending December 31, 2007 214 Year ending December 31, 2008 257 Year ending December 31, 2009 278 Year ending December 31, 2010 323 Years ending December 31, 2011-2015 3,659 Supplemental Executive Retirement Plan. The Company sponsors a Supplemental -------------------------------------- Executive Retirement Plan (the "SERP Plan") for the benefit of certain senior management executives of the Company. The purpose of the SERP Plan is to provide additional monthly pension benefits to ensure that each such senior management executive would receive lifetime monthly pension benefits equal to 3% of his or her final average compensation multiplied by his or her years of service (maximum of 20 years) to the Company or its subsidiaries, subject to a maximum of 60% of his or her final average compensation. The amount of a participant's monthly SERP benefit is reduced by (i) the amount payable under the Company's qualified Pension Plan (described above), and (ii) fifty percent (50%) of the participant's primary social security benefit. Final average compensation means the average of the 5 highest consecutive calendar years of earnings during the last 10 years of service prior to termination of employment. The Company's funding policy with respect to the SERP Plan is to fund the related benefits through investments in life insurance policies, which are not considered plan assets for the purpose of determining the SERP Plan's funded status. The cash surrender values of the life insurance policies are included in the line item "other assets." The following table reconciles the beginning and ending balances of the SERP Plan's benefit obligation, as computed by the Company's independent actuarial consultants: (In thousands) 2005 2004 2003 ------ ------ ------ Projected benefit obligation at beginning of year $2,553 1,631 1,248 Service cost 247 242 105 Interest cost 154 128 88 Actuarial loss 269 329 179 Effect of amendments -- 223 11 Benefits paid -- -- -- ------ ------ ------ Projected benefit obligation at end of year $3,223 2,553 1,631 ====== ====== ====== Accumulated benefit obligation at end of year $2,556 2,119 1,391 ====== ====== ====== 88
The following table presents information regarding the funded status of the SERP Plan, the amounts not recognized in the consolidated balance sheets, and the amounts recognized in the consolidated balance sheets: (In thousands) 2005 2004 ------- ------- Funded status $(3,223) (2,553) Unrecognized net actuarial loss 1,079 862 Unrecognized prior service cost 237 273 Additional minimum liability (701) (422) ------- ------- Accrued pension cost $(2,608) (1,840) ======= ======= Net pension cost for the SERP Plan included the following components for the years ended December 31, 2005, 2004 and 2003: (In thousands) 2005 2004 2003 ------ ------ ------ Service cost - benefits earned during the period $ 247 242 105 Interest cost on projected benefit obligation 154 128 88 Net amortization and deferral 88 80 45 ------ ------ ------ Net periodic pension cost $ 489 450 238 ====== ====== ====== The following table is an estimate of the benefits that will be paid in accordance with the SERP Plan during the indicated time periods: (In thousands) Estimated benefit payments -------- Year ending December 31, 2006 $ 164 Year ending December 31, 2007 156 Year ending December 31, 2008 148 Year ending December 31, 2009 140 Year ending December 31, 2010 159 Years ending December 31, 2011-2015 1,268 The following assumptions were used in determining the actuarial information for the Pension Plan and the SERP Plan for the years ended December 31, 2005, 2004 and 2003: <TABLE> <CAPTION> 2005 2004 2003 ------------------ ------------------ ------------------- Pension SERP Pension SERP Pension SERP Plan Plan Plan Plan Plan Plan ------- ------- ------- ------- ------- ------- <S> <C> <C> <C> <C> <C> <C> Discount rate used to determine net periodic pension cost 6.00% 6.00% 6.25% 6.25% 6.75% 6.75% Discount rate used to calculate end of year liability disclosures 5.50% 5.50% 6.00% 6.00% 6.25% 6.25% Expected long-term rate of return on assets 9.00% n/a 9.00% n/a 9.00% n/a Rate of compensation increase 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% </TABLE> For the years ended December 31, 2004 and 2003, the Company determined the year end discount rate based on discussions with the Company's third-party actuarial consultant, giving weight to the year end Moody's corporate Aa rate and its change during the year, and the expected cash flows associated with the Company's retirement payment obligations. During 2005, the Company adopted a policy that the year end discount rate would be a rate no greater than the Moody's Aa corporate bond rate as of December 31 of each year, rounded up to the nearest quarter point. The Company believes that this policy is appropriate given the Company's desire that the discount rate be based on the rate of return of a high-quality fixed-income security and the expected cash flows of its retirement obligation. 89
Included in intangible assets at December 31, 2005 and 2004 is $273,000 and $84,000, respectively, that has been recognized in connection with the accrual of the additional minimum liability for the SERP Plan. Note 12. Commitments, Contingencies, and Concentrations of Credit Risk See Note 10 with respect to future obligations under noncancelable operating leases. See Note 18 for a subsequent event related to a branch purchase agreement executed in January 2006. In the normal course of business there are various outstanding commitments and contingent liabilities such as commitments to extend credit, which are not reflected in the financial statements. As of December 31, 2005, the Company had outstanding loan commitments of $277,044,000, of which $236,047,000 were at variable rates and $40,997,000 were at fixed rates. Included in outstanding loan commitments were unfunded commitments of $157,257,000 on revolving credit plans, of which $132,796,000 were at variable rates and $24,461,000 were at fixed rates. At December 31, 2005 and 2004, the Company had $4,283,000 and $3,762,000, respectively in standby letters of credit outstanding. The Company has no carrying amount for these standby letters of credit at either of those dates. The nature of the standby letters of credit is a guarantee made on behalf of the Company's customers to suppliers of the customers to guarantee payments owed to the supplier by the customer. The standby letters of credit are generally for terms for one year, at which time they may be renewed for another year if both parties agree. The payment of the guarantees would generally be triggered by a continued nonpayment of an obligation owed by the customer to the supplier. The maximum potential amount of future payments (undiscounted) the Company could be required to make under the guarantees in the event of nonperformance by the parties to whom credit or financial guarantees have been extended is represented by the contractual amount of the financial instruments discussed above. In the event that the Company is required to honor a standby letter of credit, a note, already executed with the customer, is triggered which provides repayment terms and any collateral. Over the past ten years, the Company has had to honor one standby letter of credit, which was repaid by the borrower without any loss to the Company. Management expects any draws under existing commitments to be funded through normal operations. In 1999, in consultation with the Company's tax advisors, the Company established an operating structure involving a real estate investment trust ("REIT") that resulted in a reduction in the Company's state tax liability to the state of North Carolina. In late 2004, the North Carolina Department of Revenue indicated that it would challenge taxpayers engaged in activities deemed to be "income-shifting," and they indicated that they believed certain REIT operating structures were a type of "income-shifting." During 2005, the North Carolina Department of Revenue began an audit of the Company's tax returns for 2001-2004, which represented all years eligible for audit. In the third quarter of 2005, based on consultations with the Company's external auditor and legal counsel, the Company determined that it should record a $6.3 million loss accrual to reserve for this issue. In February 2006, the North Carolina Department of Revenue announced a "Settlement Initiative" that offered companies with certain transactions, including those with a REIT operating structure, the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative by June 15, 2006. Although the Company continues to believe that its tax returns complied with the relevant statutes, the board of directors of the Company has tentatively decided that it is in the best interests of the Company to settle this matter by participating in the initiative. Based on the terms of the initiative, the Company estimates that its total liability to settle the matter will be approximately $4.3 million, net of the federal tax benefit, or $2.0 million less than the amount that was originally accrued. Accordingly, in March 2006, the Company retroactively recorded an adjustment to its fourth quarter of 2005 earnings to reverse $2.0 million of tax expense. The financial statements contained herein reflect this revised estimate. The aspects of the REIT structure that gave rise to this issue were discontinued effective January 1, 2005, and thus the Company does not believe it has any additional exposure related to this item beyond the amount of the accrual other than ongoing interest on the unpaid taxes amounting to $65,000 per quarter (after-tax). 90
The Company is not involved in any legal proceedings which, in management's opinion, could have a material effect on the consolidated financial position of the Company. The Bank grants primarily commercial and installment loans to customers throughout its market area, which consists of Anson, Cabarrus, Chatham, Davidson, Duplin, Guilford, Harnett, Iredell, Lee, Montgomery, Moore, New Hanover, Randolph, Richmond, Robeson, Rockingham, Rowan, Scotland, Stanly and Wake Counties in North Carolina, Dillon County in South Carolina, and Wythe, Washington, and Montgomery Counties in Virginia. The real estate loan portfolio can be affected by the condition of the local real estate market. The commercial and installment loan portfolios can be affected by local economic conditions. The Company's loan portfolio is not concentrated in loans to any single borrower or to a relatively small number of borrowers. Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly affected by economic conditions. In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries and geographic regions, the Company monitors exposure to credit risk that could arise from potential concentrations of lending products and practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc), and loans with high loan-to-value ratios. Additionally, there are industry practices that could subject the Company to increased credit risk should economic conditions change over the course of a loan's life. For example, the Company makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. The Company has determined that there is no concentration of credit risk associated with its lending policies or practices. The Company's investment portfolio consists principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities. In the opinion of the Company, there is no concentration of credit risk in its investment portfolio. The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. The Company believes credit risk associated with correspondent accounts is not significant. Note 13. Fair Value of Financial Instruments Fair value estimates as of December 31, 2005 and 2004 and limitations thereon are set forth below for the Company's financial instruments. Please see Note 1 for a discussion of fair value methods and assumptions, as well as fair value information for off-balance sheet financial instruments. <TABLE> <CAPTION> December 31, 2005 December 31, 2004 ----------------------- ----------------------- Carrying Estimated Carrying Estimated (In thousands) Amount Fair Value Amount Fair Value ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Cash and due from banks, noninterest-bearing $ 32,985 32,985 $ 28,486 28,486 Due from banks, interest-bearing 41,655 41,655 45,135 45,135 Federal funds sold 28,883 28,883 15,780 15,780 Securities available for sale 113,613 113,613 88,554 88,554 Securities held to maturity 14,172 14,321 14,025 14,451 Presold mortgages in process of settlement 3,347 3,347 1,771 1,771 Loans, net of allowance 1,466,895 1,460,119 1,352,336 1,352,998 Accrued interest receivable 8,947 8,947 6,832 6,832 Deposits 1,494,577 1,494,043 1,388,768 1,388,994 Securities sold under agreements to repurchase 33,530 33,530 -- -- Borrowings 100,239 101,671 92,239 92,459 Accrued interest payable 3,835 3,835 2,677 2,677 </TABLE> 91
Limitations Of Fair Value Estimates. Fair value estimates are made at a ------------------------------------- specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no highly liquid market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include net premises and equipment, intangible and other assets such as foreclosed properties, deferred income taxes, prepaid expense accounts, income taxes currently payable and other various accrued expenses. In addition, the income tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates. Note 14. Stock Option Plan Pursuant to provisions of the Company's 2004 Stock Option Plan (the "Option Plan"), options to purchase up to 1,275,000 shares of First Bancorp's authorized but unissued common stock may be granted to employees ("Employee Options") and directors ("Nonemployee Director Options") of the Company and its subsidiaries. The purposes of the Option Plan are (i) to align the interests of participating employees and directors with the Company's shareholders by reinforcing the relationship between shareholder gains and participant rewards, (ii) to encourage equity ownership in the Company by participants, and (iii) to provide an incentive to employee participants to continue their employment with the Company. Since the inception of the Option Plan and its predecessor plan (the 1994 Stock Option Plan), each nonemployee director has been granted 2,250 Nonemployee Director Options in June of each year. Employee Options were granted to substantially all officers at the inception of the 1994 Stock Option Plan and since then have been granted to new officers, officers that have assumed increased responsibilities, and for performance rewards. For both Employee and Nonemployee Director Options, the option price is the fair market value of the stock at the date of grant. Employee Options may require a vesting period. Director Options are 100% vested on the date of grant. All options expire not more than 10 years from the date of grant. Forfeited options become available for future grants. In addition to the Option Plan and its predecessor plan, the Company has four stock option plans that were assumed in connection with mergers and acquisitions of the companies that originally established those plans. As of December 31, 2005, a total of 76,995 shares of common stock were issuable upon exercise under those assumed plans. The weighted average exercise price of those outstanding options is $10.14 per share. No additional options may be granted under those assumed plans. The tables on the following page include these options. 92
At December 31, 2005, there were 1,211,590 additional shares available for grant under the Option Plan. The per share weighted-average fair value of options granted during 2005, 2004, and 2003 was $6.68, $7.07, and $5.03, respectively on the date(s) of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2005 2004 2003 -------- -------- -------- Expected dividend yield 3.08% 2.97% 3.73% Risk-free interest rate 3.88% 3.49% 3.30% Expected life 7 years 7 years 8 years Expected volatility 32.97% 36.67% 33.08% The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost has been recognized for its stock options in the financial statements. Note 1(k) reflects the pro forma effects had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123. The following table sets forth a summary of the activity of the Company's outstanding options since December 31, 2002: Options Exercisable Options Outstanding at Year End -------------------- -------------------- Weighted- Weighted- Average Average Number of Exercise Number of Exercise Shares Price Shares Price -------- -------- -------- -------- Balance at December 31, 2002 850,023 $ 10.69 702,123 $ 9.81 Granted 76,500 16.35 Assumed in corporate acquisition 78,000 4.17 Exercised (226,764) 6.38 Forfeited -- -- Expired -- -- Balance at December 31, 2003 777,759 11.85 626,583 11.05 Granted 183,230 21.35 Exercised (181,663) 7.83 Forfeited (600) 15.32 Expired -- -- Balance at December 31, 2004 778,726 15.01 668,260 14.88 Granted 34,000 22.11 Exercised (65,844) 11.41 Forfeited -- -- Expired -- -- Balance at December 31, 2005 746,882 15.75 678,883 15.69 93
The following table summarizes information about the stock options outstanding at December 31, 2005: Options Outstanding Options Exercisable --------------------------------------- --------------------- Weighted- Weighted- Weighted- Number Average Average Number Average Range of Outstanding Remaining Exercise Exercisable Exercise Exercise Prices at 12/31/05 Contractual Life Price at 12/31/05 Price --------------- ------------ ---------------- ---------- ------------ --------- $4.00 to $7.99 38,699 1.0 $ 6.94 38,699 $ 6.94 $8.00 to $11.99 168,651 3.3 10.87 168,651 10.87 $12.00 to $15.99 251,052 5.4 15.08 192,927 14.95 $16.00 to $19.99 96,750 7.0 17.62 96,750 17.62 $20.00 to $22.00 191,730 8.4 21.77 181,856 21.77 ----------- ----------- 746,882 5.7 $15.75 678,883 $15.69 =========== =========== Note 15. Regulatory Restrictions The Company is regulated by the Board of Governors of the Federal Reserve System ("FED") and is subject to securities registration and public reporting regulations of the Securities and Exchange Commission. The Bank is regulated by the Federal Deposit Insurance Corporation ("FDIC") and the North Carolina Office of the Commissioner of Banks. The primary source of funds for the payment of dividends by First Bancorp is dividends received from its subsidiary, First Bank. The Bank, as a North Carolina banking corporation, may pay dividends only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. As of December 31, 2005, the Bank had undivided profits of approximately $117,241,000 which were available for the payment of dividends. As of December 31, 2005, approximately $77,063,000 of the Company's investment in the Bank is restricted as to transfer to the Company without obtaining prior regulatory approval. The average reserve balance maintained by the Bank under the requirements of the Federal Reserve was approximately $498,000 for the year ended December 31, 2005. The Company and the Bank must comply with regulatory capital requirements established by the FED and FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. These capital standards require the Company and the Bank to maintain minimum ratios of "Tier 1" capital to total risk-weighted assets ("Tier I Capital Ratio") and total capital to risk-weighted assets of 4.00% and 8.00% ("Total Capital Ratio"), respectively. Tier 1 capital is comprised of total shareholders' equity, excluding unrealized gains or losses from the securities available for sale, less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which for the Company and the Bank is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company and the Bank, adjusted for their related risk levels using formulas set forth in FED and FDIC regulations. In addition to the risk-based capital requirements described above, the Company and the Bank are subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets ("Leverage Ratio) of 3.00% to 5.00%, depending upon the institution's composite ratings as determined by its regulators. The FED has not advised the Company of any requirement specifically applicable to it. 94
In addition to the minimum capital requirements described above, the regulatory framework for prompt corrective action also contains specific capital guidelines applicable to banks for classification as "well capitalized," which are presented with the minimum ratios, the Company's ratios and the Bank's ratios as of December 31, 2005 and 2004 in the following table. Based on the most recent notification from its regulators, the Bank is well capitalized under the framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. <TABLE> <CAPTION> To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Provisions -------------------- -------------------- -------------------- ($ in thousands) Amount Ratio Amount Ratio Amount Ratio -------- -------- -------- -------- -------- -------- <S> <C> <C> <C> <C> <C> <C> (must equal or exceed) (must equal or exceed) As of December 31, 2005 Total Capital Ratio Company $163,117 11.51% $113,378 8.00% $ N/A N/A Bank 162,776 11.51% 113,178 8.00% 141,472 10.00% Tier I Capital Ratio Company 147,401 10.52% 56,061 4.00% N/A N/A Bank 147,060 10.51% 55,960 4.00% 83,940 6.00% Leverage Ratio Company 147,401 8.62% 68,438 4.00% N/A N/A Bank 147,060 8.61% 68,335 4.00% 85,419 5.00% As of December 31, 2004 Total Capital Ratio Company $153,348 11.97% $102,450 8.00% $ N/A N/A Bank 146,377 11.49% 102,252 8.00% 127,815 10.00% Tier I Capital Ratio Company 138,631 10.95% 50,636 4.00% N/A N/A Bank 131,660 10.46% 50,537 4.00% 75,806 6.00% Leverage Ratio Company 138,631 8.90% 62,332 4.00% N/A N/A Bank 131,660 8.50% 62,191 4.00% 77,739 5.00% </TABLE> Note 16. Supplementary Income Statement Information Components of other operating expenses exceeding 1% of total income for any of the years ended December 31, 2005, 2004 and 2003 are as follows: (In thousands) 2005 2004 2003 ------ ------ ------ Stationery and supplies $1,590 1,523 1,498 Telephone 1,260 1,345 1,229 Professional fees 1,090 989 650 95
Note 17. Condensed Parent Company Information Condensed financial data for First Bancorp (parent company only) follows: CONDENSED BALANCE SHEETS As of December 31, -------------------- (In thousands) 2005 2004 -------- -------- Assets - ------ Cash on deposit with bank subsidiary $ 2,000 5,935 Investment in wholly-owned subsidiaries, at equity 196,170 184,316 Land 7 7 Other assets 1,993 2,170 -------- -------- Total assets $200,170 192,428 ======== ======== Liabilities and shareholders' equity - ------------------------------------ Borrowings $ 41,239 41,239 Other liabilities 3,203 2,711 -------- -------- Total liabilities 44,442 43,950 Shareholders' equity 155,728 148,478 -------- -------- Total liabilities and shareholders' equity $200,170 192,428 ======== ======== <TABLE> <CAPTION> CONDENSED STATEMENTS OF INCOME Year Ended December 31, -------------------------------- (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Dividends from wholly-owned subsidiaries $ 6,050 -- 3,400 Undistributed earnings of wholly-owned subsidiaries 13,155 22,332 17,453 Interest expense (2,846) (2,086) (1,110) All other income and expenses, net (269) (132) (326) -------- -------- -------- Net income $ 16,090 20,114 19,417 ======== ======== ======== </TABLE> <TABLE> <CAPTION> CONDENSED STATEMENTS OF CASH FLOWS Year Ended December 31, -------------------------------- (In thousands) 2005 2004 2003 -------- -------- -------- <S> <C> <C> <C> Operating Activities: Net income $ 16,090 20,114 19,417 Equity in undistributed earnings of subsidiaries (13,155) (22,332) (17,453) Amortization of securities and intangible assets -- -- 60 Decrease (increase) in other assets 177 122 (667) Increase in other liabilities 325 356 90 -------- -------- -------- Total - operating activities 3,437 (1,740) 1,447 -------- -------- -------- Investing Activities: Net cash paid in acquisitions -- -- (9,050) -------- -------- -------- Total - investing activities -- -- (9,050) -------- -------- -------- Financing Activities: Proceeds from borrowings -- -- 20,000 Payment of cash dividends (9,761) (9,138) (8,670) Proceeds from issuance of common stock 2,389 2,547 2,444 Purchases and retirement of common stock -- (6,528) (5,195) -------- -------- -------- Total - financing activities (7,372) (13,119) 8,579 -------- -------- -------- Net increase (decrease) in cash and cash equivalents (3,935) (14,859) 976 Cash and cash equivalents, beginning of year 5,935 20,794 19,818 -------- -------- -------- Cash and cash equivalents, end of year $ 2,000 5,935 20,794 ======== ======== ======== </TABLE> 96
Note 18. Subsequent Events In March 2006, the Company adjusted its originally reported earnings for the three and twelve months ended December 31, 2005 to reflect a change in the Company's estimate of a contingent loss liability as of December 31, 2005 that occurred as a result of an event occurring subsequent to December 31, 2005 and prior to the issuance of the Company's financial statements. As discussed in Note 12, the Company recorded a loss amount of $6.3 million in the third quarter of 2005 to accrue for contingent tax loss exposure involving the North Carolina Department of Revenue. In February 2006, the North Carolina Department of Revenue announced a "Settlement Initiative" that offered companies with certain transactions that had been challenged by the North Carolina Department of Revenue the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative by June 15, 2006. Although the Company continues to believe that its tax returns complied with the relevant statutes, the board of directors of the Company has tentatively decided that it is in the best interests of the Company to settle this matter by participating in the initiative. Based on the terms of the initiative, the Company estimated that its total liability to settle the matter will be approximately $4.3 million, net of the federal tax benefit, or $2.0 million less than the amount that was originally accrued. Accordingly, in March 2006, the Company adjusted its originally reported 2005 earnings to reflect the impact of this subsequent event by reducing originally reported tax expense for the three and twelve months ended December 31, 2005 by $1,982,000. The financial statements contained herein reflect this revised estimate. In January 2006, the Company reported that it had agreed to purchase a bank branch in Dublin, Virginia with approximately $20 million in deposits from another financial institution. 97
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders First Bancorp Troy, North Carolina We have audited the accompanying consolidated balance sheet of First Bancorp and subsidiaries (the "Company") as of December 31, 2005, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for the year then ended. We also have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of December 31, 2005, 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 these consolidated financial statements, 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 these consolidated financial statements, 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 the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting 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 audits provide a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Bancorp and subsidiaries as of December 31, 2005, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management's assessment that First Bancorp and subsidiaries maintained effective 98
internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Furthermore, in our opinion, First Bancorp and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). /s/ Elliot Davis PLLC Greenville, South Carolina March 7, 2006 99
Report of Independent Registered Public Accounting Firm ------------------------------------------------------- The Board of Directors and Shareholders First Bancorp: We have audited the accompanying consolidated balance sheets of First Bancorp and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Bancorp 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 U.S. generally accepted accounting principles. /s/ KPMG LLP Charlotte, North Carolina March 6, 2005 100
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures During the two years ended December 31, 2005, and any subsequent interim periods, there were no disagreements on any matters of accounting principles or practices or financial statement disclosures. For information on the Company's change in independent accountants on July 26, 2005, from KPMG LLP to Elliott Davis, PLLC, see the Form 8-K filed with the SEC on August 1, 2005 and Form 8-K/A filed with the SEC on August 15, 2005. Item 9A. Controls and Procedures As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic reports with the Securities and Exchange Commission. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. In addition, no change in our internal control over financial reporting has occurred during the Company's fourth fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Management's Report On Internal Control Over Financial Reporting Management of First Bancorp and its subsidiaries (the "Company") is responsible for establishing and maintaining effective internal control over financial reporting. 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 U.S. generally accepted accounting principles. Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in Internal Control - Integrated Framework, management of the Company has concluded the Company maintained effective internal control over financial reporting, as such term is defined in Securities Exchange Act of 1934 Rules 13a-15(f), as of December 31, 2005. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is also responsible for the preparation and fair presentation of the consolidated financial statements and other financial information contained in this report. The accompanying consolidated financial 101
statements were prepared in conformity with U.S. generally accepted accounting principles and include, as necessary, best estimates and judgments by management. Elliott Davis, PLLC, an independent, registered public accounting firm, has audited the Company's consolidated financial statements as of and for the year ended December 31, 2005, and the Company's assertion as to the effectiveness of internal control over financial reporting as of December 31, 2005, as stated in their report, which is included in Item 8 hereof. /s/ James H. Garner /s/ Eric P. Credle James H. Garner Eric P. Credle President and Senior Vice President and Chief Executive Officer Chief Financial Officer March 7, 2006 Item 9B. Other Information Not applicable. 102
PART III Item 10. Directors and Executive Officers of the Registrant Incorporated herein by reference is the information under the captions "Directors, Nominees and Executive Officers," "Section 16(a) Beneficial Ownership Reporting Compliance," and "Corporate Governance" from the Company's definitive proxy statement to be filed pursuant to Regulation 14A. Item 11. Executive Compensation Incorporated herein by reference is the information under the captions "Compensation of Executive Officers" and "Board Committees, Attendance, and Compensation" from the Company's definitive proxy statement to be filed pursuant to Regulation 14A. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters Incorporated herein by reference is the information under the captions "Principal Holders of First Bancorp Voting Securities" and "Directors, Nominees and Executive Officers" from the Company's definitive proxy statement to be filed pursuant to Regulation 14A. Additional Information Regarding the Registrant's Equity Compensation Plans At December 31, 2005, the Company had six equity compensation plans. Each of these plans is a stock option plan. Four of the six plans were assumed in corporate acquisitions. The Company's 2004 Stock Option Plan is the only one of the six plans for which new grants of stock options are possible. The following table presents information as of December 31, 2005 regarding shares of the Company's stock that may be issued pursuant to the Company's stock options plans. The table does not include information with respect to shares subject to outstanding options granted under stock incentive plans assumed by the Company in connection with mergers and acquisitions of companies that originally granted those options. Footnote (2) to the table indicates the total number of shares of common stock issuable upon the exercise of options under the assumed plans as of December 31, 2005, and the weighted average exercise price of those options. No additional options may be granted under those assumed plans. The Company has no warrants or stock appreciation rights outstanding. <TABLE> <CAPTION> As of December 31, 2005 ---------------------------------------------------------------------------------- (a) (b) (c) Number of securities available for Number of securities to Weighted-average future issuance under equity be issued upon exercise exercise price of compensation plans (excluding Plan category of outstanding options outstanding options securities reflected in column (a)) - --------------------- ----------------------- ------------------- ---------------------------------- <S> <C> <C> <C> Equity compensation plans approved by security holders (1) 669,887 $ 16.40 1,211,590 Equity compensation plans not approved by security holders -- -- -- ----------------------- ------------------- ---------------------------------- Total 669,887 16.40 1,211,590 ======================= =================== ================================== </TABLE> (1) Consists of (A) the Company's 2004 Stock Option Plan, which is currently in effect and (B) the Company's 1994 Option Plan, each of which was approved by shareholders. The table does not include information for stock incentive plans that the Company assumed in connection 103
with mergers and acquisitions of the companies that originally established those plans. As of December 31, 2005, a total of 76,995 shares of common stock were issuable upon exercise under those assumed plans. The weighted average exercise price of those outstanding options is $10.14 per share. No additional options may be granted under those assumed plans. Item 13. Certain Relationships and Related Transactions Incorporated herein by reference is the information under the caption "Certain Transactions" from the Company's definitive proxy statement to be filed pursuant to Regulation 14A. Item 14. Principal Accountant Fees and Services Incorporated herein by reference is the information under the caption "Principal Accountant Fees and Services" from the Company's definitive proxy statement to be filed pursuant to Regulation 14A. PART IV Item 15. Exhibits and Financial Statement Schedules (a) 1. Financial Statements - See Item 8 and the Cross Reference Index on page 2 for information concerning the Company's consolidated financial statements and report of independent auditors. 2. Financial Statement Schedules - not applicable 3. Exhibits The following exhibits are filed with this report or, as noted, are incorporated by reference. Management contracts, compensatory plans and arrangements are marked with an asterisk (*). 3.a Copy of Articles of Incorporation of the Company and amendments thereto were filed as Exhibits 3.a.i through 3.a.v to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2002, and are incorporated herein by reference. 3.b Copy of the Amended and Restated Bylaws of the Company was filed as Exhibit 3.b to the Company's Annual Report on Form 10-K for the year ended December 31, 2003, and is incorporated herein by reference. 4 Form of Common Stock Certificate was filed as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and is incorporated herein by reference. 10 Material Contracts 10.a Data Processing Agreement dated October 1, 1984 by and between Bank of Montgomery (First Bank) and Montgomery Data Services, Inc. was filed as Exhibit 10(k) to the Registrant's Registration Statement Number 33-12692, and is incorporated herein by reference. 10.b First Bancorp Annual Incentive Plan was filed as Exhibit 10(a) to the Form 8-K filed on January 26, 2005 and is incorporated herein by reference. (*) 10.c Indemnification Agreement between the Company and its Directors and Officers was filed as Exhibit 10(t) to the Registrant's Registration Statement Number 33-12692, and is incorporated herein by reference. 104
10.d First Bancorp Senior Management Supplemental Executive Retirement Plan was filed as Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 2001, and is incorporated herein by reference. (*) 10.e First Bancorp 1994 Stock Option Plan was filed as Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 2001, and is incorporated herein by reference. (*) 10.f First Bancorp 2004 Stock Option Plan was filed as Exhibit B to the Registrant's Form Def 14A filed on March 30, 2004 and is incorporated herein by reference. (*) 10.g Employment Agreement between the Company and James H. Garner dated August 17, 1998 was filed as Exhibit 10(l) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, and is incorporated by reference (Commission File Number 000-15572). (*) 10.h Employment Agreement between the Company and Anna G. Hollers dated August 17, 1998 was filed as Exhibit 10(m) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, and is incorporated by reference (Commission File Number 000-15572). (*) 10.i Employment Agreement between the Company and Teresa C. Nixon dated August 17, 1998 was filed as Exhibit 10(n) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998, and is incorporated by reference (Commission File Number 000-15572). (*) 10.j Employment Agreement between the Company and Eric P. Credle dated August 17, 1998 was filed as Exhibit 10(p) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998, and is incorporated herein by reference (Commission File Number 333-71431). (*) 10.k Employment Agreement between the Company and John F. Burns dated September 14, 2000 was filed as Exhibit 10.w to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000 and is incorporated herein by reference. (*) 10.l Employment Agreement between the Company and James G. Hudson, Jr. dated May 17, 2001 was filed as Exhibit 10(p) to the Company's Annual Report on Form 10-K for the year ended December 31, 2001, and is incorporated herein by reference. (*) 10.n Amendment to the employment agreement between the Company and James G. Hudson, Jr. dated April 26, 2005 was filed as Exhibit 10.a to the Form 8-K filed on April 29, 2005 and is incorporated herein by reference. (*) 10.o Employment Agreement between the Company and R. Walton Brown dated January 15, 2003 was filed as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and is incorporated herein by reference. (*) 10.p Amendment to the employment agreement between the Company and R. Walton Brown dated March 8, 2005 was filed as Exhibit 10.n to the Company's Annual Report on Form 10-K for the year ended December 31, 2004 and is incorporated herein by reference. (*) 10.q Copy of Employment Agreement between the Company and Jerry L. Ocheltree was filed as Exhibit 10.1 to the Form 8-K filed on January 25, 2006, and is incorporated herein by reference. (*) 10.r Copy of First Bancorp Long Term Care Insurance Plan was filed as Exhibit 10(o) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, and is incorporated by reference. (*) 105
10.s Description of Director Compensation pursuant to Item 601(b)(10)(iii)(A) of Regulation S-K. 21 List of Subsidiaries of Registrant was filed as Exhibit 21 to the Company's Annual Report on Form 10-K for the year ended December 31, 2003, and is incorporated herein by reference. 23.a Consent of Independent Registered Public Accounting Firm, Elliott Davis, PLLC 23.b Consent of Independent Registered Public Accounting Firm, KPMG LLP 31.a Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. 31.b Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. 32.a Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.b Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Exhibits - see (a)(3) above (c) No financial statement schedules are filed herewith. Copies of exhibits are available upon written request to: First Bancorp, Anna G. Hollers, Executive Vice President, P.O. Box 508, Troy, NC 27371 106
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, FIRST BANCORP has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Troy, and State of North Carolina, on the 7th day of March 2006. First Bancorp By: /s/ James H. Garner ------------------- James H. Garner President, Chief Executive Officer and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on behalf of the Company by the following persons and in the capacities and on the dates indicated. Executive Officers ------------------ /s/ James H. Garner ------------------- James H. Garner President, Chief Executive Officer and Treasurer /s/ Anna G. Hollers /s/ Eric P. Credle - ------------------- ------------------ Anna G. Hollers Eric P. Credle Executive Vice President Senior Vice President Secretary Chief Financial Officer March 7, 2006 (Principal Accounting Officer) March 7, 2006 Board of Directors ------------------ /s/ David L. Burns /s/ William E. Samuels - ------------------ ---------------------- David L. Burns William E. Samuels Chairman of the Board Vice-Chairman of the Board Director Director March 7, 2006 March 7, 2006 /s/ Jack D. Briggs /s/ George R. Perkins, Jr. - ------------------ -------------------------- Jack D. Briggs George R. Perkins, Jr. Director Director March 7, 2006 March 7, 2006 /s/ R. Walton Brown /s/ Thomas F. Phillips - ------------------- ---------------------- R. Walton Brown Thomas F. Phillips Director Director March 7, 2006 March 7, 2006 /s/ H. David Bruton /s/ Edward T. Taws, Jr. - ------------------- ----------------------- H. David Bruton Edward T. Taws, Jr. Director Director March 7, 2006 March 7, 2006 /s/ John F. Burns /s/ Frederick L. Taylor II - ----------------- -------------------------- John F. Burns Frederick L. Taylor II Director Director March 7, 2006 March 7, 2006 107
/s/ Mary Clara Capel /s/ Virginia C. Thomasson ------------------- ------------------------- Mary Clara Capel Virginia C. Thomasson Director Director March 7, 2006 March 7, 2006 /s/ Goldie H. Wallace-Gainey /s/ A. Jordan Washburn - ---------------------------- ---------------------- Goldie H. Wallace-Gainey A. Jordan Washburn Director Director March 7, 2006 March 7, 2006 /s/ James H. Garner /s/ Dennis A. Wicker ------------------ -------------------- James H. Garner Dennis A. Wicker Director Director March 7, 2006 March 7, 2006 /s/ James G. Hudson, Jr. /s/ John C. Willis - ------------------------ ------------------ James G. Hudson, Jr. John C. Willis Director Director March 7, 2006 March 7, 2006 108