================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2004 ---------- Commission File Number 0-15572 FIRST BANCORP (Exact Name of Registrant as Specified in its Charter) North Carolina 56-1421916 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) 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 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. |X| YES |_| NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act. |X| YES |_| NO As of April 15, 2004, 9,459,133 shares of the registrant's Common Stock, no par value, were outstanding. The registrant had no other classes of securities outstanding. ================================================================================
INDEX FIRST BANCORP AND SUBSIDIARIES Page Part I. Financial Information Item 1 - Financial Statements Consolidated Balance Sheets - March 31, 2004 and 2003 (With Comparative Amounts at December 31, 2003) 3 Consolidated Statements of Income - For the Periods Ended March 31, 2004 and 2003 4 Consolidated Statements of Comprehensive Income - For the Periods Ended March 31, 2004 and 2003 5 Consolidated Statements of Shareholders' Equity - For the Periods Ended March 31, 2004 and 2003 6 Consolidated Statements of Cash Flows - For the Periods Ended March 31, 2004 and 2003 7 Notes to Consolidated Financial Statements 8 Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition 12 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 23 Item 4 - Controls and Procedures 25 Part II. Other Information Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 26 Item 6 - Exhibits and Reports on Form 8-K 26 Signatures 28 Page 2
Part I. Financial Information Item 1 - Financial Statements First Bancorp and Subsidiaries Consolidated Balance Sheets <TABLE> <CAPTION> March 31, December 31, March 31, ($ in thousands-unaudited) 2004 2003 2003 - ------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Cash & due from banks, noninterest-bearing $ 28,939 36,315 23,339 Due from banks, interest-bearing 12,555 12,632 42,613 Federal funds sold 11,778 13,967 28,677 ----------- ---------- ---------- Total cash and cash equivalents 53,272 62,914 94,629 ----------- ---------- ---------- Securities available for sale (costs of $96,216, $101,587, and $77,965) 98,796 103,455 79,151 Securities held to maturity (fair values of $14,854, $14,906, and $17,540) 14,119 14,206 16,663 Presold mortgages in process of settlement 1,929 1,307 3,754 Loans 1,251,923 1,218,895 1,071,432 Less: Allowance for loan losses (13,917) (13,569) (11,898) ----------- ---------- ---------- Net loans 1,238,006 1,205,326 1,059,534 ----------- ---------- ---------- Premises and equipment 25,273 25,356 22,906 Accrued interest receivable 5,729 6,087 5,489 Intangible assets 50,621 50,701 36,426 Other 6,673 6,417 5,095 ----------- ---------- ---------- Total assets $ 1,494,418 1,475,769 1,323,647 =========== ========== ========== LIABILITIES Deposits: Demand - noninterest-bearing $ 158,961 146,499 132,929 Savings, NOW, and money market 471,705 462,876 401,773 Time deposits of $100,000 or more 253,738 238,535 231,055 Other time deposits 405,868 401,454 378,056 ----------- ---------- ---------- Total deposits 1,290,272 1,249,364 1,143,813 Borrowings 51,000 76,000 36,000 Accrued interest payable 2,229 2,138 2,535 Other liabilities 6,988 6,411 7,748 ----------- ---------- ---------- Total liabilities 1,350,489 1,333,913 1,190,096 ----------- ---------- ---------- SHAREHOLDERS' EQUITY Common stock, No par value per share Issued and outstanding: 9,458,133, 9,435,294, and 9,411,451 shares 54,581 55,392 55,558 Retained earnings 87,952 85,502 77,448 Accumulated other comprehensive income 1,396 962 545 ----------- ---------- ---------- Total shareholders' equity 143,929 141,856 133,551 ----------- ---------- ---------- Total liabilities and shareholders' equity $ 1,494,418 1,475,769 1,323,647 =========== ========== ========== </TABLE> See notes to consolidated financial statements. Page 3
First Bancorp and Subsidiaries Consolidated Statements of Income <TABLE> <CAPTION> Three Months Ended March 31, ------------------------- ($ in thousands, except share data-unaudited) 2004 2003 - ----------------------------------------------------------------------------------------- <S> <C> <C> INTEREST INCOME Interest and fees on loans $ 18,003 17,009 Interest on investment securities: Taxable interest income 1,155 940 Tax-exempt interest income 140 209 Other, principally overnight investments 86 306 ---------- --------- Total interest income 19,384 18,464 ---------- --------- INTEREST EXPENSE Savings, NOW and money market 563 618 Time deposits of $100,000 or more 1,365 1,560 Other time deposits 2,025 2,467 Borrowings 658 477 ---------- --------- Total interest expense 4,611 5,122 ---------- --------- Net interest income 14,773 13,342 Provision for loan losses 570 520 ---------- --------- Net interest income after provision for loan losses 14,203 12,822 ---------- --------- NONINTEREST INCOME Service charges on deposit accounts 2,209 1,861 Other service charges, commissions and fees 896 776 Fees from presold mortgages 188 702 Commissions from sales of insurance and financial products 331 260 Data processing fees 96 73 Securities gains 92 -- Other gains -- 61 ---------- --------- Total noninterest income 3,812 3,733 ---------- --------- NONINTEREST EXPENSES Salaries 4,923 4,279 Employee benefits 1,320 1,047 ---------- --------- Total personnel expense 6,243 5,326 Net occupancy expense 702 590 Equipment related expenses 754 632 Intangibles amortization 95 45 Other operating expenses 2,938 2,655 ---------- --------- Total noninterest expenses 10,732 9,248 ---------- --------- Income before income taxes 7,283 7,307 Income taxes 2,563 2,614 ---------- --------- NET INCOME $ 4,720 4,693 ========== ========= Earnings per share: Basic $ 0.50 0.50 Diluted 0.49 0.49 Weighted average common shares outstanding: Basic 9,467,371 9,360,692 Diluted 9,649,939 9,539,351 </TABLE> See notes to consolidated financial statements. Page 4
First Bancorp and Subsidiaries Consolidated Statements of Comprehensive Income <TABLE> <CAPTION> Three Months Ended March 31, -------------------- ($ in thousands-unaudited) 2004 2003 - ---------------------------------------------------------------------------- <S> <C> <C> Net income $ 4,720 4,693 ------- ------ Other comprehensive income (loss): Unrealized gains (losses) on securities available for sale: Unrealized holding gains (losses) arising during the period, pretax 804 (213) Tax (expense) benefit (314) 83 Reclassification to realized gains (92) -- Tax expense 36 -- Adjustment to minimum pension liability: Additional pension charge related to unfunded pension liability -- (127) Tax benefit -- 50 ------- ------ Other comprehensive income (loss) 434 (207) ------- ------ Comprehensive income $ 5,154 4,486 ======= ====== </TABLE> See notes to consolidated financial statements. Page 5
First Bancorp and Subsidiaries Consolidated Statements of Shareholders' Equity <TABLE> <CAPTION> Accumulated Common Stock Other Share- ---------------------- Retained Comprehensive holders' (In thousands, except per share - unaudited) Shares Amount Earnings Income Equity - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Balances, January 1, 2003 9,122 $ 48,313 74,920 752 123,985 Net income 4,693 4,693 Cash dividends declared ($0.23 per share) (2,165) (2,165) Common stock issued under stock option plan 60 462 462 Common stock issued into dividend reinvestment plan 13 307 307 Purchases and retirement of common stock (117) (2,808) (2,808) Common stock issued in acquisition 333 9,284 9,284 Other comprehensive loss (207) (207) ------- --------- -------- ------- --------- Balances, March 31, 2003 9,411 $ 55,558 77,448 545 133,551 ======= ========= ======== ======= ========= Balances, January 1, 2004 9,435 $ 55,392 85,502 962 141,856 Net income 4,720 4,720 Cash dividends declared ($0.24 per share) (2,270) (2,270) Common stock issued under stock option plan 62 498 498 Common stock issued into dividend reinvestment plan 11 358 358 Purchases and retirement of common stock (50) (1,667) (1,667) Other comprehensive income 434 434 ------- --------- -------- ------- --------- Balances, March 31, 2004 9,458 $ 54,581 87,952 1,396 143,929 ======= ========= ======== ======= ========= </TABLE> See notes to consolidated financial statements. Page 6
First Bancorp and Subsidiaries Consolidated Statements of Cash Flows <TABLE> <CAPTION> Three Months Ended March 31, ---------------------- ($ in thousands-unaudited) 2004 2003 - ------------------------------------------------------------------------------------------------------- <S> <C> <C> Cash Flows From Operating Activities Net income $ 4,720 4,693 Reconciliation of net income to net cash provided by operating activities: Provision for loan losses 570 520 Net security premium amortization 63 67 Gain on disposal of other real estate -- (61) Gain on sale of securities available for sale (92) -- Decrease in loan fees and costs deferred (148) (4) Depreciation of premises and equipment 620 547 Amortization of intangible assets 95 45 Deferred income tax benefit (67) (45) Decrease (increase) in presold mortgages in process of settlement (622) 15,514 Decrease in accrued interest receivable 358 389 Decrease (increase) in other assets (195) 536 Increase (decrease) in accrued interest payable 91 (148) Increase in other liabilities 572 1,145 -------- ------- Net cash provided by operating activities 5,965 23,198 -------- ------- Cash Flows From Investing Activities Purchases of securities available for sale (3,618) (13,302) Purchases of securities held to maturity (125) (202) Proceeds from maturities/issuer calls of securities available for sale 5,922 9,981 Proceeds from maturities/issuer calls of securities held to maturity 205 1,292 Proceeds from sales of securities available for sale 3,102 -- Net increase in loans (33,389) (25,588) Purchases of premises and equipment (537) (441) Net cash paid in acquisitions -- (2,820) -------- ------- Net cash used by investing activities (28,440) (31,080) -------- ------- Cash Flows From Financing Activities Net increase in deposits 40,908 28,995 Proceeds from (repayments of) borrowings, net (25,000) 4,000 Cash dividends paid (2,264) (2,098) Proceeds from issuance of common stock 856 769 Purchases and retirement of common stock (1,667) (2,808) -------- ------- Net cash provided by financing activities 12,833 28,858 -------- ------- Increase (Decrease) In Cash And Cash Equivalents (9,642) 20,976 Cash And Cash Equivalents, Beginning Of Period 62,914 73,653 -------- ------- Cash And Cash Equivalents, End Of Period $ 53,272 94,629 ======== ======= Supplemental Disclosures Of Cash Flow Information: Cash paid during the period for: Interest $ 4,520 5,270 Income taxes 535 3 Non-cash transactions: Unrealized gain (loss) on securities available for sale, net of taxes 434 (130) Foreclosed loans transferred to other real estate 287 143 </TABLE> See notes to consolidated financial statements. Page 7
First Bancorp and Subsidiaries Notes To Consolidated Financial Statements (unaudited) For the Periods Ended March 31, 2004 and 2003 Note 1 - Basis of Presentation In the opinion of the Company, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the consolidated financial position of the Company as of March 31, 2004 and 2003 and the consolidated results of operations and consolidated cash flows for the periods ended March 31, 2004 and 2003. Reference is made to the 2003 Annual Report on Form 10-K filed with the SEC for a discussion of accounting policies and other relevant information with respect to the financial statements. The results of operations for the periods ended March 31, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year. Note 2 - Accounting Policies Note 1 to the 2003 Annual Report on Form 10-K filed with the SEC contains a description of the accounting policies followed by the Company and discussion of recent accounting pronouncements. The following paragraphs update that information as necessary. 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 (FIN 46R) in December 2003. FIN 46 and FIN 46R address the consolidation and deconsolidation by business enterprises of certain variable interest entities. The Company adopted FIN 46 as of December 31, 2003 and FIN 46R as of March 31, 2004. The adoption of FIN 46 and FIN 46R did not have a material impact on the Company's financial position or results of operations. Although the Company has no investments in variable interest entities that required consolidation under FIN 46 or FIN 46R, the application of certain provisions of FIN 46R as of March 31, 2004 resulted in the de-consolidation of the trusts that have issued trust preferred capital securities on behalf of the Company. The trust preferred capital securities have been, and continue to be, classified as "borrowings" by the Company. The only change caused by the adoption of FIN 46R was to change the description as to whom the borrowings are owed. Prior to deconsolidation, the payable to the trusts was eliminated in consolidation with the offsetting intercompany receivable of the trusts. The amounts owed to the third-party purchasers of the trust preferred securities were disclosed as being owed by the Company to those third parties. Under de-consolidation accounting, only the amount owed by the Company to the trusts is reported in the consolidated financial statements. The receivables recorded by the trusts as being due from the Company and the amounts payable by the trusts to the third-party purchasers of the trust preferred securities remain on the trusts' books and are not included in the Company's consolidated financial statements. The net effect is that the Company now describes its borrowings as being due to the trusts instead of the third-party purchasers of the trust preferred securities - there is no change to the terms of the borrowings or the amounts owed. 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 these disclosures are required only on an annual basis and were included in Note 11 to the aforementioned 2003 consolidated financial statements filed on Form 10-K with the SEC. Certain of the additional disclosures are required to be included for interim periods, and the Company has made those disclosures in Note 9 below. Page 8
Note 3 - Reclassifications Certain amounts reported in the period ended March 31, 2003 have been reclassified to conform with the presentation for March 31, 2004. These reclassifications had no effect on net income or shareholders' equity for the periods presented, nor did they materially impact trends in financial information. Note 4 - Stock Option Plans At March 31, 2004, the Company has six stock-based employee compensation plans, five of which were assumed in acquisitions. The Company accounts for each plan 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 fair value recognition provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation. <TABLE> <CAPTION> Three Months Ended March 31, ---------------------------- (In thousands except per share data) 2004 2003 --------- -------- <S> <C> <C> Net income, as reported $ 4,720 4,693 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (52) (51) --------- -------- Pro forma net income $ 4,668 4,642 ========= ======== Earnings per share: Basic - As reported $ 0.50 0.50 Basic - Pro forma 0.49 0.50 Diluted - As reported 0.49 0.49 Diluted - Pro forma 0.48 0.49 </TABLE> Note 5 - Earnings Per Share Basic earnings per share were computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share includes the potentially dilutive effects of the Company's stock option plan. The following is a reconciliation of the numerators and denominators used in computing basic and diluted earnings per share: <TABLE> <CAPTION> For the Three Months Ended March 31, ------------------------------------------------------------------------------------ 2004 2003 --------------------------------------- --------------------------------------- Income Shares Income Shares ($ in thousands except per (Numer- (Denom- Per Share (Numer- (Denom- Per Share share amounts) ator) inator) Amount ator) inator) Amount - ----------------------------------- --------- --------- --------- --------- --------- --------- <S> <C> <C> <C> <C> <C> <C> Basic EPS Net income $ 4,720 9,467,371 $ 0.50 $ 4,693 9,360,692 $ 0.50 ========= ========= Effect of Dilutive Securities -- 182,568 -- 178,659 --------- --------- --------- --------- Diluted EPS $ 4,720 9,649,939 $ 0.49 $ 4,693 9,539,351 $ 0.49 ========= ========= ========= ========= ========= ========= </TABLE> For each of the three months ended March 31, 2004 and 2003, there were no options that were antidilutive since the exercise price of all options outstanding exceeded the average market price for the period. Page 9
Note 6 - Asset Quality Information Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> March 31, December 31, March 31, ($ in thousands) 2004 2003 2003 ------------------------------------------------------------------------------ <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $3,383 4,274 2,941 Restructured loans 20 21 38 Accruing loans > 90 days past due -- -- -- ------ ------- ------- Total nonperforming loans 3,403 4,295 2,979 Other real estate 1,585 1,398 1,326 ------ ------- ------- Total nonperforming assets $4,988 5,693 4,305 ====== ======= ======= Nonperforming loans to total loans 0.27% 0.35% 0.28% Nonperforming assets as a percentage of loans and other real estate 0.40% 0.47% 0.40% Nonperforming assets to total assets 0.33% 0.39% 0.33% Allowance for loan losses to total loans 1.11% 1.11% 1.11% </TABLE> Note 7 - Deferred Loan Fees Loans are shown on the Consolidated Balance Sheets net of net deferred loan fees of approximately $455,000, $603,000, and $698,000 at March 31, 2004, December 31, 2003, and March 31, 2003, respectively. Note 8 - Goodwill and Other Intangible Assets The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of March 31, 2004, December 31, 2003, and March 31, 2003 and the carrying amount of unamortized intangible assets as of those same dates. <TABLE> <CAPTION> March 31, 2004 December 31, 2003 March 31, 2003 ----------------------------- ------------------------------ ----------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Gross Carrying Accumulated ($ in thousands) Amount Amortization Amount Amortization Amount Amortization - ------------------------- -------------- ------------ -------------- ------------ -------------- ------------ <S> <C> <C> <C> <C> <C> <C> Amortizable intangible assets: Customer lists $ 394 62 394 54 394 31 Noncompete agreements 50 34 50 25 50 6 Core deposit premiums 2,441 507 2,441 429 1,106 293 ------- -------- --------- -------- --------- -------- Total $ 2,885 603 2,885 508 1,550 330 ======= ======== ========= ======== ========= ======== Unamortizable intangible assets: Goodwill $48,246 48,231 35,113 ======= ========= ========= Pension $ 93 93 93 ======= ========= ========= </TABLE> Amortization expense totaled $95,000 and $45,000 for the three months ended March 31, 2004 and 2003, respectively. Page 10
The following table presents the estimated amortization expense for each of the five calendar years ending December 31, 2008 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 (Dollars in thousands) Expense ---------------------- ---------------------- 2004 $ 379 2005 290 2006 242 2007 220 2008 219 Thereafter 1,027 ---------- Total $ 2,377 ========== Note 9 - Pension Plans The Company sponsors two defined benefit pension plans - a qualified retirement plan (the "Pension Plan") which is generally available to all employees, and a Supplemental Executive Retirement Plan (the "SERP Plan"), which is for the benefit of certain senior management executives of the Company. The Company recorded pension expense totaling $365,000 and $313,000 for the three months ended March 31, 2004 and 2003, respectively, related to the Pension Plan and the SERP Plan. The following table contains the components of the pension expense. <TABLE> <CAPTION> For the Three Months Ended March 31, ------------------------------------------------------------------------------- 2004 2003 2004 2003 2004 Total 2003 Total (in thousands) Pension Plan Pension Plan SERP Plan SERP Plan Both Plans Both Plans ------------ ------------ --------- --------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Service cost - benefits earned during the period $ 245 172 39 26 284 198 Interest cost on projected benefit obligation 173 132 28 22 201 154 Expected return on plan assets (200) (127) -- -- (200) (127) Net amortization and deferral 67 76 13 12 80 88 ----- ------ ------ ------ ------- ------- Net periodic pension cost $ 285 253 80 60 365 313 ===== ====== ====== ====== ======= ======= </TABLE> 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. Because of the significant employer contribution made to the Pension Plan during 2003 and the high return on assets experienced, the Company does not expect that any contributions will be required by funding regulations in 2004. However, the Company expects to make a discretionary contribution of approximately $950,000 during 2004. 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 Company does not expect that any payment will be due to participants of the SERP Plan in 2004. Page 11
Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition 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 two 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, and 2) 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 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, see "Nonperforming Assets" and "Summary of Loan Loss Experience" below. Page 12
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. For the Company, the only 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 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 an 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 operations is its only material reporting unit). At its last evaluation, the fair value of the Company's community banking operations 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. Current Accounting Matters See Note 2 to the Consolidated Financial Statements above as it relates to accounting standards that have been recently adopted by the Company. The following accounting standards will be adopted by the Company subsequent to March 31, 2004. 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 Page 13
quality. 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. SOP 03-3 becomes effective for loans or debt securities acquired in fiscal years beginning after December 15, 2004. The Company does not expect the adoption of this statement to have a material impact on the Company's financial statements. In March 2004, 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 are required for such loan commitments entered into subsequent to March 31, 2004. The Company does not expect the adoption of SAB 105 to have a material impact on the Company's financial statements. RESULTS OF OPERATIONS Overview Net income for the three months ended March 31, 2004 was $4,720,000, a 0.6% increase from the $4,693,000 recorded in the first quarter of 2003. The net income for each three month period amounted to $0.49 per diluted share. Most components of the Company's earnings increased in the first quarter of 2004 compared to the same quarter of 2003 as a result of the Company's growth. Growth from the previous year has occurred internally, as well as from the Company's October 2003 acquisition of four branches with $25 million in loans and $102 million in deposits. Growth in loans and deposits resulted in an increase in net interest income for the first quarter of 2004, which totaled $14.8 million, a 10.7% increase over the $13.3 million recorded in the first quarter of 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 the first quarter of 2004 was 4.37% compared to 4.59% for the first quarter of 2003. The Company's net interest margin has been negatively impacted by the declining 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 Company's provision for loan losses did not vary significantly in 2004 compared to 2003, amounting to $570,000 in the first quarter of 2004 versus $520,000 in the first quarter of 2003. Except for fees from presold mortgages, most components of noninterest income and noninterest expense increased in 2004 as a result of the Company's overall growth. Fees from presold mortgages decreased significantly in the first quarter of 2004 compared to the prior year, amounting to $188,000 in the first quarter of 2004 compared to $702,000 in the first quarter of 2003, as a result of a decline in mortgage refinancing activity caused by higher mortgage interest rates. The Company's asset quality ratios remained sound in the first quarter of 2004. For the three months ended March 31, 2004, net charge-offs as a percentage of average loans amounted to 7 basis points (annualized) compared to 11 basis points (annualized) for the first quarter of 2003. The Company's nonperforming assets to total assets ratio of 0.33% at March 31, 2004 was the same as at March 31, 2003. The Company's annualized return on average assets for the first quarter of 2004 was 1.28% compared to 1.49% for the first quarter of 2003. The Company's return on average equity for the first quarter of 2004 was 13.09% compared to 14.25% for the first quarter of 2003. Page 14
Components Of Earnings Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets. Net interest income for the three month period ended March 31, 2004 amounted to $14,773,000, an increase of $1,431,000, or 10.7% from the $13,342,000 recorded in the first quarter of 2003. Net interest income on a taxable equivalent basis for the three month period ended March 31, 2004 amounted to $14,896,000, an increase of $1,413,000, or 10.5% from the $13,483,000 recorded in the first quarter of 2003. There are two primary factors that cause changes in the amount of net interest income recorded by the Company - 1) growth in loans and deposits, and 2) the Company's net interest margin. For the three months ended March 31, 2004, growth in loans and deposits increased net interest income, the effects of which were partially offset by a decrease in the Company's net interest margin in the first quarter of 2004 compared to the first quarter of 2003. <TABLE> <CAPTION> For the Three Months Ended March 31, --------------------------------------------------------------------------------------- 2004 2003 ------------------------------------- ------------------------------------------ Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- -------- ---------- ---------- -------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,236,076 5.86% $ 18,003 $1,049,781 6.57% $ 17,009 Taxable securities 100,100 4.64% 1,155 73,905 5.16% 940 Non-taxable securities (2) 12,915 8.19% 263 15,739 9.02% 350 Short-term investments, principally federal funds 23,018 1.50% 86 53,010 2.34% 306 ---------- ---------- ---------- ---------- Total interest-earning assets 1,372,109 5.72% 19,507 1,192,435 6.33% 18,605 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 463,120 0.49% $ 563 $ 396,173 0.63% $ 618 Time deposits >$100,000 246,120 2.23% 1,365 218,177 2.90% 1,560 Other time deposits 402,040 2.03% 2,025 375,026 2.67% 2,467 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,111,280 1.43% 3,953 989,376 1.90% 4,645 Borrowings 71,604 3.70% 658 32,511 5.95% 477 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,182,884 1.57% 4,611 1,021,887 2.03% 5,122 ---------- ---------- Non-interest-bearing deposits 148,813 115,958 Net yield on interest-earning assets and net interest income 4.37% $ 14,896 4.59% $ 13,483 ========== ========== Interest rate spread 4.15% 4.30% Average prime rate 4.00% 4.25% </TABLE> - ---------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $123,000 and $141,000 in 2004 and 2003, respectively, to reflect the tax benefit that the Company receives related to its tax-exempt securities, which carry interest rates lower than similar taxable investments due to their tax exempt status. This amount has been computed assuming a 35% tax rate and is reduced by the related nondeductible portion of interest expense. Average loans outstanding for the first quarter of 2004 were $1.236 billion, which was 17.7% higher than the average loans outstanding for the first quarter of 2003 ($1.050 billion). Average deposits outstanding for the first quarter of 2004 were $1.260 billion, which was 14.0% higher than the average amount of deposits outstanding in the first quarter of 2003 ($1.105 billion). The increases in the average loans and deposits in 2004 compared to 2003 were a result of both internally generated growth as well as growth realized from acquisitions. See additional discussion regarding the nature of the growth in loans and deposits in the section entitled "Financial Condition" below. The effect of the higher amounts of average loans and deposits was to increase net interest income in 2004. Page 15
In the table above, the yields on interest earning assets and liabilities decreased in 2004 compared to 2003 as a result of the declining rate environment. The decrease in the weighted average cost of the Company's borrowings was also affected by the Company having a higher percentage of low cost overnight borrowings outstanding during the first quarter of 2004 compared to 2003, which have the effect of decreasing the weighted average rate of all borrowings. In the first quarter of 2004, the Company had approximately $20 million in average overnight borrowings outstanding with a weighted average rate of 1.10% compared to $0.8 million in similar average borrowings outstanding in the first quarter of 2003. The Company's net interest margin (tax-equivalent net interest income divided by average earning assets) for the first quarter of 2004 was 4.37% compared to 4.59% for the first quarter of 2003. The Company's net interest margin has been 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 declining interest rate environment, and the level to which it has dropped, has resulted in the Company being unable to reset deposit rates by an amount (because of their already near-zero rates) that would offset the negative impact of the lower yields earned on the Company's interest earning assets. The shift in the Company's loan mix from fixed rate loans to adjustable rate loans has occurred primarily over the past two years. At December 31, 2001, the Company's loan portfolio was comprised of 57% fixed rate loans and 43% adjustable rate loans. Since that time, the ratio has gradually shifted towards adjustable rate loans as the Company has originated more adjustable rate loans than fixed rate loans. At March 31, 2004, the Company's loan portfolio was comprised of 58% adjustable rate loans and 42% fixed rate loans. The primary reason for this shift has been that with interest rates at a historically low level, the Company has more attractively priced adjustable rate loans in order to avoid locking in fixed rate loans at a time when most economists believe that rates will rise. Although the Company will benefit from having a higher percentage of adjustable rate loans upon a rise in rates, adjustable rate loans in this interest rate environment generally carry lower initial rates than fixed rate loans of similar maturities, and the declining rate environment experienced over the past two years has resulted in the Company's adjustable rate loans repricing to lower levels following each rate cut. See additional information regarding net interest income in the section entitled "Interest Rate Risk." The Company recorded a $570,000 provision for loan losses during the first quarter of 2004 compared to a provision for loan losses of $520,000 recorded in the first quarter of 2003. The slightly higher provision for loan losses was a result of higher credit risk associated with higher loan growth, as asset quality ratios did not vary significantly. Net internal loan growth for the first quarter of 2004 was $33 million compared to $26 million for the first quarter of 2003. Noninterest income for the first quarter of 2004 amounted to $3,812,000, a 2.1% increase over the $3,733,000 recorded in the first quarter of 2003. Except for fees from presold mortgages, each component of noninterest income increased, primarily as a result of the Company's growth - internal growth, as well as external growth from the acquisition of four branches from RBC Centura Bank in October 2003 that had $25 million in loans and $102 million in deposits. Fees from presold mortgages amounted to $188,000 in the first quarter of 2004, a decrease from the $702,000 recorded in the first quarter of 2003. The decline is attributable to a decrease in mortgage refinancing activity as a result of rising mortgage interest rates. Page 16
Within noninterest income, commissions from sales of insurance and financial products amounted to $331,000 in the first quarter of 2004 compared to the $260,000 in the first quarter of 2003. This line item includes commissions the Company receives from three sources - 1) sales of credit insurance associated with new loans, 2) commissions from the sales of investment, annuity, and long-term care insurance products, and 3) commissions from the sale of property and casualty insurance. The following table presents these components for the three month period ended March 31, 2004 compared to the same period in 2003: Three Months Ended March 31, ---------------------------------------- ($ in thousands) $ % 2004 2003 Change Change ---- ---- ------ ------ Commissions earned from: Sales of credit insurance $ 59 78 (19) (24.4)% Sales of investments, annuities, and long term care insurance 54 22 32 145.5% Sales of property and casualty insurance 218 160 58 36.3% ---- ---- ---- ------ Total $331 260 71 27.3% ==== ==== ==== ====== Also within noninterest income, in the first quarter of 2004, the Company realized security gains of $92,000 as a result of the sale of a corporate bond. The bond was sold in order to realize current income, as well as to lock-in a gain on the security, which had an approaching call date. The Company realized no security gains in the first quarter of 2003, but did record a net gain of $61,000 related primarily to the sale of excess real estate adjoining one of the Company's bank branches. Noninterest expenses for the three months ended March 31, 2004 increased 16.0% to $10,732,000 from $9,248,000 in the first quarter of 2003. The increase in noninterest expenses occurred in all categories and is associated with the overall growth of the Company in terms of branch network, employees and customer base. The provision for income taxes was $2,563,000 in the first quarter of 2004 compared to $2,614,000 in the first quarter of 2003. The effective tax rates did not vary significantly among the periods presented, amounting to approximately 35-36% in each period. In the normal course of business, the Company carries out various tax planning initiatives in order to control its effective tax rate. The Consolidated Statements of Comprehensive Income reflect "Other Comprehensive Income" of $434,000 during the first quarter of 2004, related primarily to unrealized available for sale security holding gains of $804,000 occurring during the quarter. The unrealized security holding gains resulted from a decrease in market yields for fixed income securities during the quarter. The Company's available for sale securities portfolio is predominantly comprised of fixed income securities that rise in value when market yields for fixed income securities decrease. FINANCIAL CONDITION Total assets at March 31, 2004 amounted to $1.49 billion, 12.9% higher than a year earlier. Total loans at March 31, 2004 amounted to $1.25 billion, a 16.8% increase from a year earlier, and total deposits amounted to $1.29 billion at March 31, 2004, a 12.8% increase from a year earlier. The Company's acquisition of four RBC Centura Bank branches on October 27, 2003 contributed to the year-over-year increases. As of the acquisition date, the four RBC Centura Bank branches had $25 million in loans and $102 million in deposits. Page 17
The following tables present information regarding the nature of the Company's growth since March 31, 2003. <TABLE> <CAPTION> Percentage Balance at Balance at Total growth, April 1, 2003 to beginning Internal Growth from end of percentage excluding March 31, 2004 of period Growth Acquisitions period growth acquisitions ---------- --------- ------------ ----------- ------ ------------ ($ in thousands) <S> <C> <C> <C> <C> <C> <C> Loans $1,071,432 155,680 24,811 1,251,923 16.8% 14.5% ========== ========= ========= =========== ====== ====== Deposits - Noninterest bearing $ 132,929 (3,024) 29,056 158,961 19.6% -2.3% Deposits - Savings, NOW, and Money Market 401,773 34,265 35,667 471,705 17.4% 8.5% Deposits - Time>$100,000 231,055 18,033 4,650 253,738 9.8% 7.8% Deposits - Time<$100,000 378,056 (4,781) 32,593 405,868 7.4% (1.3%) ---------- --------- --------- ----------- ------ ------ Total deposits $1,143,813 44,493 101,966 1,290,272 12.8% 3.9% ========== ========= ========= =========== ====== ====== January 1, 2004 to March 31, 2004 Loans $1,218,895 33,028 -- 1,251,923 2.7% 2.7% ========== ========= ========= =========== ====== ====== Deposits - Noninterest bearing $ 146,499 12,462 -- 158,961 8.5% 8.5% Deposits - Savings, NOW, and Money Market 462,876 8,829 -- 471,705 1.9% 1.9% Deposits - Time>$100,000 238,535 15,203 -- 253,738 6.4% 6.4% Deposits - Time<$100,000 401,454 4,414 -- 405,868 1.1% 1.1% ---------- --------- --------- ----------- ------ ------ Total deposits $1,249,364 40,908 -- 1,290,272 3.3% 3.3% ========== ========= ========= =========== ====== ====== </TABLE> As can be seen in the first table, over the past twelve months the Company's internal growth rates for loans and deposits were 14.5% and 3.9% respectively, with the growth assumed in acquisitions increasing the overall growth in loans to 16.8% and deposits to 12.8%. All of the growth in the first quarter of 2004 was internally generated, as the Company did not complete in any acquisitions in that three month period. Nonperforming Assets Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> March 31, December 31, March 31, ($ in thousands) 2004 2003 2003 ------------------------------------------------------------------------------------ <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $3,383 4,274 2,941 Restructured loans 20 21 38 Accruing loans > 90 days past due -- -- -- ------ ------- ------- Total nonperforming loans 3,403 4,295 2,979 Other real estate 1,585 1,398 1,326 ------ ------- ------- Total nonperforming assets $4,988 5,693 4,305 ====== ======= ======= Nonperforming loans to total loans 0.27% 0.35% 0.28% Nonperforming assets as a percentage of loans and other real estate 0.40% 0.47% 0.40% Nonperforming assets to total assets 0.33% 0.39% 0.33% Allowance for loan losses to total loans 1.11% 1.11% 1.11% </TABLE> Page 18
Management has reviewed the collateral for the nonperforming assets, including nonaccrual loans, and has included this review among the factors considered in the evaluation of the allowance for loan losses discussed below. Nonperforming loans (which includes nonaccrual loans and restructured loans) as of March 31, 2004, December 31, 2003, and March 31, 2003 totaled $3,403,000, $4,295,000, and $2,979,000, respectively. Nonperforming loans as a percentage of total loans amounted to 0.27%, 0.35%, and 0.28%, at March 31, 2004, December 31, 2003, and March 31, 2003, respectively. The variances in nonperforming loans among the periods has been primarily due to changes in nonaccrual loans, as restructured loans have not changed significantly. The increase in nonaccrual loans from March 31, 2003 to December 31, 2003 related primarily to the Company placing five loans totaling $1.3 million on nonaccrual basis during the second half of the year. Each of these unrelated loans had an outstanding loan balance of between $225,000 and $325,000, and each loan was secured by real estate. Two of the five loans were liquidated during the first quarter of 2004 with no material loss to the Company, while one of the loans was foreclosed upon and its real estate collateral recorded as other real estate. The removal of these three loans from nonaccrual loan status resulted in the decrease in nonaccrual loans from December 31, 2003 to March 31, 2004. The other two loans remain on nonaccrual status. The Company believes that any losses related to these loans will not be material. The Company continues to have one large credit that was on nonaccrual basis as of each of the three dates presented. The nonaccrual balance of this credit amounted to $642,000, $663,000, and $750,000 as of March 31, 2004, December 31, 2003, and March 31, 2003, respectively. This relationship, secured primarily by real estate, was placed on nonaccrual status in 2001 due to liquidity problems experienced by the borrower and had a $1.9 million balance at that time. The borrower has been actively working to sell real estate to pay down the balance. In 2002, the Company accepted a nonbinding proposal from a third party that would have resulted in the receipt of approximately $750,000 of the remaining $1.0 million balance outstanding at the time. Accordingly, in the fourth quarter of 2002, the Company established a specific impaired loan valuation allowance of $250,000 for this relationship. During the first quarter of 2003, because the Company believed that there was a high likelihood that the terms of the nonbinding proposal would occur, the Company charged-off the $250,000 specific reserve that had been established. Since that time, numerous delays have occurred relating to the pay-off proposal, and management of the Company is no longer sure whether it will occur. The Company continues to actively seek collection of the loan and has received payments from collateral sales that have reduced the loan balance to its current amount. The Company has assigned a specific impaired loan valuation allowance of $330,000 to the remaining balance at March 31, 2004. At March 31, 2004, December 31, 2003, and March 31, 2003, the recorded investment in loans considered to be impaired was $1,275,000, $1,449,000, and $1,780,000, respectively, all of which were on nonaccrual status. A significant portion of the impaired loans for each of the three periods presented is the same credit noted above that is on nonaccrual status. At March 31, 2004, December 31, 2003, and March 31, 2003, the related allowance for loan losses for all impaired loans was $435,000 (all four impaired loans at March 31, 2004 had an assigned valuation allowance), $341,000 (related to five of the seven impaired loans with a total balance of $1,207,000), and $190,000 (eight of the eleven impaired loans totaling $949,000 at March 31, 2003 had an assigned valuation allowance), respectively. The average recorded investments in impaired loans during the three month period ended March 31, 2004, the year ended December 31, 2003, and the three months ended March 31, 2003 were approximately $1,362,000, $1,590,000, and $1,656,000, respectively. For the same periods, the Company recognized no interest income on those impaired loans during the period that they were considered to be impaired. The Company's other real estate owned did not vary significantly among the periods presented, amounting to $1,585,000, $1,398,000, and $1,326,000 at March 31, 2004, December 31, 2003 and March 31, 2003, respectively. The Company's management has reviewed recent appraisals of its other real estate and believes that their fair values, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented. Page 19
Summary Of Loan Loss Experience The allowance for loan losses is created by direct charges to operations. 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 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 the Company's 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 Company recorded a $570,000 provision for loan losses during the first quarter of 2004 compared to a provision for loan losses of $520,000 recorded in the first quarter of 2003. The slightly higher provision for loan losses was a result of higher credit risk associated with higher loan growth, as asset quality ratios did not vary significantly. Net internal loan growth for the first quarter of 2004 was $33 million compared to $26 million for the first quarter of 2003. At March 31, 2004, the allowance for loan losses amounted to $13,917,000, compared to $13,569,000 at December 31, 2003 and $11,898,000 at March 31, 2003. The allowance for loan losses was 1.11% of total loans as of each of those same dates. Management believes the Company's reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and value of other real estate. Such agencies may require the Company to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations. Page 20
For the periods indicated, the following table summarizes the Company's balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries, and additions to the allowance for loan losses that have been charged to expense and additions that were recorded related to acquisitions. <TABLE> <CAPTION> Three Months Twelve Months Three Months Ended Ended Ended March 31, December 31, March 31, ($ in thousands) 2004 2003 2003 ------------ ------------- ------------ <S> <C> <C> <C> Loans outstanding at end of period $ 1,251,923 1,218,895 1,071,432 =========== =========== =========== Average amount of loans outstanding $ 1,236,076 1,113,426 1,049,781 =========== =========== =========== Allowance for loan losses, at beginning of period $ 13,569 10,907 10,907 Total charge-offs (266) (1,341) (388) Total recoveries 44 240 108 ----------- ----------- ----------- Net charge-offs (222) (1,101) (280) ----------- ----------- ----------- Additions to the allowance charged to expense 570 2,680 520 ----------- ----------- ----------- Addition related to loans assumed in corporate acquisitions -- 1,083 751 ----------- ----------- ----------- Allowance for loan losses, at end of period $ 13,917 13,569 11,898 =========== =========== =========== Ratios: Net charge-offs (annualized) as a percent of average loans 0.07% 0.10% 0.11% Allowance for loan losses as a percent of loans at end of period 1.11% 1.11% 1.11% </TABLE> Based on the results of the Company's loan analysis and grading program and management's evaluation of the allowance for loan losses at March 31, 2004, there have been no material changes to the allocation of the allowance for loan losses among the various categories of loans since December 31, 2003. Liquidity, Commitments, and Contingencies The Company's liquidity is determined by its ability to convert assets to cash or acquire alternative sources of funds to meet the needs of its customers who are withdrawing or borrowing funds, and 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. In addition to internally generated liquidity sources, the Company has the ability to obtain borrowings from the following three sources - 1) an approximately $224 million line of credit with the Federal Home Loan Bank (of which $11 million has been drawn), 2) a $50 million overnight federal funds line of credit with a correspondent bank (none of which was outstanding at March 31, 2004), and 3) an approximately $56 million line of credit through the Federal Reserve Bank of Richmond's discount window (none of which was outstanding at March 31, 2004). The Company's liquidity did not change materially from December 31, 2003 to March 31, 2004, as deposit growth and loan growth did not vary significantly. The Company's loan to deposit ratio was 97.0% at March 31, 2004 compared to 97.6% at December 31, 2003. 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 was 12.5% at March 31, 2004 compared to 12.3% at December 31, 2003. Page 21
The amount and timing of the Company's contractual obligations and commercial commitments has not changed materially since December 31, 2003, detail of which is presented in Table 18 on page 52 of the Company's 2003 Form 10-K. 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. 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. 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. Derivative financial instruments include futures, forwards, interest rate swaps, options contracts, and other financial instruments with similar characteristics. The Company has not engaged in derivative activities through March 31, 2004, and has no current plans to do so. Capital Resources The Company is regulated by the Board of Governors of the Federal Reserve Board (FED) and is subject to securities registration and public reporting regulations of the Securities and Exchange Commission. The Company's banking subsidiary is regulated by the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Office of the Commissioner of Banks. 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 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 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 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 to maintain minimum ratios of "Tier 1" capital to total risk-weighted assets and total capital to risk-weighted assets of 4.00% and 8.00%, respectively. Tier 1 capital is comprised of total shareholders' equity calculated in accordance with generally accepted accounting principles, excluding accumulated other comprehensive income (loss), less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which for the Company is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company, 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 is subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets 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. Page 22
At March 31, 2004, the Company's capital ratios exceeded the regulatory minimum ratios discussed above. The following table presents the Company's capital ratios and the regulatory minimums discussed above for the periods indicated. <TABLE> <CAPTION> March 31, December 31, March 31, 2004 2003 2003 --------- ------------ --------- <S> <C> <C> <C> Risk-based capital ratios: Tier I capital to Tier I risk adjusted assets 10.60% 10.61% 11.70% Minimum required Tier I capital 4.00% 4.00% 4.00% Total risk-based capital to Tier II risk-adjusted assets 12.49% 12.56% 12.74% Minimum required total risk-based capital 8.00% 8.00% 8.00% Leverage capital ratios: Tier I leverage capital to adjusted most recent quarter average assets 8.54% 8.70% 9.39% Minimum required Tier I leverage capital 4.00% 4.00% 4.00% </TABLE> The Company's capital ratios decreased from March 31, 2003 to December 31, 2003 primarily as a result of the acquisition of the four branches from RBC Centura Bank on October 24, 2003, the impact of which was partially offset by the Company's issuance of $20 million in trust preferred securities during December 2003. The Company's risk based capital ratios did not change significantly from December 31, 2003 to March 31, 2004, while the Company's leverage capital ratio, which uses "average assets" in its calculation, declined slightly due to the assets assumed in the aforementioned branch acquisition being outstanding for the full three months of 2004 compared to just over two months for the fourth quarter of 2003. Treatment of trust preferred securities within the Company's capital ratio calculations in light of FIN 46 is pending further guidance from the banking regulators. If the banking regulators change the capital treatment for trust preferred securities, the Company's Tier 1 and total capital could be reduced by the amount of outstanding trust preferred securities, but the Company believes that its capital classifications would not fall below the level of "adequately" capitalized. The Company's bank subsidiary is also subject to similar capital requirements as those discussed above. The bank subsidiary's capital ratios do not vary materially from the Company's capital ratios presented above. At March 31, 2004, the Company's bank subsidiary exceeded the minimum ratios established by the FED and FDIC. SHARE REPURCHASES During the first quarter of 2004, the Company repurchased 49,942 shares of its own common stock at an average price of $33.38 per share. At March 31, 2004, the Company had approximately 111,000 shares available for repurchase under existing authority from its board of directors. The Company plans to repurchase these shares in open market and privately negotiated transactions, as market conditions and the Company's liquidity warrant, subject to compliance with applicable regulations. See also Part II, Item 2 "Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities." Item 3. Quantitative and Qualitative Disclosures About Market Risk INTEREST RATE RISK (INCLUDING QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK) 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 Page 23
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 9.50%. 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 included in the period of their expected call), at March 31, 2004 the Company had $307.8 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 at March 31, 2004 subject to interest rate changes within one year are deposits totaling $471.7 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 coincidentally with or in the same proportion as general market indicators. Thus, the Company believes that in the near term (twelve months), net interest income would 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 (In fact, it has been the Company's experience that each interest rate cut occurring during the past three years has negatively 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 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, recent rate cuts, particularly the two rate cuts totaling 75 basis points that have occurred since September 30, 2002, have 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. Additionally, as previously discussed, over the past two years, the Company has originated significantly more adjustable rate loans compared to fixed rate loans. In the current interest rate environment, adjustable rate loans generally carry lower initial interest rates than fixed rate loans. If the trend of originating more adjustable rate loans than fixed rate loans continues throughout 2004, which the Company expects will occur, the Company's net interest margin will continue to be negatively impacted, unless market interest rates rise. Accordingly, under the assumption of a stable interest rate environment in 2004, the Company would expect its net interest margin, which was 4.37% for the first quarter of 2004 compared to 4.44% in the fourth quarter of 2003, to continue to decline slightly in each quarter for the remainder of 2004. If interest rates were to further decline, the Company expects that its net interest margin would decline further, whereas if interest rates were to increase, the Company expects that its net interest margin would be positively impacted. The Company has no market risk sensitive instruments held for trading purposes, nor does it maintain any foreign currency positions. Page 24
See additional discussion of the Company's net interest margin in the "Components of Earnings" section above. Item 4. 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, or subsequent to, the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. FORWARD-LOOKING STATEMENTS Part I 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. Page 25
Part II. Other Information Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities Issuer Purchases of Equity Securities ------------------------------------- <TABLE> <CAPTION> 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 Share Plans or Programs Plans or Programs - --------------------------- ---------------- ---------------------- ---------------------- ---------------------- <S> <C> <C> <C> <C> January 1, 2004 to January 31, 2004 -- -- -- 160,554 February 1, 2004 to February 29, 2004 28,000(2) $ 33.56 28,000(1) 132,554 March 1, 2004 to March 31, 2004 21,942(2) 33.15 21,942(1) 110,612 -------- ------- -------- --------- Total 49,942 $ 33.38 49,942 110,612 ======== ======= ======== ========= </TABLE> Footnotes to the Above Table (1) All shares were purchased pursuant to the share repurchase authorization announced on April 23, 2003. A total of 200,000 shares were authorized for repurchase. The repurchase authorization does not have an expiration date. There were no plans or programs that expired during the period covered by the table. 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 shares included in the table above do 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 1994 First Bancorp Stock Option Plan. In January 2004, 2,913 shares of the Company's common stock, with a weighted average market price of $33.37, were used to satisfy such exercises. In February 2004, 2,812 shares of the Company's common stock, with a weighted average market price of $33.78, were used to satisfy such exercises. There were no such exercises in March 2004. Item 6 - Exhibits and Reports on Form 8-K (a) 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 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. 31.1 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. 31.2 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. Page 26
32.1 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. 32.2 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) There was one report on Form 8-K filed during the quarter ended March 31, 2004. On January 23, 2004, the Company filed a report on Form 8-K regarding its January 23, 2004 news release in which it announced its earnings for the quarter and year ended December 31, 2003. The full text of the news release dated January 23, 2004 was attached as Exhibit 99(a) to this Form 8-K filing. Copies of exhibits are available upon written request to: First Bancorp, Anna G. Hollers, Executive Vice President, P.O. Box 508, Troy, NC 27371 Page 27
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FIRST BANCORP May 5, 2004 BY: James H. Garner --------------------------- James H. Garner President (Principal Executive Officer), Treasurer and Director May 5, 2004 BY: Anna G. Hollers --------------------------- Anna G. Hollers Executive Vice President and Secretary May 5, 2004 BY: Eric P. Credle --------------------------- Eric P. Credle Senior Vice President and Chief Financial Officer Page 28