================================================================================ UNITED STATES 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 September 30, 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 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 ------------------------------------------- </TABLE> 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 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO As of November 1, 2005, 14,212,493 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 - September 30, 2005 and 2004 (With Comparative Amounts at December 31, 2004) 3 Consolidated Statements of Income - For the Periods Ended September 30, 2005 and 2004 4 Consolidated Statements of Comprehensive Income - For the Periods Ended September 30, 2005 and 2004 5 Consolidated Statements of Shareholders' Equity - For the Periods Ended September 30, 2005 and 2004 6 Consolidated Statements of Cash Flows - For the Periods Ended September 30, 2005 and 2004 7 Notes to Consolidated Financial Statements 8 Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition 13 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 29 Item 4 - Controls and Procedures 30 Part II. Other Information Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 31 Item 6 - Exhibits 31 Signatures 32 Page 2
Part I. Financial Information Item 1 - Financial Statements First Bancorp and Subsidiaries Consolidated Balance Sheets <TABLE> <CAPTION> September 30, December 31, September 30, ($ in thousands-unaudited) 2005 2004 (audited) 2004 ====================================================================================================== <S> <C> <C> <C> ASSETS Cash & due from banks, noninterest-bearing $ 21,853 28,486 34,657 Due from banks, interest-bearing 47,402 45,135 52,555 Federal funds sold 28,586 15,780 -- ------------- ------------- ------------- Total cash and cash equivalents 97,841 89,401 87,212 ------------- ------------- ------------- Securities available for sale (costs of $115,686, $87,368, and $90,938) 115,622 88,554 92,330 Securities held to maturity (fair values of $12,820, $14,451, and $14,242) 12,799 14,025 13,721 Presold mortgages in process of settlement 3,586 1,771 1,781 Loans 1,446,185 1,367,053 1,337,583 Less: Allowance for loan losses (15,879) (14,717) (14,351) ------------- ------------- ------------- Net loans 1,430,306 1,352,336 1,323,232 ------------- ------------- ------------- Premises and equipment 33,395 30,318 28,195 Accrued interest receivable 7,779 6,832 6,432 Intangible assets 49,300 49,330 50,199 Other 7,406 6,346 7,072 ------------- ------------- ------------- Total assets $ 1,758,034 1,638,913 1,610,174 ============= ============= ============= LIABILITIES Deposits: Demand - noninterest-bearing $ 192,399 165,778 160,791 Savings, NOW, and money market 460,709 472,811 463,144 Time deposits of $100,000 or more 349,620 334,756 288,988 Other time deposits 472,800 415,423 409,702 ------------- ------------- ------------- Total deposits 1,475,528 1,388,768 1,322,625 Repurchase agreements 12,409 -- -- Borrowings 101,239 92,239 132,239 Accrued interest payable 3,543 2,677 2,539 Other liabilities 14,386 6,751 7,183 ------------- ------------- ------------- Total liabilities 1,607,105 1,490,435 1,464,586 ------------- ------------- ------------- SHAREHOLDERS' EQUITY Common stock, No par value per share Issued and outstanding: 14,196,987, 14,083,856, and 14,055,137 shares 53,574 51,614 51,515 Retained earnings 97,655 96,347 93,430 Accumulated other comprehensive income (loss) (300) 517 643 ------------- ------------- ------------- Total shareholders' equity 150,929 148,478 145,588 ------------- ------------- ------------- Total liabilities and shareholders' equity $ 1,758,034 1,638,913 1,610,174 ============= ============= ============= </TABLE> See notes to consolidated financial statements. Page 3
First Bancorp and Subsidiaries Consolidated Statements of Income <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, -------------------------- ------------------------- ($ in thousands, except share data-unaudited) 2005 2004 2005 2004 =================================================================================================================== <S> <C> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 24,240 19,321 68,331 55,516 Interest on investment securities: Taxable interest income 1,315 1,167 3,881 3,451 Tax-exempt interest income 114 123 360 403 Other, principally overnight investments 398 123 1,117 313 ------------ ---------- ----------- ---------- Total interest income 26,067 20,734 73,689 59,683 ------------ ---------- ----------- ---------- INTEREST EXPENSE Savings, NOW and money market 1,042 636 2,881 1,782 Time deposits of $100,000 or more 3,015 1,579 8,085 4,400 Other time deposits 3,532 2,062 9,013 6,093 Other, primarily borrowings 1,126 916 3,066 2,235 ------------ ---------- ----------- ---------- Total interest expense 8,715 5,193 23,045 14,510 ------------ ---------- ----------- ---------- Net interest income 17,352 15,541 50,644 45,173 Provision for loan losses 690 770 2,115 2,080 ------------ ---------- ----------- ---------- Net interest income after provision for loan losses 16,662 14,771 48,529 43,093 ------------ ---------- ----------- ---------- NONINTEREST INCOME Service charges on deposit accounts 2,180 2,325 6,333 6,879 Other service charges, commissions and fees 961 809 2,950 2,499 Fees from presold mortgages 328 220 851 698 Commissions from sales of insurance and financial products 388 387 997 1,064 Data processing fees 38 104 243 304 Securities gains -- 100 2 288 Other gains (losses) (116) 351 (175) 269 ------------ ---------- ----------- ---------- Total noninterest income 3,779 4,296 11,201 12,001 ------------ ---------- ----------- ---------- NONINTEREST EXPENSES Salaries 5,402 5,037 16,167 14,881 Employee benefits 1,407 1,487 4,712 4,180 ------------ ---------- ----------- ---------- Total personnel expense 6,809 6,524 20,879 19,061 Net occupancy expense 797 686 2,259 2,084 Equipment related expenses 744 735 2,207 2,201 Intangibles amortization 71 95 217 284 Other operating expenses 3,065 3,052 9,899 8,797 ------------ ---------- ----------- ---------- Total noninterest expenses 11,486 11,092 35,461 32,427 ------------ ---------- ----------- ---------- Income before income taxes 8,955 7,975 24,269 22,667 Income taxes 9,646 2,778 15,592 7,864 ------------ ---------- ----------- ---------- NET INCOME (LOSS) $ (691) 5,197 8,677 14,803 ============ ========== =========== ========== Earnings (loss) per share: Basic $ (0.05) 0.37 0.61 1.05 Diluted (0.05) 0.36 0.60 1.03 Weighted average common shares outstanding: Basic 14,186,887 14,112,489 14,150,527 14,163,210 Diluted 14,186,887 14,335,860 14,353,169 14,407,085 </TABLE> See notes to consolidated financial statements. Page 4
First Bancorp and Subsidiaries Consolidated Statements of Comprehensive Income <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, -------------------- --------------------- ($ in thousands-unaudited) 2005 2004 2005 2004 ================================================================================================= <S> <C> <C> <C> <C> Net income (loss) $ (691) 5,197 8,677 14,803 -------- -------- -------- -------- Other comprehensive income (loss): Unrealized gains (losses) on securities available for sale: Unrealized holding gains (losses) arising during the period, pretax (824) 2,079 (1,252) (188) Tax benefit (expense) 322 (811) 491 73 Reclassification to realized gains -- (100) (2) (288) Tax expense -- 39 1 112 Adjustment to minimum pension liability: Additional pension charge related to unfunded pension liability -- -- (90) (46) Tax benefit -- -- 35 18 -------- -------- -------- -------- Other comprehensive income (loss) (502) 1,207 (817) (319) -------- -------- -------- -------- Comprehensive income (loss) $ (1,193) 6,404 7,860 14,484 ======== ======== ======== ======== </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 (Loss) Equity ======================================================================================================================= <S> <C> <C> <C> <C> <C> Balances, January 1, 2004 14,153 $ 55,392 85,502 962 141,856 Net income 14,803 14,803 Cash dividends declared ($0.49 per share) (6,875) (6,875) Common stock issued under stock option plan 139 914 914 Common stock issued into dividend reinvestment plan 51 1,080 1,080 Purchases and retirement of common stock (288) (6,212) (6,212) Tax benefit realized from exercise of nonqualified stock options 341 341 Other comprehensive loss (319) (319) ----------- ----------- ----------- ------------- ----------- Balances, September 30, 2004 14,055 $ 51,515 93,430 643 145,588 =========== =========== =========== ============= =========== Balances, January 1, 2005 14,084 $ 51,614 96,347 517 148,478 Net income 8,677 8,677 Cash dividends declared ($0.52 per share) (7,369) (7,369) Common stock issued under stock option plan 58 656 656 Common stock issued into dividend reinvestment plan 55 1,204 1,204 Tax benefit realized from exercise of nonqualified stock options 100 100 Other comprehensive loss (817) (817) ----------- ----------- ----------- ------------- ----------- Balances, September 30, 2005 14,197 $ 53,574 97,655 (300) 150,929 =========== =========== =========== ============= =========== </TABLE> See notes to consolidated financial statements. Page 6
First Bancorp and Subsidiaries Consolidated Statements of Cash Flows <TABLE> <CAPTION> Nine Months Ended September 30, --------------------- ($ in thousands-unaudited) 2005 2004 ================================================================================================== <S> <C> <C> Cash Flows From Operating Activities Net income $ 8,677 14,803 Reconciliation of net income to net cash provided by operating activities: Provision for loan losses 2,115 2,080 Net security premium amortization 83 135 Loss (gain) on disposal of other real estate 112 (347) Gain on sale of securities available for sale (2) (288) Other losses 63 78 Decrease in loan fees and costs deferred (288) (244) Depreciation of premises and equipment 2,005 1,892 Tax benefit from exercise of nonqualified stock options 100 341 Amortization of intangible assets 217 284 Deferred income tax benefit (224) (698) Originations of presold mortgages in process of settlement (54,838) (45,135) Proceeds from sales of presold mortgages in process of settlement 53,023 44,661 Increase in accrued interest receivable (947) (345) Decrease in other assets 180 691 Increase in accrued interest payable 866 401 Increase in other liabilities 7,196 880 --------- -------- Net cash provided by operating activities 18,338 19,189 --------- -------- Cash Flows From Investing Activities Purchases of securities available for sale (47,755) (26,601) Purchases of securities held to maturity -- (395) Proceeds from maturities/issuer calls of securities available for sale 19,355 24,146 Proceeds from maturities/issuer calls of securities held to maturity 1,171 2,030 Proceeds from sales of securities available for sale 8 12,028 Net increase in loans (82,150) (120,937) Proceeds from sales of other real estate 1,732 903 Purchases of premises and equipment (5,082) (4,551) --------- -------- Net cash used by investing activities (112,721) (113,377) --------- -------- Cash Flows From Financing Activities Net increase in deposits and repurchase agreements 99,169 73,261 Proceeds from borrowings, net 9,000 56,239 Cash dividends paid (7,206) (6,796) Proceeds from issuance of common stock 1,860 1,994 Purchases and retirement of common stock -- (6,212) --------- -------- Net cash provided by financing activities 102,823 118,486 --------- -------- Increase in Cash and Cash Equivalents 8,440 24,298 Cash and Cash Equivalents, Beginning of Period 89,401 62,914 --------- -------- Cash and Cash Equivalents, End of Period $ 97,841 87,212 ========= ======== Supplemental Disclosures of Cash Flow Information: Cash paid during the period for: Interest $ 22,179 14,109 Income taxes 8,931 6,602 Non-cash transactions: Unrealized loss on securities available for sale, net of taxes (762) (291) Additions to held to maturity securities and borrowings related to deconsolidation of subsidiary trusts -- 1,239 Foreclosed loans transferred to other real estate 2,353 1,195 Other real estate transferred to premises and equipment -- 180 </TABLE> See notes to consolidated financial statements. Page 7
First Bancorp and Subsidiaries Notes To Consolidated Financial Statements (unaudited) For the Periods Ended September 30, 2005 and 2004 ================================================================================ 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 September 30, 2005 and 2004 and the consolidated results of operations and consolidated cash flows for the periods ended September 30, 2005 and 2004. All such adjustments were of a normal, recurring nature. Reference is made to the 2004 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 September 30, 2005 and 2004 are not necessarily indicative of the results to be expected for the full year. Note 2 - Accounting Policies Note 1 to the 2004 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 paragraph updates that information as necessary. 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. Note 3 - Reclassifications Certain amounts reported in the period ended September 30, 2004 have been reclassified to conform with the presentation for September 30, 2005. These reclassifications had no effect on net income (loss) or shareholders' equity for the periods presented, nor did they materially impact trends in financial information. Note 4 - Stock Option Plans At September 30, 2005, the Company has six stock-based employee compensation plans, four 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 Page 8
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 Nine Months Ended -------------------- -------------------- September 30, September 30, -------------------- -------------------- (In thousands except per share data) 2005 2004 2005 2004 -------- -------- -------- -------- <S> <C> <C> <C> <C> Net income (loss), as reported $ (691) 5,197 8,677 14,803 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (52) (52) (284) (1,238) -------- -------- -------- -------- Pro forma net income $ (743) 5,145 8,393 13,565 ======== ======== ======== ======== Earnings per share: Basic-As reported $ (0.05) 0.37 0.61 1.05 Basic-Pro forma (0.05) 0.36 0.59 0.96 Diluted-As reported (0.05) 0.36 0.60 1.03 Diluted-Pro forma (0.05) 0.36 0.58 0.94 </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 September 30, --------------------------------------------------------------------------------- 2005 2004 ---------------------------------------- --------------------------------------- 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 (loss) $ (691) 14,186,887 $ (0.05) $ 5,197 14,112,489 $ 0.37 =========== =========== Effect of Dilutive Securities -- -- -- 223,371 ----------- ----------- ----------- ----------- Diluted EPS $ (691) 14,186,887 $ (0.05) $ 5,197 14,335,860 $ 0.36 =========== =========== =========== =========== =========== =========== <CAPTION> For the Nine Months Ended September 30, --------------------------------------------------------------------------------- 2005 2004 ---------------------------------------- --------------------------------------- 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 $ 8,677 14,150,527 $ 0.61 $ 14,803 14,163,210 $ 1.05 =========== =========== Effect of Dilutive Securities -- 202,642 -- 243,875 ----------- ----------- ----------- ----------- Diluted EPS $ 8,677 14,353,169 $ 0.60 $ 14,803 14,407,085 $ 1.03 =========== =========== =========== =========== =========== =========== </TABLE> Page 9
Because the Company reported a net loss for the three months ended September 30, 2005, all options are considered to be anti-dilutive. If the Company had reported net income for the three months ended September 30, 2005, the "Effect of Dilutive Securities" in the table above would have been 170,840 shares. For the three months ended September 30, 2005, there were 189,230 options for which the exercise price exceeded the average market price for the period. For the three months ended September 30, 2004, there were 142,509 options that were anti-dilutive because the exercise price exceeded the average market price for the period. For the nine months ended September 30, 2005 there were no anti-dilutive options, and for the nine months ended September 30, 2004, there were 142,509 antidilutive options. Anti-dilutive options have been omitted from the calculation of diluted earnings per share for the respective periods. 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> September 30, December 31, September 30, ($ in thousands) 2005 2004 2004 =============================================================================================== <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 3,330 3,707 3,637 Restructured loans 14 17 18 Accruing loans > 90 days past due -- -- -- ------------- ------------- ------------- Total nonperforming loans 3,344 3,724 3,655 Other real estate 2,023 1,470 1,877 ------------- ------------- ------------- Total nonperforming assets $ 5,367 5,194 5,532 ============= ============= ============= Nonperforming loans to total loans 0.23% 0.27% 0.27% Nonperforming assets as a percentage of loans and other real estate 0.37% 0.38% 0.41% Nonperforming assets to total assets 0.31% 0.32% 0.34% Allowance for loan losses to total loans 1.10% 1.08% 1.07% </TABLE> ================================================================================ Note 7 - Deferred Loan Fees Loans are shown on the Consolidated Balance Sheets net of net deferred loan costs of $75,000 at September 30, 2005 and net deferred loan fees of approximately $213,000, and $359,000 at December 31, 2004, and September 30, 2004, respectively. Note 8 - Goodwill and Other Intangible Assets The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of September 30, 2005, December 31, 2004, and September 30, 2004 and the carrying amount of unamortized intangible assets as of those same dates. <TABLE> <CAPTION> September 30, 2005 December 31, 2004 September 30, 2004 ----------------------------- ----------------------------- ----------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Gross Carrying Accumulated ($ in thousands) Amount Amortization Amount Amortization Amount Amortization - ------------------------------ -------------- ------------- -------------- ------------- -------------- ------------- <S> <C> <C> <C> <C> <C> <C> Amortizable intangible assets: Customer lists $ 394 108 394 85 394 77 Noncompete agreements 50 50 50 50 50 44 Core deposit premiums 2,441 945 2,441 751 2,441 671 ------------- ------------- ------------- ------------- ------------- ------------- Total $ 2,885 1,103 2,885 886 2,885 792 ============= ============= ============= ============= ============= ============= Unamortizable intangible assets: Goodwill $ 47,247 47,247 48,023 ============= ============= ============= Pension $ 273 84 83 ============= ============= ============= </TABLE> Page 10
Amortization expense totaled $71,000 and $95,000 for the three months ended September 30, 2005 and 2004, respectively. Amortization expense totaled $217,000 and $284,000 for the nine months ended September 30, 2005 and 2004, respectively. The following table presents the estimated amortization expense for each of the five calendar years ending December 31, 2009 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 ------------------------ ------------------------ 2005 $ 290 2006 242 2007 220 2008 219 2009 218 Thereafter 810 ---------- Total $ 1,999 ========== 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 $447,000 and $399,000 for the three months ended September 30, 2005 and 2004, respectively, related to the Pension Plan and the SERP Plan. The following table contains the components of the pension expense for the three months ended September 30, 2005 and 2004. <TABLE> <CAPTION> For the Three Months Ended September 30, ------------------------------------------------------------------------------- 2005 2004 2005 2004 2005 Total 2004 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 $ 284 239 62 61 346 300 Interest cost on projected benefit obligation 192 161 38 32 230 193 Expected return on plan assets (237) (190) -- -- (237) (190) Net amortization and deferral 86 76 22 20 108 96 -------- -------- -------- -------- -------- -------- Net periodic pension cost $ 325 286 122 113 447 399 ======== ======== ======== ======== ======== ======== </TABLE> The Company recorded pension expense totaling $1,341,000 and $1,197,000 for the nine months ended September 30, 2005 and 2004, respectively, related to the Pension Plan and the SERP Plan. The following table contains the components of the pension expense for the nine months ended September 30, 2005 and 2004. <TABLE> <CAPTION> For the Nine Months Ended September 30, ------------------------------------------------------------------------------- 2005 2004 2005 2004 2005 Total 2004 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 $ 852 717 186 182 1,038 899 Interest cost on projected benefit obligation 576 482 114 96 690 578 Expected return on plan assets (711) (569) -- -- (711) (569) Net amortization and deferral 258 229 66 60 324 289 -------- -------- -------- -------- -------- -------- Net periodic pension cost $ 975 859 366 338 1,341 1,197 ======== ======== ======== ======== ======== ======== </TABLE> Page 11
The Company's contributions to the Pension Plan are based on computations by independent actuarial consultants and are intended to ensure that the Pension Plan exceeds minimum funding standards at all times. The contributions are invested to provide for benefits under the Pension Plan. The Company made a contribution to the Pension Plan in the amount of $1,419,000 during the third quarter of 2005. No further contributions to the Pension Plan are expected in 2005. 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 believe that there will be any payments to participants of the SERP Plan in 2005. Note 10 - Contingency During the third quarter of 2005, the Company recorded a contingency tax loss accrual amounting to $6,320,000, or $0.44 per diluted share, net of the federal tax benefit. As previously reported, the Company is currently undergoing a tax audit by the North Carolina Department of Revenue. Although the Company has not received any assessment at this time, the Company concluded that applicable accounting standards required that a loss be accrued in the third quarter to reserve for an operating structure involving a real estate investment trust (REIT) that resulted in a reduction of the Company's state tax liability. The North Carolina Department of Revenue has indicated that it will challenge the tax benefits that the Company received as a result of the REIT structure. This operating structure was established based on consultations with the Company's tax advisors, and the Company believes its state tax returns complied with the relevant North Carolina tax statutes. Therefore, the Company will devote all reasonable resources to minimize any ultimate liability. The Company does not believe that there is any additional exposure related to this item beyond the amount of the accrual other than ongoing interest on the unpaid taxes amounting to $48,000 per quarter (after-tax). Page 12
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 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 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 Page 13
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. 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 section below entitled "Liquidity, Commitments, and Contingencies" and Note 10 to the consolidated financial statements above includes the disclosure of a tax uncertainty that the Company recorded a loss accrual for during the third quarter of 2005. 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 higher amount of 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 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 insurance agency acquisitions, the identifiable intangible assets related to the customer lists were determined to have a life of ten to fifteen years, with amortization occurring on a straight-line basis. Page 14
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. 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 September 30, 2005, to the extent applicable. In November 2003, the FASB ratified a consensus reached by its Emerging Issues Task Force ("EITF") regarding quantitative and qualitative disclosures required by EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." EITF Issue No. 03-1 requires certain quantitative and qualitative disclosures as it relates to investments that have unrealized losses that have not been recognized as other-than-temporary impairments and is effective for fiscal years ending after December 15, 2003. The additional disclosures required for the Company were included in Note 3 to the Company's 2004 Form 10-K. In March 2004, the EITF released Consensus 03-1 (EITF 03-1). EITF 03-1 as released, codified the provisions of SEC Staff Accounting Bulletin No. 59 and required additional information about unrealized losses associated with debt and equity securities and also provided more detailed criteria that must be followed in evaluating whether to record losses on impaired debt and equity securities. The disclosure requirements were applicable for annual reporting periods ending after June 15, 2004 and were presented in Note 3 to the Company's 2004 Form 10-K. The impairment accounting requirements were to have been effective for periods beginning after June 15, 2004. However, in September 2004, the FASB indefinitely delayed the effective date of the requirement to record impairment losses caused by the effect of increases in interest rates or "sector spreads." In June 2005, the FASB voted to delete the proposed new impairment accounting requirements, instead deciding to provide further clarification of existing guidance at a future date. The clarification of existing guidance is not expected to materially impact the Company. 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 Page 15
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. Based on the provisions of Statement 123(R) and the options that the Company currently has outstanding, the Company's stock-based compensation expense related to options currently outstanding will be approximately $123,000 and $43,000 in 2006 and 2007, respectively. These expense amounts are lower than they otherwise would have been had the Company required five year vesting in connection with approximately 157,000 options what were granted to employees on April 1, 2004. Instead, no vesting periods were required for these options. 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. The Company expects that future employee stock option grants will revert to having five year vesting periods. New stock option grants that 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. As it relates to director stock option grants, the Company expects to continue to grant 2,250 stock options to each of the Company's directors on June 1 of each year until the 2014 expiration of the current stock option plan. In 2005, the amount of pro forma expense associated with the director grants was $127,000, which is a component of the $284,000 in pro forma stock based employee compensation expense in Note 4 to the consolidated financial statements for the nine months ended September 30, 2005. 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 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. RESULTS OF OPERATIONS Overview Page 16
The Company recorded a net loss for the three months ended September 30, 2005 amounting to $691,000, or $0.05 per diluted share, compared to net income of $5,197,000, or $0.36 per diluted share, recorded in the third quarter of 2004. Net income for the nine months ended September 30, 2005 was $8,677,000, or $0.60 per diluted share, a 41.7% decrease in diluted earnings per share from the net income of $14,803,000, or $1.03 per diluted share, reported for the nine months ended September 30, 2004. As discussed below, during the third quarter of 2005 the Company recorded a contingency loss accrual related to income tax exposure amounting to $6,320,000 (after-tax), or $0.44 per diluted share, that is included in the Company's income tax expense for the three and nine months ended September 30, 2005. Share amounts for September 30, 2004 have been adjusted from their originally reported amounts to reflect the 3-for-2 stock split paid on November 15, 2004. Net interest income for the third quarter of 2005 amounted to $17.4 million, an 11.7% increase over the $15.5 million recorded in the third quarter of 2004. Net interest income for the nine months ended September 30, 2005 amounted to $50.6 million, a 12.1% increase over the $45.2 million recorded in the same nine month period in 2004. Both of these increases are primarily attributable to growth in loans and deposits during the periods indicated. The Company's net interest margins (tax-equivalent net interest income divided by average earning assets) realized for the three and nine month periods ended September 30, 2005 were slightly higher than the net interest margins realized for the comparable periods in 2004. The Company's net interest margin for the third quarter of 2005 was 4.32% compared to 4.28% for the third quarter of 2004. The Company's net interest margin for the first nine months of 2005 was 4.32% compared to 4.30% for the same nine months of 2004. The 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. The provision for loan losses recorded by the Company for the three and nine months ended September 30, 2005 did not vary significantly from the comparable periods in 2004, amounting to $690,000 in the third quarter of 2005 compared to $770,000 in the third quarter of 2004, and $2,115,000 for the first nine months of 2005 compared to $2,080,000 for the first nine months of 2004. The Company's ratios of annualized net charge-offs to average loans were 12 basis points and 9 basis points for the three and nine month periods ended September 30, 2005, respectively, compared to 22 basis points and 14 basis points for the same three and nine month periods in 2004, respectively. The Company's level of nonperforming assets to total assets was 0.31% at September 30, 2005 compared to 0.34% a year earlier. Noninterest income amounted to $3,779,000 for the third quarter of 2005, a 12.0% decrease from $4,296,000 recorded in the third quarter of 2004. Noninterest income for the nine months ended September 30, 2005 amounted to $11,201,000, a decrease of 6.7% from the $12,001,000 recorded in the first nine months of 2004. The decreases for both periods in 2005 compared to 2004 were partly a result of lower service charges on deposit accounts. Also, in 2005 the Company has recorded significantly lower "securities gains" and "other gains" compared to 2004. Noninterest expenses amounted to $11.5 million in the third quarter of 2005, a 3.6% increase over the $11.1 million recorded in the third quarter of 2004. Noninterest expenses for the nine months ended September 30, 2005 amounted to $35.5 million, a 9.4% increase from the $32.4 million recorded in the first nine months of 2004. The increase in noninterest expenses is primarily attributable to costs associated with the Company's overall growth in loans, deposits and branch network. The Company's income tax expense for the three and nine months ended September 30, 2005 includes the previously noted contingency accrual of $6,320,000. Excluding this accrual, the Company's effective tax rate in 2005 Page 17
has generally been 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 this quarter's contingency tax accrual. For additional information, see Note 10 to the consolidated financial statements above and the section below entitled "Liquidity, Commitments, and Contingencies." The Company's annualized return on average assets for the third quarter of 2005 was (0.16%) compared to 1.32% for the third quarter of 2004. The Company's annualized return on average assets for the nine months ended September 30, 2005 was 0.69% compared to 1.30% for the comparable period of 2004. The Company's annualized return on average equity for the second quarter of 2005 was (1.73%) compared to 14.18% for the third quarter of 2004. The Company's annualized return on average equity for the nine months ended September 30, 2005 was 7.49% compared to 13.59% for the first nine months of 2004. 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 September 30, 2005 amounted to $17,352,000, an increase of $1,811,000, or 11.7%, from the $15,541,000 recorded in the third quarter of 2004. Net interest income for the nine months ended September 30, 2005 amounted to $50,644,000, an increase of $5,471,000, or 12.1%, from the $45,173,000 recorded in the first nine months of 2004. 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. Tax equivalent net interest income is a non-GAAP performance measure used by management in operating its business, which the Company also believes provides investors with a more accurate picture of net interest income and net interest margins for comparative purposes. Net interest income on a taxable equivalent basis for the three month period ended September 30, 2005 amounted to $17,463,000, an increase of $1,804,000, or 11.5%, from the $15,659,000 recorded in the third quarter of 2004. Net interest income on a taxable equivalent basis for the nine months ended September 30, 2005 amounted to $50,979,000, an increase of $5,446,000, or 12.0%, from the $45,533,000 recorded in the first nine months of 2004. The following table is a reconciliation of net interest income as calculated by GAAP to non-GAAP tax-equivalent net interest income: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, -------------------------------- ------------------------------- 2005 2004 2005 2004 -------- -------- -------- -------- <S> <C> <C> <C> <C> Net interest income, as reported $ 17,352 15,541 50,644 45,173 Tax-equivalent adjustment 111 118 335 360 -------- -------- -------- -------- Net interest income, tax-equivalent $ 17,463 15,659 50,979 45,533 ======== ======== ======== ======== </TABLE> 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 and nine month periods ended September 30, 2005, growth in loans and deposits were the primary cause for the increases in net interest income, as the Company's net interest margins in 2005 were just slightly higher than those realized in 2004. The following tables present net interest income analysis on a taxable-equivalent basis. Page 18
<TABLE> <CAPTION> For the Three Months Ended September 30, ------------------------------------------------------------------------------ 2005 2004 ------------------------------------- ------------------------------------- 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) $1,433,874 6.71% $ 24,240 $1,320,391 5.82% $ 19,321 Taxable securities 118,927 4.39% 1,315 97,405 4.77% 1,167 Non-taxable securities (2) 10,438 8.55% 225 11,451 8.37% 241 Short-term investments 41,144 3.84% 398 24,632 1.99% 123 ---------- ---------- ---------- ---------- Total interest-earning assets 1,604,383 6.47% 26,178 1,453,879 5.71% 20,852 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 465,089 0.89% $ 1,042 $ 463,995 0.55% $ 636 Time deposits >$100,000 347,057 3.45% 3,015 268,911 2.34% 1,579 Other time deposits 468,170 2.99% 3,532 408,440 2.01% 2,062 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,280,316 2.35% 7,589 1,141,346 1.49% 4,277 Other, principally borrowings 85,643 5.22% 1,126 108,094 3.37% 916 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,365,959 2.53% 8,715 1,249,440 1.65% 5,193 ---------- ---------- Non-interest-bearing deposits 186,867 160,357 Net yield on interest-earning assets and net interest income 4.32% $ 17,463 4.28% $ 15,659 ========== ========== Interest rate spread 3.94% 4.06% Average prime rate 6.42% 4.41% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $111,000 and $118,000 in 2005 and 2004, respectively, to reflect the tax benefit that the Company receives related to its tax-exempt securities, which carry interest rates lower than similar taxable investments due to their tax exempt status. This amount has been computed assuming a 39% tax rate and is reduced by the related nondeductible portion of interest expense. - -------------------------------------------------------------------------------- <TABLE> <CAPTION> For the Nine Months Ended September 30, ------------------------------------------------------------------------------ 2005 2004 ------------------------------------- ------------------------------------- Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,408,736 6.49% $ 68,331 $1,276,713 5.81% $ 55,516 Taxable securities 113,785 4.56% 3,881 100,253 4.60% 3,451 Non-taxable securities (2) 10,830 8.58% 695 12,321 8.27% 763 Short-term investments 44,780 3.34% 1,117 24,900 1.68% 313 ---------- ---------- ---------- ---------- Total interest-earning assets 1,578,131 6.27% 74,024 1,414,187 5.67% 60,043 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 472,361 0.82% $ 2,881 $ 466,545 0.51% $ 1,782 Time deposits >$100,000 349,677 3.09% 8,085 258,669 2.27% 4,400 Other time deposits 446,894 2.70% 9,013 405,784 2.01% 6,093 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,268,932 2.11% 19,979 1,130,998 1.45% 12,275 Other, principally borrowings 79,753 5.14% 3,066 84,374 3.54% 2,235 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,348,685 2.28% 23,045 1,215,372 1.59% 14,510 ---------- ---------- Non-interest-bearing deposits 180,667 156,355 Net yield on interest-earning assets and net interest income 4.32% $ 50,979 4.30% $ 45,533 ========== ========== Interest rate spread 3.99% 4.08% Average prime rate 5.93% 4.14% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. Page 19
(2) Includes tax-equivalent adjustments of $335,000 and $360,000 in 2005 and 2004, 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 39% tax rate and is reduced by the related nondeductible portion of interest expense. - -------------------------------------------------------------------------------- Average loans outstanding for the third quarter of 2005 were $1.434 billion, which was 8.6% higher than the average loans outstanding for the third quarter of 2004 ($1.320 billion). Average loans outstanding for the nine months ended September 30, 2005 were $1.409 billion, which was 10.3% higher than the average loans outstanding for the nine months ended September 30, 2004 ($1.277 billion). The mix of the Company's loan portfolio remained substantially the same at September 30, 2005 compared to December 31, 2004, with approximately 85% of the Company's loans being real estate loans, 10% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans. 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. Average total deposits outstanding for the third quarter of 2005 were $1.467 billion, which was 12.7% higher than the average deposits outstanding for the third quarter of 2004 ($1.302 billion). Average deposits outstanding for the nine months ended September 30, 2005 were $1.450 billion, which was 12.6% higher than the average deposits outstanding for the nine months ended September 30, 2004 ($1.287 billion). Generally, the Company can reinvest funds from deposits at higher yields than the interest rate being paid on those deposits, and therefore increases in deposits typically result in higher amounts of net interest income for the Company. 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 2005. As derived from the tables above, yields on interest earning assets and liabilities are both 60-90 bps higher for the periods presented in 2005 compared to 2004 as a result of the rising rate environment that began in the third quarter of 2004. From July 1, 2004 to September 30, 2005, the Federal Reserve raised short-term interest rates eleven times totaling 275 basis points. The Company's net interest margin (tax-equivalent net interest income divided by average earning assets) has remained fairly stable during the period of rising rates, with the Company's net interest margin amounting to 4.32% in the third quarter of 2005 compared to 4.28% in the third quarter of 2004, and the Company's net interest margin amounting to 4.32% for the nine months ended September 30, 2005 compared to 4.30% for the same nine months of 2004. See additional information regarding net interest income in the section entitled "Interest Rate Risk." The provisions for loan losses recorded by the Company for the three and nine months ended September 30, 2005 did not vary significantly from the comparable periods in 2004, amounting to $690,000 in the third quarter of 2005 compared to $770,000 in the third quarter of 2004, and $2,115,000 for the first nine months of 2005 compared to $2,080,000 for the first nine months of 2004. Net loan growth in 2005 has been less than that experienced in 2004, with the Company experiencing $20 million in net loan growth in the third quarter of 2005 compared to $40 million in the third quarter of 2004, and net loan growth for the nine months ended September 30, 2005 amounting to $79 million compared to $119 million for the first nine months of 2004. The favorable impact of the lower net loan growth on the provision for loan losses has been offset by the impact of having more internally classified loans. Internally classified loans amounted to $16.6 million at September 30, 2005 compared to $10.3 million at September 30, 2004. Noninterest income amounted to $3,779,000 for the third quarter of 2005, a 12.0% decrease from $4,296,000 recorded in the third quarter of 2004. Noninterest income for the nine months ended September Page 20
30, 2005 amounted to $11,201,000, a decrease of 6.7% from the $12,001,000 recorded in the first nine months of 2004. The decreases for both periods in 2005 compared to 2004 were 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. Other service charges, commissions, and fees amounted to $961,000 and $2,950,000 for the three and nine months ended September 30, 2005, reflecting increases of approximately $150,000 in each of the first three quarters of 2005 compared to the same three periods of 2004. The increases have been primarily a result of growth in credit card merchant income as a result of growth in the Company's merchant card base, and debit card income as a result of growing acceptance and usage by customers. Fees from presold mortgages amounted to $328,000 and $851,000 for the three and nine months ended September 30, 2005 compared to $220,000 and $698,000 for the comparable periods in 2004, respectively. The low single-family home mortgage interest rate environment that has been in effect over the past few years continues to result in a relatively high volume of mortgage loan originations. Over the past seven quarters, fees from presold mortgages have ranged from $188,000 to $328,000 per quarter, with an average of $260,000 per quarter. Commissions from sales of insurance and financial products amounted to $388,000 in the third quarter of 2005 compared to the $387,000 in the third quarter of 2004, and amounted to $997,000 in the first nine months of 2005 compared to $1,064,000 for the same period of 2004. This line item includes commissions the Company receives from three sources - 1) sales of credit insurance associated with new loans, 2) commissions from the sales of investment, annuity, and long-term care insurance products, and 3) commissions from the sale of property and casualty insurance. The following table presents these components for the three and nine month periods ended September 30, 2005 compared to the same periods in 2004: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, ---------------------------------------------- ---------------------------------------------- ($ in thousands) 2005 2004 $ Change % Change 2005 2004 $ Change % Change --------- --------- --------- --------- --------- --------- --------- --------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Commissions earned from: - ----------------------- Sales of credit insurance $ 76 72 4 5.6% $ 233 220 13 5.9% Sales of investments, annuities, and long term care insurance 81 74 7 9.5% 174 231 (57) (24.7)% Sales of property and casualty insurance 231 241 (10) (4.1)% 590 613 (23) (3.8)% --------- --------- --------- --------- --------- --------- Total $ 388 387 1 0.3% $ 997 1,064 (67) (6.3)% ========= ========= ========= ========= ========= ========= </TABLE> 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 for the nine months ended September 30, 2005. The decrease in this component is primarily due to an employee in this area being transferred to another division of the Company and not yet being replaced. The Company's data processing subsidiary makes its excess data processing capabilities available to area financial institutions for a fee. At September 30, 2004, the Company had five community bank customers using this service. However, during the fourth quarter of 2004, the Company was notified by three of the customers that they intended to terminate their contracts with the Company in the first half of 2005, with each customer switching to a lower cost service provider. Data processing fees amounted to Page 21
$38,000 in the third quarter of 2005 compared to $104,000 in the third quarter of 2004, while data processing fees for the first nine months of 2005 amounted to $243,000 compared to $304,000 in the same period in 2004. The Company intends to continue to market this service to area banks, but does not have any new contracts in place at this time. In 2005 the Company has recorded significantly lower "securities gains" and "other gains" compared to 2004. For the three months ended September 30, 2005, the Company recorded a combined net loss of $116,000 for these two line items compared to a net gain of $451,000 for the third quarter of 2004, a negative change of $567,000. For the nine months ended September 30, 2005, the Company recorded a combined net loss of $173,000 for these two line items compared to a net gain of $557,000 in 2004, a negative change of $730,000. The "other losses" for both periods in 2005 primarily relate to write-downs and losses of other real estate owned. The "other gains" in 2004 primarily reflects the third quarter 2004 sale of a former bank branch building for a gain of approximately $351,000. Noninterest expenses amounted to $11.5 million in the third quarter of 2005, a 3.6% increase over the $11.1 million recorded in the third quarter of 2004. Noninterest expenses for the nine months ended September 30, 2005 amounted to $35.5 million, a 9.4% increase from the $32.4 million recorded in the first nine months of 2004. The increase in noninterest expenses is primarily attributable to costs associated with the Company's overall growth in loans, deposits and branch network. Noninterest expenses for the nine months ended September 30, 2005 were also impacted by the following expenses: (i) immediately vested post-retirement benefits granted to the Company's CEO totaling $196,000 granted in the second quarter of 2005, (ii) higher external Sarbanes-Oxley costs, which have amounted to $600,000 through September 30, 2005 compared to $74,000 for the first nine months of 2004, and (iii) public relation expenses of $123,000 incurred in the second quarter of 2005 associated with the Company's sponsorship of the 2005 U.S. Open Golf Tournament that was held in the Company's largest market - Moore County, North Carolina. The Company's income tax expense for the three and nine months ended September 30, 2005 includes the previously discussed contingency accrual of $6,320,000. Excluding this accrual, the Company's effective tax rate in 2005 has generally been 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 this quarter's contingency tax accrual - see Note 10 to the consolidated financial statements and in the section below entitled "Liquidity, Commitments, and Contingencies" for additional detail. The Company expects its effective tax rate to continue to be in the 38-39% range for the foreseeable future. The Consolidated Statements of Comprehensive Income reflect "Other Comprehensive Loss" of $502,000 during the third quarter of 2005 and "Other Comprehensive Loss" of $817,000 for the nine months ended September 30, 2005, compared to "Other Comprehensive Income" of $1,207,000 for the three months ended September 30, 2004 and "Other Comprehensive Loss" of $319,000 for the nine months ended September 30, 2004, respectively. The primary component of other comprehensive income/loss for the periods presented relates to changes in unrealized holding gains/losses of the Company's available for sale securities. The Company's available for sale securities portfolio is predominantly comprised of fixed rate bonds that increase in value when market yields for fixed rate bonds decrease and decline in value when market yields for fixed rate bonds increase. Fixed rate bond yields have generally risen over the past two years, except for the third quarter of 2004 during which fixed rate bond yields declined. FINANCIAL CONDITION Total assets at September 30, 2005 amounted to $1.76 billion, 9.2% higher than a year earlier. Total loans at September 30, 2005 amounted to $1.45 billion, an 8.1% increase from a year earlier, and total deposits amounted to $1.48 billion at September 30, 2005, an 11.6% increase from a year earlier. Page 22
The following tables present information regarding the nature of the Company's growth since September 30, 2004. <TABLE> <CAPTION> Internal growth, Balance at Change in Balance at Total excludes October 1, 2004 to beginning of Internal Brokered end of percentage change in brokered September 30, 2005 period Growth Deposits period growth deposits - ------------------------------ ------------ ----------- ----------- ----------- ---------- ------------------ ($ in thousands) <S> <C> <C> <C> <C> <C> <C> Loans $ 1,337,583 108,602 -- 1,446,185 8.1% 8.1% =========== =========== =========== =========== Deposits - Noninterest bearing $ 160,791 31,608 -- 192,399 19.7% 19.7% Deposits - Savings, NOW, and Money Market 463,144 (2,435) -- 460,709 -0.5% -0.5% Deposits - Time>$100,000 288,988 82,773 (22,141) 349,620 21.0% 28.6% Deposits - Time<$100,000 409,702 63,098 -- 472,800 15.4% 15.4% ----------- ----------- ----------- ----------- Total deposits $ 1,322,625 175,044 (22,141) 1,475,528 11.6% 13.2% =========== =========== =========== =========== January 1, 2005 to September 30, 2005 - ------------------------------ Loans $ 1,367,053 79,132 -- 1,446,185 5.8% 5.8% =========== =========== =========== =========== Deposits - Noninterest bearing $ 165,778 26,621 -- 192,399 16.1% 16.1% Deposits - Savings, NOW, and Money Market 472,811 (12,102) -- 460,709 -2.6% -2.6% Deposits - Time>$100,000 334,756 64,737 (49,873) 349,620 4.4% 19.3% Deposits - Time<$100,000 415,423 57,377 -- 472,800 13.8% 13.8% ----------- ----------- ----------- ----------- Total deposits $ 1,388,768 136,633 (49,873) 1,475,528 6.2% 9.8% =========== =========== =========== =========== </TABLE> As noted in the tables above, total deposit growth that was achieved internally was partially offset by repayments of brokered deposits. The Company gathered a total of $50 million in brokered deposits in the second half of 2004 ($22 million in the third quarter of 2004 and $28 million in the fourth quarter of 2004) to help fund high loan growth, all of which were repaid (and not renewed or replaced) during the first nine months of 2005. The Company had no brokered deposits outstanding at September 30, 2005, but may utilize them again in the future. The Company experienced solid loan and deposit growth during the first nine months of 2005, with loans increasing by $79 million, or 7.7% on an annualized basis, and deposits increasing by $137 million, or 13.1% on an annualized basis (internal growth). For the twelve months ended September 30, 2005, the Company's loans increased by $109 million, or 8.1% and deposits increased $175 million, or 13.2% (internal growth). The Company opened two de novo branches in 2004 and one in 2005, which contributed to the internal growth. The mix of the Company's loan portfolio remains substantially the same at September 30, 2005 compared to December 31, 2004, with approximately 85% of the Company's loans being real estate loans, 10% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans. The majority of the Company's real estate loans are primarily various personal and commercial loans where real estate provides additional security for the loan. Over the nine and twelve months ended September 30, 2005, time deposits have experienced significantly more growth than the other deposit categories because the Company has attractively priced time deposits in order to fund loan growth and repay brokered deposits. Nonperforming Assets Page 23
Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> September 30, December 31, September 30, ($ in thousands) 2005 2004 2004 ============================================================================================ <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 3,330 3,707 3,637 Restructured loans 14 17 18 Accruing loans > 90 days past due -- -- -- -------- ------- ------- Total nonperforming loans 3,344 3,724 3,655 Other real estate 2,023 1,470 1,877 -------- ------- ------- Total nonperforming assets $ 5,367 5,194 5,532 ======== ======= ======= Nonperforming loans to total loans 0.23% 0.27% 0.27% Nonperforming assets as a percentage of loans and other real estate 0.37% 0.38% 0.41% Nonperforming assets to total assets 0.31% 0.32% 0.34% Allowance for loan losses to total loans 1.10% 1.08% 1.07% </TABLE> 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) did not vary significantly among the periods presented amounting to $3,344,000, $3,724,000, and $3,655,000 as of September 30, 2005, December 31, 2004, and September 30, 2004, respectively. Nonperforming loans as a percentage of total loans amounted to 0.23%, 0.27%, and 0.27%, at September 30, 2005, December 31, 2004, and September 30, 2004, respectively. The Company's largest nonaccrual relationship at September 30, 2005 amounted to $880,000. The Company evaluated the underlying collateral securing this loan relationship and established a specific reserve of $410,000 at September 30, 2005. The next largest nonaccrual relationship at September 30, 2005 amounted to $338,000. At September 30, 2005, December 31, 2004, and September 30, 2004, the recorded investment in loans considered to be impaired was $1,364,000, $1,578,000, and $1,066,000, respectively, all of which were on nonaccrual status. The increase in impaired loans when comparing September 30, 2004 to December 31, 2004 and September 30, 2005 is primarily attributable to the large nonaccrual relationship noted above that was on performing status at September 30, 2004 but reclassified to nonaccrual status during the fourth quarter of 2004. At September 30, 2005, December 31, 2004, and September 30, 2004, the related allowance for loan losses for all impaired loans was $620,000, $370,000, and $150,000, respectively. At September 30, 2005, December 31, 2004, and September 30, 2004, there was $182,000, $532,000, and $490,000 in impaired loans for which there was no related allowance. The average recorded investments in impaired loans during the nine month period ended September 30, 2005, the year ended December 31, 2004, and the nine months ended September 30, 2004 were approximately $1,758,000, $1,317,000, and $1,251,000, 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 amounted to $2,023,000, $1,470,000, and $1,877,000 at September 30, 2005, December 31, 2004 and September 30, 2004, respectively. The single largest property causing the increase in the balance from December 31, 2004 to September 30, 2005 was the addition in June 2005 of a four-unit apartment building with a recorded balance of $487,000 that has not yet been sold. The Company's management has reviewed recent appraisals of its other real estate and Page 24
believes that their fair values, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented. 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 provision for loan losses recorded by the Company for the three and nine months ended September 30, 2005 did not vary significantly from the comparable periods in 2004, amounting to $690,000 in the third quarter of 2005 compared to $770,000 in the third quarter of 2004, and $2,115,000 for the first nine months of 2005 compared to $2,080,000 for the first nine months of 2004. Net loan growth in 2005 has been less than that experienced in 2004, with the Company experiencing $20 million in net loan growth in the third quarter of 2005 compared to $40 million in the third quarter of 2004, and net loan growth for the nine months ended September 30, 2005 amounting to $79 million compared to $119 million for the first nine months of 2004. The favorable impact of the lower net loan growth on the provision for loan losses has been offset by the impact of having more internally classified loans. Internally classified loans amounted to $16.6 million at September 30, 2005 compared to $10.3 million at September 30, 2004. At September 30, 2005, the allowance for loan losses amounted to $15,879,000, compared to $14,717,000 at December 31, 2004 and $14,351,000 at September 30, 2004. The allowance for loan losses as a percentage of total loans did not vary significantly among the periods presented, amounting to 1.10% at September 30, 2005, 1.08% at December 31, 2004, and 1.07% at September 30, 2005. Management believes the Company's reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. See "Critical Accounting Policies - Allowance for Loan Losses" above. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and value of other real estate. Such agencies may require the Company to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations. Page 25
For the periods indicated, the following table summarizes the Company's balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries, and additions to the allowance for loan losses that have been charged to expense. <TABLE> <CAPTION> Nine Months Twelve Months Nine Months Ended Ended Ended September 30, December 31, September 30, ($ in thousands) 2005 2004 2004 ------------- ------------- ------------- <S> <C> <C> <C> Loans outstanding at end of period $ 1,446,185 1,367,053 1,337,583 ============= ============= ============= Average amount of loans outstanding $ 1,408,736 1,295,682 1,276,713 ============= ============= ============= Allowance for loan losses, at beginning of period $ 14,717 13,569 13,569 Total charge-offs (1,171) (1,938) (1,416) Total recoveries 218 181 118 ------------- ------------- ------------- Net charge-offs (953) (1,757) (1,298) ------------- ------------- ------------- Additions to the allowance charged to expense 2,115 2,905 2,080 ------------- ------------- ------------- Allowance for loan losses, at end of period $ 15,879 14,717 14,351 ============= ============= ============= Ratios: Net charge-offs (annualized) as a percent of average loans 0.09% 0.14% 0.14% Allowance for loan losses as a percent of loans at end of period 1.10% 1.08% 1.07% </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 September 30, 2005, there have been no material changes to the allocation of the allowance for loan losses among the various categories of loans since December 31, 2004. 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 $311 million line of credit with the Federal Home Loan Bank (of which $60 million had been drawn at September 30, 2005), 2) a $50 million overnight federal funds line of credit with a correspondent bank (none of which was outstanding at September 30, 2005), and 3) an approximately $66 million line of credit through the Federal Reserve Bank of Richmond's discount window (none of which was outstanding at September 30, 2005). The Company's liquidity increased slightly from December 31, 2004 to September 30, 2005, as a result of deposit growth that exceeded loan growth during the nine months of the year. The Company's loan to deposit ratio was 98.0% at September 30, 2005 compared to 98.4% at December 31, 2004. The level of the Company's liquid assets (consisting of cash, due from banks, federal funds sold, presold mortgages in Page 26
process of settlement and securities) as a percentage of deposits and borrowings was 14.5% at September 30, 2005 compared to 13.1% at December 31, 2004. 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. The amount and timing of the Company's contractual obligations and commercial commitments has not changed materially since December 31, 2004, detail of which is presented in Table 18 on page 51 of the Company's 2004 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. During the third quarter of 2005, the Company recorded a contingency tax loss accrual amounting to $6,320,000, or $0.44 per diluted share, net of the federal tax benefit. As previously reported, the Company is currently undergoing a tax audit by the North Carolina Department of Revenue. Although the Company has not received any assessment at this time, the Company concluded that applicable accounting standards required that a loss be accrued in the third quarter to reserve for an operating structure involving a real estate investment trust (REIT) that resulted in a reduction of the Company's state tax liability. The North Carolina Department of Revenue has indicated that it will challenge the tax benefits that the Company received as a result of the REIT structure. This operating structure was established based on consultations with the Company's tax advisors, and the Company believes its state tax returns complied with the relevant North Carolina tax statutes. Therefore, the Company will devote all reasonable resources to minimize any ultimate liability. The Company does not believe that there is any additional exposure related to this item beyond the amount of the accrual other than ongoing interest on the unpaid taxes amounting to $48,000 per quarter (after-tax). The aspects of the Company's REIT operating structure that have been questioned by the State of North Carolina were discontinued as of January 1, 2005, and thus the Company's effective tax rate for 2005 of approximately 38%-39%, excluding the special third quarter accrual, is expected to be indicative of future periods. 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 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 significant derivative activities through September 30, 2005, 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. Page 27
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. At September 30, 2005, 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> September 30, December 31, September 30, 2005 2004 2004 ------------- ------------ ------------- <S> <C> <C> <C> Risk-based capital ratios: Tier I capital to Tier I risk adjusted assets 10.42% 10.95% 10.92% Minimum required Tier I capital 4.00% 4.00% 4.00% Total risk-based capital to Tier II risk-adjusted assets 11.46% 11.97% 11.94% 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 8.49% 8.90% 8.92% Minimum required Tier I leverage capital 4.00% 4.00% 4.00% </TABLE> The Company's capital ratios decreased from December 31, 2004 to September 30, 2005 as a result of strong balance sheet growth and the $6,320,000 contingency tax accrual recorded in the third quarter of 2005. 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 September 30, 2005, the Company's bank subsidiary exceeded the minimum ratios established by the FED and FDIC. SHARE REPURCHASES For the nine months ended September 30, 2005, the Company did not repurchase any of its own common stock. At September 30, 2005, the Company had approximately 315,000 shares available for repurchase under existing authority from its board of directors. The Company may 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 "Unregistered Sales of Equity Securities and Use of Proceeds." Page 28
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 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 September 30, 2005 the Company had $256 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 September 30, 2005 subject to interest rate changes within one year are deposits totaling $461 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. 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 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 Page 29
assets. Additionally, over the past few years, the Company has originated significantly more adjustable rate loans compared to fixed rate loans in an effort to protect itself from an anticipated rise in the interest rate environment. 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 the second half of 2004, the Federal Reserve has increased interest rates eleven times totaling 275 basis points, which was largely responsible for the Company's net interest margin reversing its downward trend and increasing for three consecutive quarters (the last two quarters of 2004 and the first quarter of 2005) before stabilizing in the 4.31%-4.33% range for the past three quarters. 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. The Company has no market risk sensitive instruments held for trading purposes, nor does it maintain any foreign currency positions. 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. 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 30
Part II. Other Information Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds <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 Share Plans or Programs Plans or Programs (1) ------------------------- ------------------ ---------------------- ---------------------- ---------------------- <S> <C> <C> <C> <C> July 1, 2005 to July 31, 2005 -- -- -- 315,015 August 1, 2005 to August 31, 2005 -- -- -- 315,015 September 1, 2005 to September 30, 2005 -- -- -- 315,015 ------- ------- ------- ------- Total -- -- -- 315,015(2) ======= ======= ======= ======= </TABLE> Footnotes to the Above Table - ---------------------------- (1) All shares available for repurchase are 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. There were no such options exercised during the periods shown. Item 6 - 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. 10.a Copy of Employment Agreement between the Company and Jerry L. Ocheltree was filed as Exhibit 99(b) to the Form 8-K filed on September 14, 2005, 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 31
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. Copies of exhibits are available upon written request to: First Bancorp, Anna G. Hollers, Executive Vice President, P.O. Box 508, Troy, NC 27371 SIGNATURES 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 November 8, 2005 BY: James H. Garner --------------------------- James H. Garner President (Principal Executive Officer), Treasurer and Director November 8, 2005 BY: Anna G. Hollers --------------------------- Anna G. Hollers Executive Vice President and Secretary November 8, 2005 BY: Eric P. Credle --------------------------- Eric P. Credle Senior Vice President and Chief Financial Officer Page 32