================================================================================ 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 June 30, 2006 ----------------------- Commission File Number 0-15572 FIRST BANCORP -------------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) North Carolina 56-1421916 - ---------------------------------------- --------------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification Number) 341 North Main Street, Troy, North Carolina 27371-0508 - ------------------------------------------------ --------------------------- (Address of Principal Executive Offices) (Zip Code) (Registrant's telephone number, including area code) (910) 576-6171 --------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] YES [ ] NO Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. [ ] Large Accelerated Filer [X] Accelerated Filer [ ] Non-Accelerated Filer Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] YES [X] NO The number of shares of the registrant's Common Stock outstanding on July 31, 2006 was 14,294,946. ================================================================================
INDEX FIRST BANCORP AND SUBSIDIARIES Page Part I. Financial Information Item 1 - Financial Statements Consolidated Balance Sheets - June 30, 2006 and 2005 (With Comparative Amounts at December 31, 2005) 3 Consolidated Statements of Income - For the Periods Ended June 30, 2006 and 2005 4 Consolidated Statements of Comprehensive Income - For the Periods Ended June 30, 2006 and 2005 5 Consolidated Statements of Shareholders' Equity - For the Periods Ended June 30, 2006 and 2005 6 Consolidated Statements of Cash Flows - For the Periods Ended June 30, 2006 and 2005 7 Notes to Consolidated Financial Statements 8 Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition 16 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 29 Item 4 - Controls and Procedures 31 Part II. Other Information Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 32 Item 4 - Submission of Matters to a Vote of Security Holders 33 Item 6 - Exhibits 33 Signatures 34 Page 2
Part I. Financial Information Item 1 - Financial Statements <TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Balance Sheets June 30, December 31, June 30, ($ in thousands-unaudited) 2006 2005 (audited) 2005 - ------------------------------------------------------------------------------------------------ <S> <C> <C> <C> ASSETS Cash & due from banks, noninterest-bearing $ 31,295 32,985 35,642 Due from banks, interest-bearing 83,894 41,655 41,741 Federal funds sold 22,029 28,883 20,700 ----------- ----------- ----------- Total cash and cash equivalents 137,218 103,523 98,083 ----------- ----------- ----------- Securities available for sale (costs of $118,549, $114,662, and $118,958) 115,579 113,613 119,716 Securities held to maturity (fair values of $14,310, $14,321, and $13,076) 14,333 14,172 12,820 Presold mortgages in process of settlement 2,586 3,347 2,063 Loans 1,635,899 1,482,611 1,425,856 Less: Allowance for loan losses (17,642) (15,716) (15,622) ----------- ----------- ----------- Net loans 1,618,257 1,466,895 1,410,234 ----------- ----------- ----------- Premises and equipment 37,152 34,840 31,758 Accrued interest receivable 9,887 8,947 7,553 Intangible assets 49,070 49,227 49,373 Other 8,627 6,486 6,997 ----------- ----------- ----------- Total assets $ 1,992,709 1,801,050 1,738,597 =========== =========== =========== LIABILITIES Deposits: Demand - noninterest-bearing $ 209,062 194,051 184,605 Savings, NOW, and money market 480,522 458,221 476,642 Time deposits of $100,000 or more 390,589 356,281 349,972 Other time deposits 510,495 486,024 459,661 ----------- ----------- ----------- Total deposits 1,590,668 1,494,577 1,470,880 Securities sold under agreements to repurchase 30,602 33,530 1,850 Borrowings 195,013 100,239 101,239 Accrued interest payable 4,856 3,835 3,267 Other liabilities 11,655 13,141 7,159 ----------- ----------- ----------- Total liabilities 1,832,794 1,645,322 1,584,395 ----------- ----------- ----------- SHAREHOLDERS' EQUITY Common stock, No par value per share Issued and outstanding: 14,279,847, 14,229,148, and 14,170,722 shares 54,827 54,121 53,098 Retained earnings 107,151 102,507 100,902 Accumulated other comprehensive income (loss) (2,063) (900) 202 ----------- ----------- ----------- Total shareholders' equity 159,915 155,728 154,202 ----------- ----------- ----------- Total liabilities and shareholders' equity $ 1,992,709 1,801,050 1,738,597 =========== =========== =========== See notes to consolidated financial statements. Page 3 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Income Three Months Ended Six Months Ended June 30, June 30, ---------------------------- ---------------------------- ($ in thousands, except share data-unaudited) 2006 2005 2006 2005 - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 29,215 22,732 55,977 44,091 Interest on investment securities: Taxable interest income 1,402 1,411 2,731 2,566 Tax-exempt interest income 127 117 254 246 Other, principally overnight investments 571 447 1,068 719 ------------ ------------ ------------ ------------ Total interest income 31,315 24,707 60,030 47,622 ------------ ------------ ------------ ------------ INTEREST EXPENSE Savings, NOW and money market 1,635 958 2,968 1,839 Time deposits of $100,000 or more 4,174 2,725 7,851 5,070 Other time deposits 5,004 3,007 9,436 5,481 Other, primarily borrowings 2,058 1,010 3,478 1,940 ------------ ------------ ------------ ------------ Total interest expense 12,871 7,700 23,733 14,330 ------------ ------------ ------------ ------------ Net interest income 18,444 17,007 36,297 33,292 Provision for loan losses 1,400 845 2,415 1,425 ------------ ------------ ------------ ------------ Net interest income after provision for loan losses 17,044 16,162 33,882 31,867 ------------ ------------ ------------ ------------ NONINTEREST INCOME Service charges on deposit accounts 2,225 2,145 4,299 4,153 Other service charges, commissions and fees 1,119 935 2,324 1,989 Fees from presold mortgages 244 285 511 523 Commissions from sales of insurance and financial products 325 314 764 609 Data processing fees 37 58 73 205 Securities gains 205 2 205 2 Other gains (losses) (311) (27) (378) (59) ------------ ------------ ------------ ------------ Total noninterest income 3,844 3,712 7,798 7,422 ------------ ------------ ------------ ------------ NONINTEREST EXPENSES Salaries 5,734 5,393 11,519 10,765 Employee benefits 1,786 1,791 3,567 3,305 ------------ ------------ ------------ ------------ Total personnel expense 7,520 7,184 15,086 14,070 Net occupancy expense 858 723 1,674 1,462 Equipment related expenses 818 768 1,629 1,463 Intangibles amortization 60 73 121 146 Other operating expenses 3,808 3,512 7,283 6,834 ------------ ------------ ------------ ------------ Total noninterest expenses 13,064 12,260 25,793 23,975 ------------ ------------ ------------ ------------ Income before income taxes 7,824 7,614 15,887 15,314 Income taxes 3,029 2,962 6,101 5,946 ------------ ------------ ------------ ------------ NET INCOME $ 4,795 4,652 9,786 9,368 ============ ============ ============ ============ Earnings per share: Basic $ 0.34 0.33 0.69 0.66 Diluted 0.33 0.32 0.68 0.65 Weighted average common shares outstanding: Basic 14,296,159 14,159,117 14,275,472 14,132,347 Diluted 14,433,830 14,345,013 14,425,500 14,354,852 See notes to consolidated financial statements. Page 4 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Comprehensive Income Three Months Ended Six Months Ended June 30, June 30, ------------------ ------------------ ($ in thousands-unaudited) 2006 2005 2006 2005 - --------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $ 4,795 4,652 9,786 9,368 ------- ------- ------- ------- Other comprehensive income (loss): Unrealized gains (losses) on securities available for sale: Unrealized holding gains (losses) arising during the period, pretax (1,621) 886 (1,717) (428) Tax benefit (expense) 632 (343) 669 169 Reclassification to realized gains (205) (2) (205) (2) Tax expense 80 1 80 1 Adjustment to minimum pension liability: Additional pension charge related to unfunded pension liability -- -- 16 (90) Tax benefit (expense) -- -- (6) 35 ------- ------- ------- ------- Other comprehensive income (loss) (1,114) 542 (1,163) (315) ------- ------- ------- ------- Comprehensive income $ 3,681 5,194 8,623 9,053 ======= ======= ======= ======= See notes to consolidated financial statements. Page 5 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Shareholders' Equity 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, 2005 14,084 $ 51,614 96,347 517 148,478 Net income 9,368 9,368 Cash dividends declared ($0.34 per share) (4,813) (4,813) Common stock issued under stock option plan 51 585 585 Common stock issued into dividend reinvestment plan 36 799 799 Tax benefit realized from exercise of nonqualified stock options -- 100 100 Other comprehensive loss (315) (315) ------------ ------------ ------------ ------------ ------------ Balances, June 30, 2005 14,171 $ 53,098 100,902 202 154,202 ============ ============ ============ ============ ============ Balances, January 1, 2006 14,229 $ 54,121 102,507 (900) 155,728 Net income 9,786 9,786 Cash dividends declared ($0.36 per share) (5,142) (5,142) Common stock issued under stock option plan 66 618 618 Common stock issued into dividend reinvestment plan 37 815 815 Purchases and retirement of common stock (53) (1,112) (1,112) Tax benefit realized from exercise of nonqualified stock options -- 94 94 Stock-based compensation -- 291 291 Other comprehensive loss (1,163) (1,163) ------------ ------------ ------------ ------------ ------------ Balances, June 30, 2006 14,279 $ 54,827 107,151 (2,063) 159,915 ============ ============ ============ ============ ============ See notes to consolidated financial statements. Page 6 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Cash Flows Six Months Ended June 30, ($ in thousands-unaudited) 2006 2005 - ---------------------------------------------------------------------------------------------------- <S> <C> <C> Cash Flows From Operating Activities Net income $ 9,786 9,368 Reconciliation of net income to net cash provided by operating activities: Provision for loan losses 2,415 1,425 Net security premium amortization 45 39 Gain on sale of securities available for sale (205) (2) Other losses 378 59 Net loan origination fees (costs) deferred 247 (224) Depreciation of premises and equipment 1,382 1,336 Tax benefit from exercise of nonqualified stock options -- 100 Stock-based compensation expense 291 -- Amortization of intangible assets 121 146 Deferred income tax benefit (1,849) (394) Origination of presold mortgages in process of settlement (31,781) (32,877) Proceeds from sales of presold mortgages in process of settlement 32,542 32,585 Increase in accrued interest receivable (940) (721) Decrease in other assets 213 2,044 Increase in accrued interest payable 1,021 590 Increase (decrease) in other liabilities (1,479) 116 --------- --------- Net cash provided by operating activities 12,187 13,590 --------- --------- Cash Flows From Investing Activities Purchases of securities available for sale (23,565) (44,747) Purchases of securities held to maturity (2,682) -- Proceeds from maturities/issuer calls of securities available for sale 18,248 13,117 Proceeds from maturities/issuer calls of securities held to maturity 3,186 1,168 Proceeds from sales of securities available for sale 1,575 8 Net increase in loans (154,743) (61,227) Purchases of premises and equipment (3,730) (2,776) --------- --------- Net cash used by investing activities (161,711) (94,457) --------- --------- Cash Flows From Financing Activities Net increase in deposits and repurchase agreements 93,163 83,962 Proceeds from borrowings, net 94,774 9,000 Cash dividends paid (5,133) (4,797) Proceeds from issuance of common stock 1,433 1,384 Purchases and retirement of common stock (1,112) -- Tax benefit from exercise of nonqualified stock options 94 -- --------- --------- Net cash provided by financing activities 183,219 89,549 --------- --------- Increase in Cash and Cash Equivalents 33,695 8,682 Cash and Cash Equivalents, Beginning of Period 103,523 89,401 --------- --------- Cash and Cash Equivalents, End of Period $ 137,218 98,083 ========= ========= Supplemental Disclosures of Cash Flow Information: Cash paid during the period for: Interest $ 22,712 13,740 Income taxes 7,571 5,771 Non-cash transactions: Unrealized loss on securities available for sale, net of taxes (1,173) (260) Foreclosed loans transferred to other real estate 774 2,128 See notes to consolidated financial statements. Page 7 </TABLE>
First Bancorp and Subsidiaries Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- (unaudited) For the Periods Ended June 30, 2006 and 2005 - -------------------------------------------------------------------------------- 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 June 30, 2006 and 2005 and the consolidated results of operations and consolidated cash flows for the periods ended June 30, 2006 and 2005. All such adjustments were of a normal, recurring nature. Reference is made to the 2005 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 June 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full year. Note 2 - Accounting Policies Note 1 to the 2005 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 July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" (FIN 48). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The Company will adopt FIN 48 in the first quarter of 2007. The cumulative effect of applying the provisions of this interpretation is required to be reported separately as an adjustment to the opening balance of retained earnings in the year of adoption. The Company is in the process of reviewing and evaluating FIN 48, and therefore the ultimate impact of its adoption is not yet known. On January 1, 2006, the Company adopted 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 Accounting Principles Board Opinion No. 25 (Opinion 25), "Accounting for Stock Issued to Employees." Statement 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. Statement 123(R) permits public companies to adopt its requirements using one of two methods. The "modified prospective" method recognizes compensation for all stock options granted after the date of adoption and for all previously granted stock options that become vested after the date of adoption. The "modified retrospective" method includes the requirements of the "modified prospective" method described above, but also permits entities to restate prior period results based on the amounts previously presented under Statement 123 for purposes of pro-forma disclosures. The Company has elected to adopt Statement 123(R) under the "modified prospective" method and accordingly will not restate prior period results. See Note 4 for a more detailed description the Company's adoption of Statement 123(R). 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 Page 8
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 initial adoption of Statement 154 did not have a material impact on 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. Note 3 - Reclassifications Certain amounts reported in the period ended June 30, 2005 have been reclassified to conform with the presentation for June 30, 2006. These reclassifications had no effect on net income or shareholders' equity for the periods presented, nor did they materially impact trends in financial information. Note 4 - Equity-Based Compensation Plans At June 30, 2006, the Company had the following equity-based compensation plans, all of which are stock option plans: the First Bancorp 2004 Stock Option Plan, the First Bancorp 1994 Stock Option Plan, and four plans that were assumed from acquired entities, which are all described below. The Company's shareholders approved all equity-based compensation plans, except for those assumed from acquired companies. As of June 30, 2006, the First Bancorp 2004 Stock Option Plan was the only plan that had shares available for future grants. The First Bancorp 2004 Stock Option Plan and its predecessor plan, the First Bancorp 1994 Stock Option Plan, were intended to serve as a means of attracting, retaining and motivating key employees and directors and to associate the interests of the plans' participants with those of the Company and its shareholders. Stock option grants to non-employee directors have historically had no vesting requirements, whereas, except as discussed below, stock option grants to employees have generally had five-year vesting schedules (20% vesting each year). In April 2004, the Company granted 128,000 options to employees with no vesting requirements. These options were granted without any vesting requirements for two reasons - 1) the options were granted primarily as a reward for past performance and therefore had already been "earned" in the view of the Committee, and 2) to potentially minimize the impact that any change in accounting standards for stock options could have on future years' reported net income. Employee stock option grants since the April 2004 grant have reverted to having five year vesting periods. The Company's options provide for immediate vesting if there is a change in control (as defined in the plans). Under the terms of these two plans, options can have a term of no longer than ten years, and all options granted thus far under these plans have had a term of ten years. 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 directors, the Company has historically granted 2,250 stock options to each of the Company's non-employee directors in June of each year, and expects to continue doing so for the foreseeable future. At June 30, 2006, there were 658,883 options outstanding related to these two plans with exercise prices ranging from $4.45 to $22.12. At June 30, 2006, there were 1,186,840 shares remaining available for grant under the First Bancorp 2004 Stock Option Plan. Page 9
The Company also has four stock option plans as a result of assuming plans of acquired companies. At June 30, 2006, there were 44,686 stock options outstanding in connection with these plans, with option prices ranging from $10.22 to $11.49. The Company issues new shares when options are exercised. Prior to January 1, 2006, the Company accounted for all of these plans using the intrinsic value method prescribed by Opinion 25 and related interpretations. Because all of the Company's stock options had an exercise price equal to the market value of the underlying common stock on the date of grant, no compensation cost had ever been recognized. On January 1, 2006, the Company adopted Statement 123(R). Statement 123(R) supersedes Opinion 25 (and related interpretations) and requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. Statement 123(R) permits public companies to adopt its requirements using one of two methods. The "modified prospective" method recognizes compensation for all stock options granted after the date of adoption and for all previously granted stock options that become vested after the date of adoption. The "modified retrospective" method includes the requirements of the "modified prospective" method described above, but also permits entities to restate prior period results based on the amounts previously presented under Statement 123 for purposes of pro-forma disclosures. The Company has elected to adopt Statement 123(R) under the "modified prospective" method and accordingly will not restate prior period results. The Company measures the fair value of each option award on the date of grant using the Black-Scholes option-pricing model. The Company determines the assumptions used in the Black-Scholes option pricing model as follows: the risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant; the dividend yield is based on the Company's dividend yield at the time of the grant (subject to adjustment if the dividend yield on the grant date is not expected to approximate the dividend yield over the expected life of the option); the volatility factor is based on the historical volatility of the Company's stock (subject to adjustment if historical volatility is reasonably expected to differ from the past); the weighted-average expected life is based on the historical behavior of employees related to exercises, forfeitures and cancellations. As noted above, prior to the adoption of Statement 123(R), the Company applied Opinion 25 to account for its stock options. The following table illustrates the effect on net income and earnings per share had the Company accounted for share-based compensation in accordance with Statement 123(R) for the periods indicated: <TABLE> <CAPTION> Three Months Six Months Ended June 30, Ended June 30, (In thousands except per share data) 2005 2005 ------------ ------------ <S> <C> <C> Net income, as reported $ 4,652 9,368 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (180) (232) ------------ ------------ Pro forma net income $ 4,472 9,136 ============ ============ Earnings per share: Basic - As reported $ 0.33 0.66 Basic - Pro forma 0.32 0.65 Diluted - As reported 0.32 0.65 Diluted - Pro forma 0.31 0.64 </TABLE> For the three and six month periods ended June 30, 2006, the Company recorded stock-based compensation expense in the income statement of $244,000 and $291,000, respectively. The Company recognized income tax benefits in the income statement related to stock-based compensation of $78,000 for each of the three and six month periods ended June 30, 2006, respectively. This stock-based compensation expense related to the vesting of several stock option grants made prior to January 1, 2006, as well as a grant of 29,250 options (2,250 options to Page 10
each non-employee director of the Company) on June 1, 2006 with no vesting requirements. This compensation expense was reflected as an adjustment to cash flows from operating activities on the Company's Consolidated Statement of Cash Flows. At June 30, 2006, the Company had $90,000 of unrecognized compensation costs related to unvested stock options. The cost is expected to be amortized over a weighted-average life of 1.8 years, with $22,000 being expensed in the third quarter of 2006, $12,000 being expensed in the fourth quarter of 2006, $47,000 being expensed in 2007 equally distributed among each of the four quarters, and $3,000 being expensed in each of 2008, 2009 and 2010, equally distributed among each of the four quarters of each year. In addition, as discussed above, the Company granted 2,250 options, without vesting requirements, to each of its non-employee directors on June 1, 2006 and expects to continue this grant on June 1 of each year thereafter. As noted above, certain of the Company's stock option grants contain terms that provide for a graded vesting schedule whereby portions of the award vest in increments over the requisite service period. As provided for under Statement 123(R), the Company has elected to recognize compensation expense for awards with graded vesting schedules on a straight-line basis over the requisite service period for the entire award. Statement 123(R) requires companies to recognize compensation expense based on the estimated number of stock options and awards for which service is to be rendered. Over the past five years, there have only been four forfeitures or expirations, totaling 9,600 options, and therefore the Company assumes that all options granted will become vested. The Company's only option grants for the first six months of 2006 and 2005 were grants of 29,250 and 31,500 options to non-employee directors on June 1, 2006 and 2005, respectively (2,250 option per director). The per share weighted-average fair value of options granted during the six months ended June 30, 2006 and June 30, 2005, was $6.79, and $6.68, respectively, on the date of the grant using the following weighted-average assumptions: Six months Six months ended ended June 30, 2006 June 30, 2005 ------------- ------------- Expected dividend yield 3.30% 3.07% Risk-free interest rate 5.05% 3.84% Expected life 7 years 7 years Expected volatility 32.56% 32.99% The following table presents information regarding the activity during the first six months of 2006 related to all of the Company's stock options outstanding: <TABLE> <CAPTION> All Options Outstanding ------------------------------------------------------- Weighted- Average Weighted- Remaining Aggregate Number of Average Contractual Intrinsic Value Six months ended June 30, 2006 Shares Exercise Price Term ($000) - ------------------------------------------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Outstanding at the beginning of the period 746,882 $ 15.75 Granted during the period 29,250 21.83 Exercised during the period 68,063 9.69 Forfeited or expired during the period 4,500 6.55 ---------- Outstanding at end of period 703,569 $ 16.65 5.7 $ 3,523 ========== ========== ========== ========== Exercisable at June 30, 2006 651,944 $ 16.72 5.7 $ 3,219 ========== ========== ========== ========== </TABLE> The Company received $618,000 and $585,000 as a result of stock option exercises during the six Page 11
months ended June 30, 2006 and 2005, respectively. The intrinsic value of the stock options exercised during the six months ended June 30, 2006 and 2005 was $787,000 and $585,000, respectively. The Company recorded $94,000 and $100,000 in associated tax benefits from the exercise of nonqualified stock options during the six months ended June 30, 2006 and 2005, respectively. In accordance with Statement 123(R), this benefit is included as a financing activity in the accompanying Statement of Cash Flows for periods subsequent to the adoption of Statement 123(R), but continues to be reported as an operating activity in periods prior to its adoption. The following table presents information regarding the activity during the first six months of 2006 related to the Company's stock options outstanding that are nonvested: <TABLE> <CAPTION> Nonvested Options ------------------------- Weighted-Average Number of Grant-Date Six months ended June 30, 2006 Shares Fair Value - ------------------------------------------------------------ -------- ---------- <S> <C> <C> Nonvested options outstanding at the beginning of the period 67,999 $4.75 Granted during the period -- -- Vested during the period (16,374) 4.83 Forfeited or expired during the period -- -- ------ Nonvested options outstanding at end of period 51,625 $4.74 ====== </TABLE> Note 5 - Earnings Per Share Basic earnings per share were computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share includes the potentially dilutive effects of the Company's stock option plan. The following is a reconciliation of the numerators and denominators used in computing basic and diluted earnings per share: <TABLE> <CAPTION> For the Three Months Ended June 30, --------------------------------------------------------------------------- 2006 2005 ------------------------------------ ------------------------------------ Income Shares Income Shares ($ in thousands except per (Numer- (Denom- Per Share (Numer- (Denom- Per Share share amounts) ator) inator) Amount ator) inator) Amount - ----------------------------- ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Basic EPS Net income $ 4,795 14,296,159 $ 0.34 $ 4,652 14,159,117 $ 0.33 ========== ========== Effect of Dilutive Securities -- 137,671 -- 185,896 ---------- ---------- ---------- ---------- Diluted EPS $ 4,795 14,433,830 $ 0.33 $ 4,652 14,345,013 $ 0.32 ========== ========== ========== ========== ========== ========== <CAPTION> For the Six Months Ended June 30, --------------------------------------------------------------------------- 2006 2005 ------------------------------------ ------------------------------------ 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 $ 9,786 14,275,472 $ 0.69 $ 9,368 14,132,347 $ 0.66 ========== ========== Effect of Dilutive Securities -- 150,028 -- 222,505 ---------- ---------- ---------- ---------- Diluted EPS $ 9,786 14,425,500 $ 0.68 $ 9,368 14,354,852 $ 0.65 ========== ========== ========== ========== ========== ========== </TABLE> For the three months ended June 30, 2006 and 2005, there were options of 220,980, and 189,230, respectively, that were antidilutive because the exercise price exceeded the average market price for the period. For the six months ended June 30, 2006, there were 220,980 antidilutive options, while there were no antidilutive options for the six months ended June 30, 2005. Antidilutive options have been omitted from the calculation of diluted Page 12
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> June 30, December 31, June 30, ($ in thousands) 2006 2005 2005 - ----------------------------------------------------------------------------------------- <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 3,973 1,640 3,806 Restructured loans 12 13 15 Accruing loans > 90 days past due -- -- -- ------------ ------------ ------------ Total nonperforming loans 3,985 1,653 3,821 Other assets - primarily other real estate 2,024 1,421 2,520 ------------ ------------ ------------ Total nonperforming assets $ 6,009 3,074 6,341 ============ ============ ============ Nonperforming loans to total loans 0.24% 0.11% 0.27% Nonperforming assets as a percentage of loans and other real estate 0.37% 0.21% 0.44% Nonperforming assets to total assets 0.30% 0.17% 0.36% Allowance for loan losses to total loans 1.08% 1.06% 1.10% </TABLE> - -------------------------------------------------------------------------------- Note 7 - Deferred Loan Fees Loans are shown on the Consolidated Balance Sheets net of net deferred loan costs (fees) of ($64,000), $184,000, and $11,000 at June 30, 2006, December 31, 2005, and June 30, 2005, respectively. Note 8 - Goodwill and Other Intangible Assets The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of June 30, 2006, December 31, 2005, and June 30, 2005 and the carrying amount of unamortized intangible assets as of those same dates. <TABLE> <CAPTION> June 30, 2006 December 31, 2005 June 30, 2005 --------------------------- --------------------------- --------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Gross Carrying Accumulated ($ in thousands) Amount Amortization Amount Amortization Amount Amortization - ------------------------ ------------ ------------ ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> <C> <C> Amortizable intangible assets: Customer lists $ 394 131 394 115 394 101 Noncompete agreements 50 50 50 50 50 50 Core deposit premiums 2,441 1,116 2,441 1,011 2,441 881 ------------ ------------ ------------ ------------ ------------ ------------ Total $ 2,885 1,297 2,885 1,176 2,885 1,032 ============ ============ ============ ============ ============ ============ Unamortizable intangible assets: Goodwill $ 47,247 47,247 47,247 ============ ============ ============ Pension $ 237 273 273 ============ ============ ============ </TABLE> Amortization expense totaled $60,000 and $73,000 for the three months ended June 30, 2006 and 2005, respectively. Amortization expense totaled $121,000 and $146,000 for the six months ended June 30, 2006 and 2005, respectively. Page 13
The following table presents the estimated amortization expense for each of the five calendar years ending December 31, 2010 and the estimated amount amortizable thereafter. These estimates are subject to change in future periods to the extent management determines it is necessary to make adjustments to the carrying value or estimated useful lives of amortized intangible assets. Estimated Amortization (Dollars in thousands) Expense ---------------------- ---------------------- 2006 $ 242 2007 220 2008 219 2009 218 2010 218 Thereafter 592 ---------------------- Total $ 1,709 ====================== 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 $581,000 and $447,000 for the three months ended June 30, 2006 and 2005, 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 June 30, 2006 and 2005. <TABLE> <CAPTION> For the Three Months Ended June 30, ------------------------------------------------------------------------------ 2006 2005 2006 2005 2006 Total 2005 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 $ 341 284 79 62 420 346 Interest cost on projected benefit obligation 227 192 52 38 279 230 Expected return on plan assets (268) (237) -- -- (268) (237) Net amortization and deferral 119 86 31 22 150 108 ---------- ---------- ---------- ---------- ---------- ---------- Net periodic pension cost $ 419 325 162 122 581 447 ========== ========== ========== ========== ========== ========== </TABLE> The Company recorded pension expense totaling $1,162,000 and $894,000 for the six months ended June 30, 2006 and 2005, respectively, related to the Pension Plan and the SERP Plan. The following table contains the components of the pension expense for the six months ended June 30, 2006 and 2005. <TABLE> <CAPTION> For the Six Months Ended June 30, ------------------------------------------------------------------------------ 2006 2005 2006 2005 2006 Total 2005 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 $ 682 $ 568 158 124 840 692 Interest cost on projected benefit obligation 454 384 104 76 558 460 Expected return on plan assets (536) (474) -- -- (536) (474) Net amortization and deferral 238 172 62 44 300 216 ---------- ---------- ---------- ---------- ---------- ---------- Net periodic pension cost $ 838 $ 650 324 244 1,162 894 ========== ========== ========== ========== ========== ========== </TABLE> The Company's contributions to the Pension Plan are based on computations by independent actuarial consultants and are intended to provide the Company with the maximum deduction for income tax purposes. The contributions are invested to provide for benefits under the Pension Plan. The Company estimates that its contribution to the Pension Plan will be $945,000 during 2006. Page 14
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 estimates that its payments to participants in the SERP Plan will be $25,000 in 2006. Note 10 - Contingency The Company recorded a loss amount of $6,320,000, or $0.44 per diluted share, in the third quarter of 2005 to accrue for contingent tax loss exposure involving the North Carolina Department of Revenue. In February 2006, the North Carolina Department of Revenue announced a "Settlement Initiative" that offered companies with certain transactions that had been challenged by the North Carolina Department of Revenue the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative by June 15, 2006. Although the Company believed that its tax returns complied with the relevant statutes, the Board of Directors of the Company decided that it was in the best interests of the Company to settle this matter by participating in the initiative. Based on the terms of the initiative, the Company estimated that its total liability to settle the matter will be approximately $4.3 million, net of the federal tax benefit, or $2.0 million less than the amount that was originally accrued. Accordingly, in March 2006, the Company adjusted its originally reported 2005 earnings to reflect the impact of this subsequent event by reducing originally reported tax expense for the three and twelve months ended December 31, 2005 by $1,982,000, or $0.14 per diluted share. The Company believes it has fully reserved for this liability and does not have any additional state income tax exposure other than the ongoing interest that will continue to accrue ($65,000 per quarter on an after-tax basis) until the Settlement Initiative is completed and the Company pays the amounts due in accordance with the settlement, which is expected to occur in the fourth quarter of this year. Note 11 - Pending Acquisitions On January 20, 2006, the Company reported that it had agreed to purchase a bank branch in Dublin, Virginia with approximately $20 million in deposits from another financial institution. This transaction was completed in July 2006. On April 26, 2006, the Company reported that it had agreed to purchase a bank branch with approximately $25 million in deposits located in Carthage, North Carolina from another financial institution. This transaction is expected to close in September 2006. Page 15
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 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. Page 16
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. See Note 10 to the Consolidated Financial Statements above for information related to a tax loss contingency accrual that was recorded in 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. 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 Page 17
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. RESULTS OF OPERATIONS Overview Net income for the three months ended June 30, 2006 was $4,795,000, or $0.33 per diluted share, a 3.1% increase in diluted earnings per share compared to earnings of $4,652,000, or $0.32 per diluted share, recorded in the second quarter of 2005. Net income for the six months ended June 30, 2006 was $9,786,000, or $0.68 per diluted share, a 4.6% increase in diluted earnings per share from the net income of $9,368,000, or $0.65 per diluted share, reported for the six months ended June 30, 2005. The increase in loans and deposits over the past twelve months resulted in an increase in the Company's net interest income when comparing the three and six month periods of 2006 to comparable periods in 2005. Net interest income for the second quarter of 2006 amounted to $18.4 million, an 8.4% increase over the $17.0 million recorded in the second quarter of 2005. Net interest income for the six months ended June 30, 2006 amounted to $36.3 million, a 9.0% increase over the $33.3 million recorded in the same six month period in 2005. The impact of the growth in loans and deposits on the Company's net interest income was partially offset by declines in the Company's net interest margin (tax-equivalent net interest income divided by average earning assets). The Company's net interest margin for the second quarter of 2006 was 4.22% compared to 4.31% for the second quarter of 2005. The Company's net interest margin for the first six months of 2006 was 4.28% compared to 4.32% for the same six months of 2005. The 4.22% net interest margin realized in the second quarter of 2006 was an 11 basis point decrease from the first quarter of 2006 net interest margin of 4.33%. The compressing margin is primarily due to deposit rates paid by the Company rising by more than loan and investment yields. The Company has also been negatively impacted by customers shifting their funds from low cost deposits to higher cost deposits as rates have risen. The Company's provision for loan losses amounted to $1,400,000 in the second quarter of 2006, an increase of 65.7% over the $845,000 recorded in the second quarter of 2005. The provision for loan losses for the first six months of 2006 was $2,415,000, an increase of 69.5% over the $1,425,000 recorded in first half of 2005. The higher provisions are a result of the strong loan growth realized in 2006, as asset quality ratios have remained stable and compare favorably to peers. Loan growth was $83 million in the second quarter of 2006 compared to $31 million in the second quarter of 2005, while loan growth was $153 million for the first half of 2006 compared to $59 million for the first half of 2005. The Company's ratios of annualized net charge-offs to average loans were 9 basis points and 6 basis points for the three and six month periods in 2006, respectively, compared to 8 basis Page 18
points for each of the three and six month periods in 2005. The Company's level of nonperforming assets to total assets was 0.30% at June 30, 2006 compared to 0.36% a year earlier. Noninterest income amounted to $3.8 million in the second quarter of 2006, a 3.6% increase from the $3.7 million recorded in the second quarter of 2005. Noninterest income for the six months ended June 30, 2006 amounted to $7.8 million, an increase of 5.1% from the $7.4 million recorded in the first half of 2005. Noninterest expenses amounted to $13.1 million in the second quarter of 2006, a 6.6% increase over the $12.3 million recorded in the comparable period of 2005. Noninterest expenses for the six months ended June 30, 2006 amounted to $25.8 million, a 7.6% increase from the $24.0 million recorded in the first six months of 2005. 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 effective tax rate was 38%-39% for each of the three and six month periods in 2005 and 2006. The Company's annualized return on average assets for the second quarter of 2006 was 1.02% compared to 1.09% for the second quarter of 2005. The Company's annualized return on average assets for the six months ended June 30, 2006 was 1.07% compared to 1.13% for the first half of 2005. The Company's annualized return on average equity for the second quarter of 2006 was 11.83% compared to 12.07% for the second quarter of 2005. The Company's annualized return on average equity for the six months ended June 30, 2006 was 12.30% compared to 12.32% for the first half of 2005. 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 June 30, 2006 amounted to $18,444,000, an increase of $1,437,000, or 8.4%, from the $17,007,000 recorded in the second quarter of 2005. Net interest income on a taxable equivalent basis for the three months ended June 30, 2006, amounted to $18,569,000, an increase of $1,451,000, or 8.5%, from the $17,118,000 recorded in the second quarter of 2005. Management believes that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest income amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods. Net interest income for the six months ended June 30, 2006 amounted to $36,297,000, an increase of $3,005,000, or 9.0%, from the $33,292,000 recorded in the first six months of 2005. Net interest income on a taxable equivalent basis for the six months ended June 30, 2006 amounted to $36,548,000, an increase of $3,032,000, or 9.0%, from the $33,516,000 recorded in the first six months of 2005. There are two primary factors that cause changes in the amount of net interest income recorded by the Company - 1) growth in loans and deposits, and 2) the Company's net interest margin. For the three and six month periods ended June 30, 2006, growth in loans and deposits were the primary cause for the increases in net interest income, as the Company's net interest margins in 2006 were slightly lower than those realized in 2005. For internal purposes and in the discussion that follows, the Company evaluates its net interest income on a tax-equivalent basis by adding the tax benefit realized from tax-exempt securities to reported interest income. The following tables present net interest income analysis on a taxable-equivalent basis. Page 19
<TABLE> <CAPTION> For the Three Months Ended June 30, ----------------------------------------------------------------------------- 2006 2005 ------------------------------------- ------------------------------------- Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,593,070 7.36% $ 29,215 $1,409,118 6.47% $ 22,732 Taxable securities 118,172 4.76% 1,402 119,180 4.75% 1,411 Non-taxable securities (2) 12,058 8.38% 252 10,712 8.54% 228 Short-term investments 40,927 5.60% 571 53,835 3.33% 447 ---------- ---------- ---------- ---------- Total interest-earning assets 1,764,227 7.15% 31,440 1,592,845 6.25% 24,818 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 475,558 1.38% $ 1,635 $ 477,311 0.81% $ 958 Time deposits >$100,000 380,229 4.40% 4,174 359,487 3.04% 2,725 Other time deposits 507,359 3.96% 5,004 447,634 2.69% 3,007 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,363,146 3.18% 10,813 1,284,432 2.09% 6,690 Securities sold under agreements to repurchase 29,102 3.76% 273 420 1.91% 2 Borrowings 109,422 6.54% 1,785 76,513 5.28% 1,008 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,501,670 3.44% 12,871 1,361,365 2.27% 7,700 ---------- ---------- Non-interest-bearing deposits 206,635 182,461 Net yield on interest-earning assets and net interest income 4.22% $ 18,569 4.31% $ 17,118 ========== ========== Interest rate spread 3.71% 3.98% Average prime rate 7.90% 5.91% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $125,000 and $111,000 in 2006 and 2005, respectively, to reflect the tax benefit that the Company receives related to its tax-exempt securities, which carry interest rates lower than similar taxable investments due to their tax exempt status. This amount has been computed assuming a 39% tax rate and is reduced by the related nondeductible portion of interest expense. - -------------------------------------------------------------------------------- Page 20
<TABLE> <CAPTION> For the Six Months Ended June 30, ----------------------------------------------------------------------------- 2006 2005 ------------------------------------- ------------------------------------- Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,554,763 7.26% $ 55,977 $1,396,167 6.37% $ 44,091 Taxable securities 116,541 4.73% 2,731 111,214 4.65% 2,566 Non-taxable securities (2) 11,940 8.53% 505 11,026 8.60% 470 Short-term investments 40,137 5.37% 1,068 46,598 3.11% 719 ---------- ---------- ---------- ---------- Total interest-earning assets 1,723,381 7.05% 60,281 1,565,005 6.17% 47,846 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 471,659 1.27% $ 2,968 $ 475,997 0.78% $ 1,839 Time deposits >$100,000 372,847 4.25% 7,851 350,987 2.91% 5,070 Other time deposits 501,103 3.80% 9,436 436,256 2.53% 5,481 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,345,609 3.04% 20,255 1,263,240 1.98% 12,390 Securities sold under agreements to repurchase 29,708 3.63% 535 210 1.92% 2 Borrowings 91,486 6.49% 2,943 76,598 5.10% 1,938 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,466,803 3.26% 23,733 1,340,048 2.16% 14,330 ---------- ---------- Non-interest-bearing deposits 201,865 177,567 Net yield on interest-earning assets and net interest income 4.28% $ 36,548 4.32% $ 33,516 ========== ========== Interest rate spread 3.79% 4.01% Average prime rate 7.66% 5.67% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $251,000 and $224,000 in 2006 and 2005, 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 second quarter of 2006 were $1.593 billion, which was 13.1% higher than the average loans outstanding for the second quarter of 2005 ($1.409 billion). Average loans outstanding for the six months ended June 30, 2006 were $1.555 billion, which was 11.4% higher than the average loans outstanding for the six months ended June 30, 2005 ($1.396 billion). The mix of the Company's loan portfolio remained substantially the same at June 30, 2006 compared to December 31, 2005 with approximately 86% of the Company's loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans. Average total deposits outstanding for the second quarter of 2006 were $1.570 billion, which was 7.0% higher than the average deposits outstanding for the second quarter of 2005 ($1.467 billion). Average deposits outstanding for the six months ended June 30, 2006 were $1.547 billion, which was 7.4% higher than the average deposits outstanding for the six months ended June 30, 2005 ($1.441 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 reasons for and 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 2006. As derived from the tables above, yields on interest earning assets and liabilities are higher for the periods presented in 2006 compared to 2005, which is a result of the rising rate environment that began in the third quarter Page 21
of 2004. From July 1, 2004 to June 30, 2006, the Federal Reserve raised short-term interest rates 17 times totaling 425 basis points. The tables also indicate that the interest-bearing liability rates paid by the Company have risen by more than yields realized on interest-earning assets. For each of the three and six month periods ended June 30, 2006, interest-earning asset yields have increased by approximately 90 basis points, whereas the average rate paid on interest-bearing liabilities has risen by 110-117 basis points. This narrowing spread was caused by rates paid on most of the Company's categories of interest-bearing liabilities increasing by more than the increases in yields realized on most of the Company's earning assets, as well as a higher concentration of the Company's funding sources being comprised of time deposits and borrowings, the highest cost funding sources for the Company. As a result of the narrowed interest rate spread, the Company's net interest margin (tax-equivalent net interest income divided by average earning assets) has declined in 2006, with the Company's net interest margin amounting to 4.22% in the second quarter of 2006 compared to 4.31% in the second quarter of 2005, and the Company's net interest margin amounting to 4.28% for the six months ended June 30, 2006 compared to 4.32% for the same six months of 2005. See additional information regarding net interest income in the section entitled "Interest Rate Risk." The provision for loan losses amounted to $1,400,000 in the second quarter of 2006 compared to $845,000 in the second quarter of 2005, and the provision for loan losses for the first six months of 2006 was $2,415,000 compared to $1,425,000 for the first six months of 2005. The higher provisions for loan losses in 2006 compared to 2005 are a result of the strong loan growth realized in 2006, as asset quality ratios have remained stable and compare favorably to peers. Loan growth was $83 million in the second quarter of 2006 compared to $31 million in the second quarter of 2005, while loan growth was $153 million for the first half of 2006 compared to $59 million for the first half of 2005. The Company's ratios of annualized net charge-offs to average loans were 9 basis points and 6 basis points for the three and six month periods in 2006, respectively, compared to 8 basis points for each of the three and six month periods in 2005. The Company's level of nonperforming assets to total assets was 0.30% at June 30, 2006 compared to 0.36% a year earlier. Noninterest income amounted to $3,844,000 for the second quarter of 2006, a 3.6% increase from $3,712,000 recorded in the second quarter of 2005. Noninterest income for the six months ended June 30, 2006 amounted to $7,798,000, an increase of 5.1% from the $7,422,000 recorded in the first half of 2005. The increases were primarily a result of general growth in the Company's customer base and increased usage of credit cards and debit cards by the Company's customers (which impacted the line item "other service charges, commissions and fees"). These increases were partially offset by a $132,000 decrease in data processing income in the first six months of 2006 compared to 2005. The Company's data processing subsidiary makes its excess data processing capabilities available to area financial institutions for a fee. At January 1, 2005, the Company had five community bank customers using this service. Three of these customers terminated their contracts with the Company in the latter half of 2005, which resulted in the decrease in data processing fee income. The Company intends to continue to market this service to area banks, but does not currently have any near-term prospects for additional business. Also negatively impacting noninterest income for each of the three and six month periods ended June 30, 2006 were higher amounts of "other losses," which were only partially offset by higher amounts of securities gains in 2006. Gains from sales of securities and "other losses" amounted to a net loss of $106,000 in the second quarter of 2006 compared to a net loss of $25,000 in the second quarter of 2005. For the six months ended June 30, 2006, gains from sales of securities and "other losses" amounted to a net loss of $173,000 compared to a net loss of $57,000 in the first half of 2005. During the second quarter of 2006, the Company recorded an "other loss" of $230,000 related to a merchant card customer of the Company that sells furniture over the internet. The furniture store did not deliver furniture that its customers had ordered and paid for, and was unable to refund their credit card purchases. As the furniture store's credit card processor, the Company became liable for the amounts that were required to be refunded. Through June 30, 2006, the Company had funded $240,000 in customer refunds, while the total exposure is believed to be approximately $1.9 million. The Company is vigorously pursuing repayment of these advances from the furniture store. The furniture store is under new management and intends to repay the Company for all funds advanced. Although the furniture store has begun repaying the Company, the Company Page 22
determined that recording a $230,000 loss was prudent to reserve for this situation. The Company reports outstanding advances related to this situation as an "other asset," and within the line item - "Other assets - primarily other real estate" in asset quality tables, while the corresponding reserve is classified as a valuation allowance within other assets. The Company sold securities for a gain of $205,000 during the second quarter of 2006 partially in response to this loss situation. Noninterest expenses amounted to $13,064,000 in the second quarter of 2006, a 6.6% increase over the $12,260,000 in 2005. Noninterest expenses for the six months ended June 30, 2006 amounted to $25,793,000, a 7.6% increase from the $23,975,000 recorded in the first six months of 2005. The increase in noninterest expenses occurred in all categories and is associated with the overall growth of the Company in terms of branch network, employees and customer base. In accordance with the new accounting requirements regarding stock-based compensation that were effective on January 1, 2006, the Company recorded stock option expense of $244,000 ($166,000 after-tax effect) and $291,000 ($212,000 after-tax effect) for the three and six month periods ended June 30, 2006, respectively - see Note 4 to the Consolidated Financial Statements above for additional discussion. Noninterest expenses for the second quarter of 2005 were impacted by several expenses that did not recur in 2006 totaling approximately $500,000, including; immediately vested post-retirement benefits granted to the Company's CEO totaling $196,000, external Sarbanes-Oxley costs related to the prior year SOX certification of $181,000, and public relation expenses of $123,000 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 provision for income taxes was $3,029,000 in the second quarter of 2006, an effective tax rate of 38.7%, compared to $2,962,000 in the second quarter of 2005, an effective tax rate of 38.9%. The provision for income taxes was $6,101,000 for the six months ended June 30, 2006, an effective tax rate of 38.4%, compared to $5,946,000 for the six months ended June 30, 2005, an effective tax rate of 38.8%. The Company expects its effective tax rate to remain at approximately 38-39% for the foreseeable future. The Consolidated Statements of Comprehensive Income reflect "Other Comprehensive Loss" of $1,114,000 during the second quarter of 2006 and "Other Comprehensive Loss" of $1,163,000 for the six months ended June 30, 2006, compared to "Other Comprehensive Income" of $542,000 for the second quarter of 2005 and "Other Comprehensive Loss" of $315,000 for the six months ended June 30, 2005. The primary component of other comprehensive 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. Except for a brief decrease in bond yields in the second quarter of 2005, generally rising short-term and long-term bond yields in the marketplace have resulted in significant declines in value of the Company's available for sale securities portfolio. Page 23
FINANCIAL CONDITION Total assets at June 30, 2006 amounted to $1.99 billion, 14.6% higher than a year earlier. Total loans at June 30, 2006 amounted to $1.64 billion, a 14.7% increase from a year earlier, and total deposits amounted to $1.59 billion at June 30, 2006, an 8.1% increase from a year earlier. The following tables present information regarding the nature of the Company's growth since June 30, 2005. <TABLE> <CAPTION> July 1, 2005 to Balance at Balance at Total Percentage growth, June 30, 2006 beginning of Internal Growth from end of percentage excluding period Growth Acquisitions period growth acquisitions - ------------------------------ ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> ($ in thousands) Loans $1,425,856 210,043 -- 1,635,899 14.7% 14.7% ========== ========== ========== ========== Deposits - Noninterest bearing $ 184,605 24,457 -- 209,062 13.2% 13.2% Deposits - Savings, NOW, and Money Market 476,642 3,880 -- 480,522 0.8% 0.8% Deposits - Time>$100,000 349,972 40,617 -- 390,589 11.6% 11.6% Deposits - Time<$100,000 459,661 50,834 -- 510,495 11.1% 11.1% ---------- ---------- ---------- ---------- Total deposits $1,470,880 119,788 -- 1,590,668 8.1% 8.1% ========== ========== ========== ========== January 1, 2006 to June 30, 2006 - ------------------------------ Loans $1,482,611 153,288 -- 1,635,899 10.3% 10.3% ========== ========== ========== ========== Deposits - Noninterest bearing $ 194,051 15,011 -- 209,062 7.7% 7.7% Deposits - Savings, NOW, and Money Market 458,221 22,301 -- 480,522 4.9% 4.9% Deposits - Time>$100,000 356,281 34,308 -- 390,589 9.6% 9.6% Deposits - Time<$100,000 486,024 24,471 -- 510,495 5.0% 5.0% ---------- ---------- ---------- ---------- Total deposits $1,494,577 96,091 -- 1,590,668 6.4% 6.4% ========== ========== ========== ========== </TABLE> The Company experienced strong loan and deposit growth during the first half of 2006, with loans increasing by $153 million, or 20.8% on an annualized basis, and deposits increasing by $96 million, or 13.0% on an annualized basis. For the twelve months preceding June 30, 2006, the Company's loans increased by $210 million, or 14.7% and deposits increased $120 million, or 8.1%. The Company opened two de novo branches and two loan production offices in 2005, while in the first half of 2006, the Company opened one loan production office and upgraded one loan production office to a full service branch, which has contributed to the internal growth. In the second half of 2006, the Company plans to open two de novo branches and convert two loan production offices to full service branches. Additionally, the Company completed a branch purchase of $20 million in deposits (no loans) in July 2006 and expects to complete the purchase of another branch in September 2006 with approximately $25 million in deposits and $5 million in loans. The mix of the Company's loan portfolio remains substantially the same at June 30, 2006 compared to December 31, 2005 with approximately 86% of the Company's loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans. The majority of the Company's real estate loans are personal and commercial loans where real estate provides additional security for the loan. Page 24
Nonperforming Assets Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> June 30, December 31, June 30, ($ in thousands) 2006 2005 2005 - ----------------------------------------------------------------------------------------- <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 3,973 1,640 3,806 Restructured loans 12 13 15 Accruing loans > 90 days past due -- -- -- ------------ ------------ ------------ Total nonperforming loans 3,985 1,653 3,821 Other assets - primarily other real estate 2,024 1,421 2,520 ------------ ------------ ------------ Total nonperforming assets $ 6,009 3,074 6,341 ============ ============ ============ Nonperforming loans to total loans 0.24% 0.11% 0.27% Nonperforming assets as a percentage of loans and other real estate 0.37% 0.21% 0.44% Nonperforming assets to total assets 0.30% 0.17% 0.36% Allowance for loan losses to total loans 1.08% 1.06% 1.10% </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) as of June 30, 2006, December 31, 2005, and June 30, 2005 totaled $3,985,000, $1,653,000, and $3,821,000, respectively. Nonperforming loans as a percentage of total loans amounted to 0.24%, 0.11%, and 0.27%, at June 30, 2006, December 31, 2005, and June 30, 2005, respectively. The variances in the dollar amount of nonperforming loans among the periods has been primarily due to changes in nonaccrual loans, as restructured loans have not changed significantly. In the fourth quarter of 2005, the collection process for several of the Company's largest nonaccrual loan relationships reached a conclusion and their principal balances were reduced to zero either as a result of cash received or the recording of a charge-off. This resulted in the amount of the Company's nonperforming loans at December 31, 2005 reaching their lowest level in over five years. In 2006, the Company has experienced more typical activity within its nonaccrual loan category, and the amount of nonaccrual loans increased to more normal levels. Although nonperforming loans increased from December 31, 2005 to June 30, 2006, the 0.24% ratio of nonperforming loans to total loans at June 30, 2006 is lower than the 0.27% ratio at June 30, 2005 and compares favorably to industry averages. The largest nonaccrual relationship at June 30, 2006 amounted to $338,000. At June 30, 2006, December 31, 2005, and June 30, 2005, the recorded investment in loans considered to be impaired was $1,225,000, $338,000, and $1,956,000, respectively, all of which were on nonaccrual status. At June 30, 2006, December 31, 2005, and June 30, 2005, the related allowance for loan losses for all impaired loans was $311,000, $100,000, and $629,000, respectively. At June 30, 2006, December 31, 2005, and June 30, 2005, there was $618,000, $0, and $178,000 in impaired loans for which there was no related allowance. The average recorded investments in impaired loans during the six month period ended June 30, 2006, the year ended December 31, 2005, and the six months ended June 30, 2005 were approximately $782,000, $1,474,000, and $1,891,000, respectively. For the same periods, the Company recognized no interest income on those loans during the period that they were considered to be impaired. Other nonperforming assets - primarily other real estate - amounted to $2,024,000, $1,421,000, and $2,520,000 at June 30, 2006, December 31, 2005 and June 30, 2005, respectively. Included in this category at June 30, 2006 was the aforementioned $240,000 merchant card receivable - see additional information in the "Components of Page 25
Earnings" section above within the discussion of noninterest income. The Company's management has reviewed recent appraisals of its other real estate and believes that their fair values, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented. In July 2006, the Company completed the sale of two pieces of its other real estate totaling $440,000 at a total gain of approximately $50,000. 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 amounted to $1,400,000 in the second quarter of 2006 compared to $845,000 in the second quarter of 2005, and the provision for loan losses for the first six months of 2006 was $2,415,000 compared to $1,425,000 for the first six months of 2005. The increases are primarily the result of the strong loan growth realized in 2006, as asset quality ratios remained stable. Loan growth was $153 million in the first half of 2006 compared to $59 million in the first half of 2005. The Company's ratio of annualized net charge-offs to average loans amounted to 6 basis points for the first half of 2006 compared to 8 basis points for the first half of 2005. The Company's ratio of nonperforming assets to total assets was 0.30% at June 30, 2006 compared to 0.36% at June 30, 2005. At June 30, 2006, the allowance for loan losses amounted to $17,642,000, compared to $15,716,000 at December 31, 2005 and $15,622,000 at June 30, 2005. The allowance for loan losses as a percentage of total loans did not vary significantly among the periods presented, amounting to 1.08% at June 30, 2006, 1.06% at December 31, 2005, and 1.10% at June 30, 2005. Management believes the Company's reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. See "Critical Accounting Policies - Allowance for Loan Losses" above. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and value of other real estate. Such agencies may require the Company to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations. Page 26
For the periods indicated, the following table summarizes the Company's balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries, and additions to the allowance for loan losses that have been charged to expense. <TABLE> <CAPTION> Six Months Twelve Months Six Months Ended Ended Ended June 30, December 31, June 30, ($ in thousands) 2006 2005 2005 ----------- ----------- ----------- <S> <C> <C> <C> Loans outstanding at end of period $ 1,635,899 1,482,611 1,425,856 =========== =========== =========== Average amount of loans outstanding $ 1,554,763 1,422,419 1,396,167 =========== =========== =========== Allowance for loan losses, at beginning of period $ 15,716 14,717 14,717 Total charge-offs (613) (2,363) (680) Total recoveries 124 322 160 ----------- ----------- ----------- Net charge-offs (489) (2,041) (520) ----------- ----------- ----------- Additions to the allowance charged to expense 2,415 3,040 1,425 ----------- ----------- ----------- Allowance for loan losses, at end of period $ 17,642 15,716 15,622 =========== =========== =========== Ratios: Net charge-offs (annualized) as a percent of average loans 0.06% 0.14% 0.08% Allowance for loan losses as a percent of loans at end of period 1.08% 1.06% 1.10% </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 June 30, 2006, there have been no material changes to the allocation of the allowance for loan losses among the various categories of loans since December 31, 2005. 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 $398 million line of credit with the Federal Home Loan Bank (of which $128 million was outstanding at June 30, 2006), 2) a $50 million overnight federal funds line of credit with a correspondent bank (none of which was outstanding at June 30, 2006), and 3) an approximately $71 million line of credit through the Federal Reserve Bank of Richmond's discount window (none of which was outstanding at June 30, 2006). The Company's liquidity decreased slightly from December 31, 2005 to June 30, 2006, as a result of loan growth that exceeded deposit growth during the first half of the year. Loans increased during the first half of 2006 by $153 million compared to deposit growth of $96 million. The Company's loan to deposit ratio was 102.8% at June 30, 2006 compared to 99.2% at December 31, 2005. The higher growth in loans compared to deposits is the primary factor in the Company increasing its outstanding borrowings from $100 million at December 31, 2005 to $195 million at June 30, 2006. Page 27
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, 2005, detail of which is presented in Table 18 on page 56 of the Company's 2005 Form 10-K. See Note 10 to the Consolidated Financial Statements above for information related to a tax contingency 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. 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 June 30, 2006, and has no current plans to do so. Capital Resources The Company is regulated by the Board of Governors of the Federal Reserve Board (FED) and is subject to securities registration and public reporting regulations of the Securities and Exchange Commission. The Company's banking subsidiary is regulated by the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Office of the Commissioner of Banks. The Company is not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on its liquidity, capital resources, or operations. The Company must comply with regulatory capital requirements established by the FED and FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. These capital standards require the Company to maintain minimum ratios of "Tier 1" capital to total risk-weighted assets and total capital to risk-weighted assets of 4.00% and 8.00%, respectively. Tier 1 capital is comprised of total shareholders' equity calculated in accordance with generally accepted accounting principles, excluding accumulated other comprehensive income (loss), less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which for the Company is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company, adjusted for their related risk levels using formulas set forth in FED and FDIC regulations. In addition to the risk-based capital requirements described above, the Company is subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets Page 28
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 June 30, 2006, 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> June 30, December 31, June 30, 2006 2005 2005 ------------ ------------ ------------ <S> <C> <C> <C> Risk-based capital ratios: Tier I capital to Tier I risk adjusted assets 10.55% 10.52% 10.81% Minimum required Tier I capital 4.00% 4.00% 4.00% Total risk-based capital to Tier II risk-adjusted assets 12.27% 11.51% 11.83% 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 9.04% 8.62% 8.73% Minimum required Tier I leverage capital 4.00% 4.00% 4.00% </TABLE> The Company's capital ratios decreased from June 30, 2005 to December 31, 2005 primarily as a result of the Company's strong balance sheet growth. In April 2006, the Company issued an additional $25 million in trust preferred securities, which qualify as regulatory capital and resulted in an increase to the Company's capital ratios. 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 June 30, 2006, the Company's bank subsidiary exceeded the minimum ratios established by the FED and FDIC. SHARE REPURCHASES During the second quarter of 2006, the Company repurchased 53,000 shares of its common stock at an average price of $20.97 per share. At June 30, 2006, the Company had approximately 262,000 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." 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 Page 29
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 June 30, 2006 the Company had $369.5 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 June 30, 2006 subject to interest rate changes within one year are deposits totaling $221.9 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. Interest rate caps and floors which are in place for a portion of the Company's variable rate loans can also impact its repricing characteristics. Overall, 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. 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. The general discussion in this paragraph applies most directly in a "normal" interest rate environment in which longer term maturity instruments carry higher interest rates than short term maturity instruments, and is less applicable in periods in which there is a "flat" interest rate curve, which is discussed in the following paragraph. Since the second half of 2004, the Federal Reserve has increased the discount rate 17 times totaling 425 basis points. However the impact of these rate increases has not had an equal effect on short-term interest rates and long-term interest rates in the marketplace. In the marketplace, short-term rates have risen by a significantly higher amount than have longer-term interest rates. For example, from June 30, 2004 to June 30, 2006, the interest rate on three-month treasury bills rose by 371 basis points, whereas the interest rate for seven-year treasury notes increased by just 95 basis points. This has resulted in what economists refer to as a "flat yield curve", which means that short-term interest rates are substantially the same as long-term interest rates. This is an unfavorable interest rate environment for many banks, including the Company, as short-term interest rates generally drive the Company's deposit pricing and longer-term interest rates generally drive loan pricing. When these rates converge, as they have recently (particularly in the last six months), the "profit" spread the Company realizes between loan yields and deposit rates narrows, which reduces the Company's net interest margin. In addition to the negative impact of the flat yield curve interest rate environment, the Company's net interest margin has also been negatively impacted 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. These are the Company's highest cost categories of deposits and adjust upwards when rates change to a greater extent than the Company's other categories of deposits. Page 30
The factors just discussed are the primary reasons for the Company experiencing a decline in its net interest margin for the second consecutive quarter. The Company's net interest margin was 4.37% in the fourth quarter of 2005, 4.33% in the first quarter of 2006 and 4.22% in the second quarter of 2006. Based on rate projections the Company has reviewed, the Company expects its net interest margin to continue to experience compression for each of the two remaining quarters of 2006. 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, which are our controls and other procedures that are designed to ensure that information required to be disclosed in our periodic reports with the SEC is recorded, processed, summarized and reported within the required time periods. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed is communicated to our management to allow timely decisions regarding required disclosure. Based on the evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective in allowing timely decisions regarding disclosure to be made about material information required to be included in our periodic reports with the SEC. 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. For additional information that could affect the matters discussed in this paragraph, see the "Risk Factors" section of the Company's 2005 Annual Report on Form 10-K. Page 31
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 Purchased as Maximum Number of Part of Publicly Shares that May Yet Be Total Number of Shares Average Price Paid per Announced Plans or Purchased Under the Period Purchased Share Programs Plans or Programs (1) - ----------------------- --------------- --------------- --------------- -------------------- <S> <C> <C> <C> <C> April 1, 2006 to April 30, 2006 -- -- -- 315,015 May 1, 2006 to May 31, 31, 2006 20,000 21.06 20,000 295,015 June 1, 2006 to June 30, 2006 33,000 20.92 33,000 262,015 --------------- --------------- --------------- --------------- Total 53,000 20.97 53,000 262,015(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 Company has determined to terminate prior to expiration, or under which the Company 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 exercises during the three months ended June 30, 2006. Page 32
Item 4 - Submission of Matters to a Vote of Security Holders The following proposal was considered and acted upon at the annual meeting of shareholders of the Company held on May 3, 2006: Proposal 1 A proposal to elect eighteen (18) directors to serve until the next annual meeting of shareholders and until their successors are elected and qualified. Voted Withheld Nominee For Authority ------- ---------- --------- Jack D. Briggs 11,972,114 98,978 R. Walton Brown 11,982,139 88,593 H. David Bruton, M.D. 11,975,233 95,859 David L. Burns 11,981,399 89,693 John F. Burns 11,863,703 207,389 Mary Clara Capel 11,982,579 88,513 Goldie Wallace-Gainey 10,753,809 1,317,283 James H. Garner 11,939,170 131,922 James G. Hudson, Jr. 11,981,995 89,097 Jerry L. Ocheltree 11,980,291 90,801 George R. Perkins, Jr. 11,669,059 402,033 Thomas F. Philips 11,918,262 152,830 Edward T. Taws 11,976,452 94,640 Frederick L. Taylor II 11,943,771 127,321 Virginia C. Thomasson 11,981,387 89,705 A. Jordan Washburn 11,977,503 93,589 Dennis A. Wicker 11,973,880 97,212 John C. Willis 11,976,162 94,930 Proposal 2 A proposal to ratify the appointment of Elliott Davis, PLLC as the independent registered public accounting firm of the Company for 2006. For 11,887,304 Against 124,074 Abstain 59,713 ---------- ------- ------ 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 Amended and Restated Bylaws of the Company was filed as Exhibit 3.b to the Company's Annual Report on Form 10-K for the year ended December 31, 2003, and is incorporated herein by reference. Page 33
4 Form of Common Stock Certificate was filed as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and is incorporated herein by reference. 31.1 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 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002. 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 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 August 8, 2006 BY: James H. Garner --------------------------- James H. Garner President, Chief Executive Officer (Principal Executive Officer), Treasurer and Director August 8, 2006 BY: Anna G. Hollers --------------------------- Anna G. Hollers Executive Vice President, Chief Operating Officer and Secretary August 8, 2006 BY: Eric P. Credle --------------------------- Eric P. Credle Senior Vice President and Chief Financial Officer Page 34