UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 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 November 1, 2006 was 14,325,735. ================================================================================
INDEX FIRST BANCORP AND SUBSIDIARIES Page Part I. Financial Information Item 1 - Financial Statements Consolidated Balance Sheets - September 30, 2006 and 2005 (With Comparative Amounts at December 31, 2005) 3 Consolidated Statements of Income - For the Periods Ended September 30, 2006 and 2005 4 Consolidated Statements of Comprehensive Income - For the Periods Ended September 30, 2006 and 2005 5 Consolidated Statements of Shareholders' Equity - For the Periods Ended September 30, 2006 and 2005 6 Consolidated Statements of Cash Flows - For the Periods Ended September 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 18 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 32 Item 4 - Controls and Procedures 33 Part II. Other Information Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds 34 Item 6 - Exhibits 34 Signatures 35 Page 2
Part I. Financial Information Item 1 - Financial Statements <TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Balance Sheets September 30, December 31, September 30, ($ in thousands-unaudited) 2006 2005 (audited) 2005 - ------------------------------------------------------------------------------------------------ <S> <C> <C> <C> ASSETS Cash & due from banks, noninterest-bearing $ 35,931 32,985 21,853 Due from banks, interest-bearing 83,571 41,655 47,402 Federal funds sold 24,212 28,883 28,586 ----------- ----------- ----------- Total cash and cash equivalents 143,714 103,523 97,841 ----------- ----------- ----------- Securities available for sale (costs of $127,353, $114,662, and $115,686) 125,950 113,613 115,622 Securities held to maturity (fair values of $14,326, $14,321, and $12,820) 14,270 14,172 12,799 Presold mortgages in process of settlement 3,145 3,347 3,586 Loans 1,696,835 1,482,611 1,446,185 Less: Allowance for loan losses (18,465) (15,716) (15,879) ----------- ----------- ----------- Net loans 1,678,370 1,466,895 1,430,306 ----------- ----------- ----------- Premises and equipment 43,207 34,840 33,395 Accrued interest receivable 11,368 8,947 7,779 Goodwill 49,489 47,247 47,247 Other intangible assets 2,229 1,980 2,053 Other 6,716 6,486 7,406 ----------- ----------- ----------- Total assets $ 2,078,458 1,801,050 1,758,034 =========== =========== =========== LIABILITIES Deposits: Demand - noninterest-bearing $ 212,509 194,051 192,399 Savings, NOW, and money market 497,097 458,221 460,709 Time deposits of $100,000 or more 411,178 356,281 349,620 Other time deposits 544,118 486,024 472,800 ----------- ----------- ----------- Total deposits 1,664,902 1,494,577 1,475,528 Repurchase agreements 32,804 33,530 12,409 Borrowings 200,013 100,239 101,239 Accrued interest payable 5,382 3,835 3,543 Other liabilities 12,268 13,141 14,386 ----------- ----------- ----------- Total liabilities 1,915,369 1,645,322 1,607,105 ----------- ----------- ----------- SHAREHOLDERS' EQUITY Common stock, No par value per share Issued and outstanding: 14,310,335, 14,229,148, and 14,196,987 shares 55,394 54,121 53,574 Retained earnings 108,803 102,507 97,655 Accumulated other comprehensive income (loss) (1,108) (900) (300) ----------- ----------- ----------- Total shareholders' equity 163,089 155,728 150,929 ----------- ----------- ----------- Total liabilities and shareholders' equity $ 2,078,458 1,801,050 1,758,034 =========== =========== =========== See notes to consolidated financial statements. Page 3 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Income Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- ($ in thousands, except share data-unaudited) 2006 2005 2006 2005 - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 31,727 24,240 87,704 68,331 Interest on investment securities: Taxable interest income 1,456 1,315 4,187 3,881 Tax-exempt interest income 140 114 394 360 Other, principally overnight investments 584 398 1,652 1,117 ------------ ------------ ------------ ------------ Total interest income 33,907 26,067 93,937 73,689 ------------ ------------ ------------ ------------ INTEREST EXPENSE Savings, NOW and money market 1,976 1,042 4,944 2,881 Time deposits of $100,000 or more 4,668 3,015 12,519 8,085 Other time deposits 5,646 3,532 15,082 9,013 Other, primarily borrowings 2,576 1,126 6,054 3,066 ------------ ------------ ------------ ------------ Total interest expense 14,866 8,715 38,599 23,045 ------------ ------------ ------------ ------------ Net interest income 19,041 17,352 55,338 50,644 Provision for loan losses 1,215 690 3,630 2,115 ------------ ------------ ------------ ------------ Net interest income after provision for loan losses 17,826 16,662 51,708 48,529 ------------ ------------ ------------ ------------ NONINTEREST INCOME Service charges on deposit accounts 2,323 2,180 6,622 6,333 Other service charges, commissions and fees 1,102 961 3,426 2,950 Fees from presold mortgages 278 328 789 851 Commissions from sales of insurance and financial products 357 388 1,121 997 Data processing fees 40 38 113 243 Securities gains -- -- 205 2 Other gains (losses) (1,646) (116) (2,024) (175) ------------ ------------ ------------ ------------ Total noninterest income 2,454 3,779 10,252 11,201 ------------ ------------ ------------ ------------ NONINTEREST EXPENSES Salaries 6,062 5,402 17,581 16,167 Employee benefits 1,892 1,407 5,459 4,712 ------------ ------------ ------------ ------------ Total personnel expense 7,954 6,809 23,040 20,879 Net occupancy expense 895 797 2,569 2,259 Equipment related expenses 877 744 2,506 2,207 Intangibles amortization 100 71 221 217 Other operating expenses 3,709 3,065 10,992 9,899 ------------ ------------ ------------ ------------ Total noninterest expenses 13,535 11,486 39,328 35,461 ------------ ------------ ------------ ------------ Income before income taxes 6,745 8,955 22,632 24,269 Income taxes 2,373 9,646 8,474 15,592 ------------ ------------ ------------ ------------ NET INCOME (LOSS) $ 4,372 (691) 14,158 8,677 ============ ============ ============ ============ Earnings (loss) per share: Basic $ 0.31 (0.05) 0.99 0.61 Diluted 0.30 (0.05) 0.98 0.60 Weighted average common shares outstanding: Basic 14,294,948 14,186,887 14,281,964 14,150,527 Diluted 14,421,380 14,186,887 14,425,347 14,353,169 See notes to consolidated financial statements. Page 4 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Comprehensive Income Three Months Ended Nine Months Ended September 30, September 30, ------------------ ------------------ ($ in thousands-unaudited) 2006 2005 2006 2005 - --------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income (loss) $ 4,372 (691) 14,158 8,677 ------- ------- ------- ------- Other comprehensive income (loss): Unrealized gains (losses) on securities available for sale: Unrealized holding gains (losses) arising during the period, pretax 1,568 (824) (149) (1,252) Tax benefit (expense) (613) 322 57 491 Reclassification to realized gains -- -- (205) (2) Tax expense -- -- 79 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) 955 (502) (208) (817) ------- ------- ------- ------- Comprehensive income (loss) $ 5,327 (1,193) 13,950 7,860 ======= ======= ======= ======= 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 8,677 8,677 Cash dividends declared ($0.52 per share) (7,369) (7,369) Common stock issued under stock option plan 58 656 656 Common stock issued into dividend reinvestment plan 55 1,204 1,204 Tax benefit realized from exercise of nonqualified stock options -- 100 100 Other comprehensive loss (817) (817) ------------ ------------ ------------ ------------ ------------ Balances, September 30, 2005 14,197 $ 53,574 97,655 (300) 150,929 ============ ============ ============ ============ ============ Balances, January 1, 2006 14,229 $ 54,121 102,507 (900) 155,728 Net income 14,158 14,158 Cash dividends declared ($0.55 per share) (7,862) (7,862) Common stock issued under stock option plan 77 758 758 Common stock issued into dividend reinvestment plan 57 1,219 1,219 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 -- 314 314 Other comprehensive loss (208) (208) ------------ ------------ ------------ ------------ ------------ Balances, September 30, 2006 14,310 $ 55,394 108,803 (1,108) 163,089 ============ ============ ============ ============ ============ See notes to consolidated financial statements. Page 6 </TABLE>
<TABLE> <CAPTION> First Bancorp and Subsidiaries Consolidated Statements of Cash Flows Nine Months Ended September 30, ---------------------- ($ in thousands-unaudited) 2006 2005 - --------------------------------------------------------------------------------------------------- <S> <C> <C> Cash Flows From Operating Activities Net income $ 14,158 8,677 Reconciliation of net income to net cash provided by operating activities: Provision for loan losses 3,630 2,115 Net security premium amortization 69 83 Gain on sale of securities available for sale (205) (2) Other losses 124 175 Net loan origination fees (costs) deferred 263 (288) Depreciation of premises and equipment 2,118 2,005 Tax benefit from exercise of nonqualified stock options -- 100 Stock-based compensation expense 314 -- Amortization of intangible assets 221 217 Deferred income tax benefit (1,555) (224) Originations of presold mortgages in process of settlement (48,413) (54,838) Proceeds from sales of presold mortgages in process of settlement 48,615 53,023 Increase in accrued interest receivable (2,386) (947) Decrease in other assets 2,849 1,912 Increase in accrued interest payable 1,469 866 Increase (decrease) in other liabilities (1,005) 7,196 --------- --------- Net cash provided by operating activities 20,266 20,070 --------- --------- Cash Flows From Investing Activities Purchases of securities available for sale (45,182) (47,755) Purchases of securities held to maturity (3,468) -- Proceeds from maturities/issuer calls of securities available for sale 31,004 19,355 Proceeds from maturities/issuer calls of securities held to maturity 3,192 1,171 Proceeds from sales of securities available for sale 1,575 8 Net increase in loans (210,973) (82,150) Purchases of premises and equipment (9,779) (5,082) Net cash received in purchase of branches 34,915 -- --------- --------- Net cash used by investing activities (198,716) (114,453) --------- --------- Cash Flows From Financing Activities Net increase in deposits and repurchase agreements 125,622 99,169 Proceeds from borrowings, net 99,774 9,000 Cash dividends paid (7,714) (7,206) Proceeds from issuance of common stock 1,977 1,860 Purchases and retirement of common stock (1,112) -- Tax benefit from exercise of nonqualified stock options 94 -- --------- --------- Net cash provided by financing activities 218,641 102,823 --------- --------- Increase in Cash and Cash Equivalents 40,191 8,440 Cash and Cash Equivalents, Beginning of Period 103,523 89,401 --------- --------- Cash and Cash Equivalents, End of Period $ 143,714 97,841 ========= ========= Supplemental Disclosures of Cash Flow Information: Cash paid during the period for: Interest $ 37,130 22,179 Income taxes 10,915 8,931 Non-cash transactions: Unrealized loss on securities available for sale, net of taxes (218) (762) Foreclosed loans transferred to other real estate 1,302 2,353 See notes to consolidated financial statements. Page 7 </TABLE>
First Bancorp and Subsidiaries Notes to Consolidated Financial Statements (unaudited) For the Periods Ended September 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 September 30, 2006 and 2005 and the consolidated results of operations and consolidated cash flows for the periods ended September 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 September 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 September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The bulletin is effective for the first fiscal year ending after November 15, 2006. The Company does not expect the adoption of SAB 108 to materially impact the Company's consolidated financial statements. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 (Statement 157), "Fair Value Measurements." Statement 157 provides enhanced guidance for using fair value to measure assets and liabilities. The standard also requires expanded disclosures about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. Statement 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect the adoption of Statement 157 to materially impact the Company's consolidated financial statements. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158 (Statement 158), "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R)." Statement 158 requires an employer to: (a) recognize in its statement of financial position an asset for a plan's overfunded status or a liability for a plan's underfunded status (b) measure a plan's assets and its obligations that determine its funded status as of the end of the employer's fiscal year (with limited exceptions) and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income. The requirement to recognize the funded status of a benefit plan and the disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006. The Company has not fully assessed the impact of the adoption of Statement 158 at this time. However, if the provisions of Statement 158 had been applied as of December 31, 2005, the Company's shareholders' equity would have been reduced by approximately $6.8 million before tax and approximately $4.1 million after tax. 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. Page 8
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 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 September 30, 2005 have been reclassified to conform with the presentation for September 30, 2006. These reclassifications had no effect on net income (loss) or shareholders' equity for the periods presented, nor did they materially impact trends in financial information. Note 4 - Equity-Based Compensation Plans At September 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 September 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). Page 9
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 September 30, 2006, there were 653,658 options outstanding related to these two plans with exercise prices ranging from $7.83 to $22.12. At September 30, 2006, there were 1,186,840 shares remaining available for grant under the First Bancorp 2004 Stock Option Plan. The Company also has four stock option plans as a result of assuming plans of acquired companies. At September 30, 2006, there were 38,586 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 expense 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. Page 10
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 Three Months Nine Months Nine Months Ended Ended Ended Ended September 30, September 30, September 30, September 30, (In thousands except per share data) 2006 2005 2006 2005 ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> Net income, as reported $ 4,372 (691) 14,158 8,677 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 22 -- 235 -- Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (22) (52) (235) (284) ------------ ------------ ------------ ------------ Pro forma net income $ 4,372 (743) 14,158 8,393 ============ ============ ============ ============ Earnings per share: Basic-As reported $ 0.31 (0.05) 0.99 0.61 Basic-Pro forma 0.31 (0.05) 0.99 0.59 Diluted-As reported 0.30 (0.05) 0.98 0.60 Diluted-Pro forma 0.30 (0.05) 0.98 0.58 </TABLE> For the three and nine month periods ended September 30, 2006, the Company recorded stock-based compensation expense in the income statement of $22,000 and $314,000, respectively, which reduced income before income taxes by those same amounts for the respective periods. The Company recognized no income tax benefits in the income statement related to stock-based compensation for the three month period ended September 30, 2006. The Company recognized $79,000 of income tax benefits in the income statement for the first nine months of 2006. Thus, the impact of stock-based compensation expense on net income for the three months ended September 30, 2006 was to reduce it by $22,000, or less than one cent basic and diluted earnings share. The impact of stock-based compensation expense on net income for the nine months ended September 30, 2006 was to reduce it by $235,000, or approximately 1.6 cents basic and diluted earnings share. The 2006 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 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 September 30, 2006, the Company had $68,000 of unrecognized compensation costs related to unvested stock options. The cost is expected to be amortized over a weighted-average life of 1.9 years, with $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. Page 11
The Company's only option grants for the first nine 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 nine months ended September 30, 2006 and September 30, 2005, was $6.79, and $6.68, respectively, on the date of the grant using the following weighted-average assumptions: Nine months ended Nine months ended September 30, 2006 September 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 nine 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 Nine months ended September 30, 2006 Shares Exercise Price Term ($000) - ------------------------------------------ ------------ ------------ ------------ ------------ <S> <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 79,388 10.08 Forfeited or expired during the period 4,500 6.55 ------------ Outstanding at end of period 692,244 $ 16.72 5.5 years $ 2,532 ============ ============ ============ ============ Exercisable at September 30, 2006 671,744 $ 16.73 5.4 years $ 2,452 ============ ============ ============ ============ </TABLE> The Company received $758,000 and $656,000 as a result of stock option exercises during the nine months ended September 30, 2006 and 2005, respectively. The intrinsic value of the stock options exercised during the nine months ended September 30, 2006 and 2005 was $882,000 and $654,000, respectively. The Company recorded $94,000 and $100,000 in associated tax benefits from the exercise of nonqualified stock options during the nine months ended September 30, 2006 and 2005, respectively. In accordance with Statement 123(R), this benefit is included as a financing activity in the accompanying Statements 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 nine months of 2006 related to the Company's stock options outstanding that are nonvested: <TABLE> <CAPTION> Nonvested Options ---------------------------------- Weighted-Average Number of Grant-Date Nine months ended September 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 (47,499) 4.60 Forfeited or expired during the period -- -- --------------- Nonvested options outstanding at end of period 20,500 $ 5.05 =============== </TABLE> Page 12
Note 5 - Earnings Per Share Basic earnings per share were computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share includes the potentially dilutive effects of the Company's stock option plan. The following is a reconciliation of the numerators and denominators used in computing basic and diluted earnings per share: <TABLE> <CAPTION> For the Three Months Ended September 30, ---------------------------------------------------------------------------- 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 (loss) $ 4,372 14,294,948 $ 0.31 $ (691) 14,186,887 $ (0.05) ========== ========== Effect of Dilutive Securities -- 126,432 -- -- ---------- ---------- ---------- ---------- Diluted EPS $ 4,372 14,421,380 $ 0.30 $ (691) 14,186,887 $ (0.05) ========== ========== ========== ========== ========== ========== <CAPTION> For the Nine Months Ended September 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 $ 14,158 14,281,964 $ 0.99 $ 8,677 14,150,527 $ 0.61 ========== ========== Effect of Dilutive Securities -- 143,383 -- 202,642 ---------- ---------- ---------- ---------- Diluted EPS $ 14,158 14,425,347 $ 0.98 $ 8,677 14,353,169 $ 0.60 ========== ========== ========== ========== ========== ========== </TABLE> For the three and nine months ended September 30, 2006, there were 220,980 options that were antidilutive because the exercise price exceeded the average market price for the period. Because the Company reported a net loss for the three months ended September 30, 2005, all options are considered to be anti-dilutive. If the Company had reported net income for the three months ended September 30, 2005, the "Effect of Dilutive Securities" in the table above would have been 170,840 shares. There were no antidilutive options for the nine months ended September 30, 2005. Antidilutive options have been omitted from the calculation of diluted earnings per share for the respective periods. Page 13
Note 6 - Asset Quality Information Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> September 30, December 31, September 30, ($ in thousands) 2006 2005 2005 - -------------------------------------------- ------------ ------------ ------------ <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 5,170 1,640 3,330 Restructured loans 11 13 14 Accruing loans > 90 days past due -- -- -- ------------ ------------ ------------ Total nonperforming loans 5,181 1,653 3,344 Other real estate 1,799 1,421 2,023 ------------ ------------ ------------ Total nonperforming assets $ 6,980 3,074 5,367 ============ ============ ============ Nonperforming loans to total loans 0.31% 0.11% 0.23% Nonperforming assets as a percentage of loans and other real estate 0.41% 0.21% 0.37% Nonperforming assets to total assets 0.34% 0.17% 0.31% Allowance for loan losses to total loans 1.09% 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 ($79,000), $184,000, and $75,000 at September 30, 2006, December 31, 2005, and September 30, 2005, respectively. Note 8 - Goodwill and Other Intangible Assets The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of September 30, 2006, December 31, 2005, and September 30, 2005 and the carrying amount of unamortized intangible assets as of those same dates. <TABLE> <CAPTION> September 30, 2006 December 31, 2005 September 30, 2005 --------------------------- --------------------------- --------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Gross Carrying Accumulated ($ in thousands) Amount Amortization Amount Amortization Amount Amortization - ------------------------ ------------ ------------ ------------ ------------ ------------ ------------ <S> <C> <C> <C> <C> <C> <C> Amortizable intangible assets: Customer lists $ 394 139 394 115 394 108 Noncompete agreements 50 50 50 50 50 50 Core deposit premiums 2,945 1,208 2,441 1,011 2,441 945 ------------ ------------ ------------ ------------ ------------ ------------ Total $ 3,389 1,397 2,885 1,176 2,885 1,103 ============ ============ ============ ============ ============ ============ Unamortizable intangible assets: Goodwill $ 49,489 47,247 47,247 ============ ============ ============ Pension $ 237 273 273 ============ ============ ============ </TABLE> Amortization expense totaled $100,000 and $71,000 for the three months ended September 30, 2006 and 2005, respectively. Amortization expense totaled $221,000 and $217,000 for the nine months ended September 30, 2006 and 2005, respectively. Page 14
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 $ 323 2007 374 2008 316 2009 279 2010 262 Thereafter 658 ----------- Total $ 2,212 =========== 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 $808,000 and $447,000 for the three months ended September 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 September 30, 2006 and 2005. <TABLE> <CAPTION> For the Three Months Ended September 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 $ 359 284 217 62 576 346 Interest cost on projected benefit obligation 222 192 111 38 333 230 Expected return on plan assets (242) (237) -- -- (242) (237) Net amortization and deferral 57 86 84 22 141 108 ---------- ---------- ---------- ---------- ---------- ---------- Net periodic pension cost $ 396 325 412 122 808 447 ========== ========== ========== ========== ========== ========== <CAPTION> The Company recorded pension expense totaling $1,970,000 and $1,341,000 for the nine months ended September 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 nine months ended September 30, 2006 and 2005. For the Nine Months Ended September 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 $ 1,041 852 375 186 1,416 1,038 Interest cost on projected benefit obligation 676 576 215 114 891 690 Expected return on plan assets (778) (711) -- -- (778) (711) Net amortization and deferral 295 258 146 66 441 324 ---------- ---------- ---------- ---------- ---------- ---------- Net periodic pension cost $ 1,234 975 736 366 1,970 1,341 ========== ========== ========== ========== ========== ========== </TABLE> The Company's contributions to the Pension Plan are based on computations by independent actuarial consultants and are intended to ensure that the Pension Plan exceeds minimum funding standards at all times according to standards established by the Internal Revenue Service. The contributions are invested to provide for benefits under the Pension Plan. The Company estimates that its contribution to the Pension Plan will be $1,500,000 during 2006. Page 15
The Company's funding policy with respect to the SERP Plan is to fund the related benefits primarily from the operating cash flow of the Company. The Company estimates that its payments to participants in the SERP Plan will be $25,000 in 2006. Note 2 includes discussion of a newly issued accounting standard that will impact the Company's accounting for its two defined benefit penion plans. 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 first quarter of 2007. Note 11 - Completed Acquisitions The Company completed two branch acquisitions in the third quarter of 2006 as follows: (a) On July 7, 2006, the Company completed the purchase of a branch of First Citizens Bank located in Dublin, Virginia. The Company assumed the branch's $21 million in deposits and did not purchase any loans in this transaction. The primary reason for this acquisition was to increase the Company's presence in southwestern Virginia, a market in which the Company already had three branches with a large customer base. The Company paid a deposit premium for the branch of approximately $994,000, all of which is deductible for tax purposes. The identifiable intangible asset associated with the fair value of the core deposit base, as determined by an independent consulting firm, was determined to be $269,000 and is being amortized as expense on an accelerated basis over an eight year period based on an amortization schedule provided by the consulting firm. The remaining intangible asset of $725,000 has been classified as goodwill, and thus is not being systematically amortized, but rather is subject to an annual impairment test. The primary factors that contributed to a purchase price that resulted in recognition of goodwill were the Company's desire to expand its presence in southwestern Virginia with facilities, operations and experienced staff in place. This branch's operations are included in the accompanying Consolidated Statements of Income beginning on the acquisition date of July 7, 2006. Historical pro forma information is not presented due to the immateriality of this transaction to the overall consolidated financial statements of the Company. (b) On September 1, 2006, the Company completed the purchase of a branch of Bank of the Carolinas in Carthage, North Carolina. The Company assumed the branch's $24 million in deposits and $6 million in loans. The primary reason for this acquisition was to increase the Company's presence in Moore County, a market in which the Company already had ten branches with a large customer base. The Company paid a deposit premium for the branch of approximately $1,754,000, all of which is deductible for tax purposes. The identifiable intangible asset associated with the fair value of the core deposit base, as determined by an independent consulting firm, was determined to be approximately $235,000 and is being amortized as expense on an accelerated basis over a ten year period based on an amortization schedule provided by the consulting firm. The remaining intangible asset of $1,519,000 has been classified as goodwill, and thus is not being systematically amortized, but rather is subject to an annual impairment test. The primary factors that contributed to a purchase price that resulted in recognition of goodwill were the Company's desire to expand in an existing high-growth market with facilities, operations and Page 16
experienced staff in place. This branch's operations are included in the accompanying Consolidated Statements of Income beginning on the acquisition date of September 1, 2006. Historical pro forma information is not presented due to the immateriality of this transaction to the overall consolidated financial statements of the Company. Page 17
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 18
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 approximately 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 19
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 The Company recorded net income of $4,372,000, or $0.30 per diluted share for the three months ended September 30, 2006, compared to a net loss of $691,000, or $0.05 per diluted share, recorded in the third quarter of 2005. Net income for the nine months ended September 30, 2006 was $14,158,000, or $0.98 per diluted share, a 63.3% increase in diluted earnings per share from the net income of $8,677,000, or $0.60 per diluted share, reported for the nine months ended September 30, 2005. Results for 2006 include the write-off loss of a merchant credit card receivable amounting to $1,900,000, of which $230,000 was recorded in the second quarter of 2006 and the remaining $1,670,000 was recorded in the third quarter of 2006. The after-tax impact on net income for the second quarter of 2006 was $139,000, or $0.01 per diluted share, and the after-tax impact on net income for the third quarter of 2006 was $1,010,000, or $0.07 per diluted share. Results for 2005 include a loss accrual related to income tax exposure amounting to $6,320,000 (after-tax), or $0.44 per diluted share, which was recorded in the third quarter of 2005. Both of these items are discussed in more detail below. Growth in loans and deposits was the primary reason for the increases in the Company's net interest income when comparing the three and nine month periods in 2006 to the comparable periods of 2005. Net interest income for the third quarter of 2006 amounted to $19.0 million, a 9.7% increase over the $17.4 million recorded in the third quarter of 2005. Net interest income for the nine months ended September 30, 2006 amounted to $55.3 million, a 9.3% increase over the $50.6 million recorded in the same nine 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 third quarter of 2006 was 4.12% compared to 4.32% for the third quarter of 2005. The Company's net interest margin for the first nine months of 2006 was 4.22% compared to 4.32% for the same nine months of 2005. The 4.12% net interest margin realized in the third quarter of 2006 was a 10 basis point decrease from the second quarter of 2006 net interest margin of 4.22%, and a 21 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, which is associated with the flat interest rate yield curve currently prevailing in the marketplace. The Company has also been negatively impacted by customers shifting their funds from low cost deposits to higher cost deposits as rates have risen. Page 20
The Company's provision for loan losses amounted to $1,215,000 in the third quarter of 2006, an increase of 76.1% over the $690,000 recorded in the third quarter of 2005. The provision for loan losses for the first nine months of 2006 was $3,630,000, an increase of 71.6% over the $2,115,000 recorded in first nine months 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. Net internal loan growth was $55 million in the third quarter of 2006 compared to $20 million in the third quarter of 2005, while net internal loan growth was $208 million for the first nine months of 2006 compared to $79 million for the first nine months of 2005. The Company's ratios of annualized net charge-offs to average loans were 11 basis points and 8 basis points for the three and nine month periods in 2006, respectively, compared to 12 basis points and 9 basis points for the three and nine month periods in 2005, respectively. The Company's ratio of nonperforming assets to total assets was 0.34% at September 30, 2006 compared to 0.31% a year earlier. Noninterest income amounted to $2,454,000 for the third quarter of 2006, a 35.1% decrease from the $3,779,000 recorded in the third quarter of 2005. Noninterest income for the nine months ended September 30, 2006 amounted to $10,252,000, a decrease of 8.5% from the $11,201,000 recorded in the first nine months of 2005. The decreases in 2006 were caused by the write-off loss of a merchant credit card receivable that is discussed in more detail below. Noninterest expenses amounted to $13.5 million in the third quarter of 2006, a 17.8% increase over the $11.5 million recorded in the third quarter of 2005. Noninterest expenses for the nine months ended September 30, 2006 amounted to $39.3 million, a 10.9% increase from the $35.5 million recorded in the first nine 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 approximately 35% and 37% for the three and nine month periods ended September 30, 2006, respectively. The Company recorded a tax benefit of $182,000 in the third quarter of 2006 related to several nonrecurring adjustments that reduced otherwise reported income tax expense. The Company's income tax expense for the three and nine months ended September 30, 2005 included a loss accrual related to income tax exposure amounting to $6,320,000 (after-tax), or $0.44 per diluted share, which was recorded in the third quarter of 2005 and is discussed in more detail below. The Company's annualized return on average assets for the third quarter of 2006 was 0.88% compared to (0.16%) for the third quarter of 2005. The Company's annualized return on average assets for the nine months ended September 30, 2006 was 1.00% compared to 0.69% for the comparable period of 2005. The Company's annualized return on average equity for the third quarter of 2006 was 10.54% compared to (1.73%) for the third quarter of 2005. The Company's annualized return on average equity for the nine months ended September 30, 2006 was 11.70% compared to 7.49% for the first nine months 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 September 30, 2006 amounted to $19,041,000, an increase of $1,689,000, or 9.7%, from the $17,352,000 recorded in the third quarter of 2005. Net interest income on a taxable equivalent basis for the three months ended September 30, 2006, amounted to $19,174,000, an increase of $1,711,000, or 9.8%, from the $17,463,000 recorded in the third 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 nine months ended September 30, 2006 amounted to $55,338,000 an increase of Page 21
$4,694,000, or 9.3%, from the $50,644,000 recorded in the first nine months of 2005. Net interest income on a taxable equivalent basis for the nine months ended September 30, 2006 amounted to $55,722,000, an increase of $4,743,000, or 9.3%, from the $50,979,000 recorded in the first nine months of 2005. There are two primary factors that cause changes in the amount of net interest income recorded by the Company - 1) growth in loans and deposits, and 2) the Company's net interest margin. For the three and nine month periods ended September 30, 2006, growth in loans and deposits were the primary causes for the increases in net interest income, as the Company's net interest margins in 2006 were lower than those realized in 2005. For internal purposes and in the discussion that follows, the Company evaluates its net interest income on a tax-equivalent basis by adding the tax benefit realized from tax-exempt securities to reported interest income. The following tables present net interest income analysis on a taxable-equivalent basis. <TABLE> <CAPTION> For the Three Months Ended September 30, ----------------------------------------------------------------------------- 2006 2005 ------------------------------------- ------------------------------------- Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,669,423 7.54% $ 31,727 $1,433,874 6.71% $ 24,240 Taxable securities 123,168 4.69% 1,456 118,927 4.39% 1,315 Non-taxable securities (2) 10,668 10.15% 273 10,438 8.55% 225 Short-term investments 41,301 5.61% 584 41,144 3.84% 398 ---------- ---------- ---------- ---------- Total interest-earning assets 1,844,560 7.32% 34,040 1,604,383 6.47% 26,178 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 491,630 1.59% $ 1,976 $ 465,089 0.89% $ 1,042 Time deposits >$100,000 397,393 4.66% 4,668 347,057 3.45% 3,015 Other time deposits 529,120 4.23% 5,646 468,170 2.99% 3,532 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,418,143 3.44% 12,290 1,280,316 2.35% 7,589 Securities sold under agreements to repurchase 28,712 3.81% 276 6,276 2.59% 41 Borrowings 136,972 6.66% 2,300 79,367 5.42% 1,085 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,583,827 3.72% 14,866 1,365,959 2.53% 8,715 ---------- ---------- Non-interest-bearing deposits 205,462 186,867 Net yield on interest-earning assets and net interest income 4.12% $ 19,174 4.32% $ 17,463 ========== ========== Interest rate spread 3.60% 3.94% Average prime rate 8.25% 6.42% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $133,000 and $111,000 in 2006 and 2005, respectively, to reflect the tax benefit that the Company receives related to its tax-exempt securities, which carry interest rates lower than similar taxable investments due to their tax exempt status. This amount has been computed assuming a 39% tax rate and is reduced by the related nondeductible portion of interest expense. - -------------------------------------------------------------------------------- Page 22
<TABLE> <CAPTION> For the Nine Months Ended September 30, ----------------------------------------------------------------------------- 2006 2005 ------------------------------------- ------------------------------------- Interest Interest Average Average Earned Average Average Earned ($ in thousands) Volume Rate or Paid Volume Rate or Paid ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Assets Loans (1) $1,592,983 7.36% $ 87,704 $1,408,736 6.49% $ 68,331 Taxable securities 118,750 4.71% 4,187 113,785 4.56% 3,881 Non-taxable securities (2) 11,516 9.03% 778 10,830 8.58% 695 Short-term investments 40,525 5.45% 1,652 44,780 3.34% 1,117 ---------- ---------- ---------- ---------- Total interest-earning assets 1,763,774 7.15% 94,321 1,578,131 6.27% 74,024 ---------- ---------- Liabilities Savings, NOW and money market deposits $ 478,316 1.38% $ 4,944 $ 472,361 0.82% $ 2,881 Time deposits >$100,000 381,029 4.39% 12,519 349,677 3.09% 8,085 Other time deposits 510,442 3.95% 15,082 446,894 2.70% 9,013 ---------- ---------- ---------- ---------- Total interest-bearing deposits 1,369,787 3.18% 32,545 1,268,932 2.11% 19,979 Securities sold under agreements to repurchase 29,376 3.69% 811 2,232 2.58% 43 Other, principally borrowings 106,648 6.57% 5,243 77,521 5.21% 3,023 ---------- ---------- ---------- ---------- Total interest-bearing liabilities 1,505,811 3.43% 38,599 1,348,685 2.28% 23,045 ---------- ---------- Non-interest-bearing deposits 203,064 180,667 Net yield on interest-earning assets and net interest income 4.22% $ 55,722 4.32% $ 50,979 ========== ========== Interest rate spread 3.72% 3.99% Average prime rate 7.86% 5.93% </TABLE> - -------------------------------------------------------------------------------- (1) Average loans include nonaccruing loans, the effect of which is to lower the average rate shown. (2) Includes tax-equivalent adjustments of $384,000 and $335,000 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 third quarter of 2006 were $1.669 billion, which was 16.4% higher than the average loans outstanding for the third quarter of 2005 ($1.434 billion). Average loans outstanding for the nine months ended September 30, 2006 were $1.593 billion, which was 13.1% higher than the average loans outstanding for the nine months ended September 30, 2005 ($1.409 billion). The mix of the Company's loan portfolio remained substantially the same at September 30, 2006 compared to December 31, 2005, with approximately 87% of the Company's loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 4% 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. Average total deposits outstanding for the third quarter of 2006 were $1.624 billion, which was 10.7% higher than the average deposits outstanding for the third quarter of 2005 ($1.467 billion). Average deposits outstanding for the nine months ended September 30, 2006 were $1.573 billion, which was 8.5% higher than the average deposits outstanding for the nine months ended September 30, 2005 ($1.450 billion). Generally, the Company can reinvest funds from deposits at higher yields than the interest rate being paid on those deposits, and therefore increases in deposits typically result in higher amounts of net interest income for the Company. See additional discussion regarding the nature of the growth in loans and deposits in the section entitled "Financial Condition" below. The effect of the higher amounts of average loans and deposits was to increase net interest income in 2006. Page 23
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 of 2004. From July 1, 2004 to September 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 nine month periods ended September 30, 2006, interest-earning asset yields have increased by 85-88 basis points, whereas the average rate paid on interest-bearing liabilities has risen by 115-119 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, which was primarily caused by the flat interest rate yield curve prevailing in the marketplace. The spread has also been negatively impacted by customers shifting their funds from low cost deposits to high cost deposits as rates have risen. 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 4.12% in the third quarter of 2006 compared to 4.32% in the third quarter of 2005, and the Company's net interest margin amounting to 4.22% for the nine months ended September 30, 2006 compared to 4.32% for the same nine months of 2005. See additional information regarding net interest income in the section entitled "Interest Rate Risk" (Item 3 below). The provision for loan losses amounted to $1,215,000 in the third quarter of 2006 compared to $690,000 in the third quarter of 2005, and the provision for loan losses for the first nine months of 2006 was $3,630,000 compared to $2,115,000 for the first nine 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. Net internal loan growth was $55 million in the third quarter of 2006 compared to $20 million in the third quarter of 2005, while net internal loan growth was $208 million for the first nine months of 2006 compared to $79 million for the first nine months of 2005. The Company's ratios of annualized net charge-offs to average loans were 11 basis points and 8 basis points for the three and nine month periods in 2006, respectively, compared to 12 basis points and 9 basis points for the three and nine month periods in 2005, respectively. The Company's level of nonperforming assets to total assets was 0.34% at September 30, 2006 compared to 0.31% a year earlier Noninterest income amounted to $2,454,000 for the third quarter of 2006, a 35.1% decrease from $3,779,000 recorded in the third quarter of 2005. Noninterest income for the nine months ended September 30, 2006 amounted to $10,252,000, a decrease of 8.5% from the $11,201,000 recorded in the first nine months of 2005. The decreases in 2006 were caused by the write-off loss of a merchant credit card receivable. During the second quarter of 2006, the Company discovered that it had liability associated with a customer that sold furniture over the internet. The furniture store did not deliver furniture that its customers had ordered and paid for, and was unable to immediately 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. During the second quarter of 2006, the furniture store changed management, stated its intention to repay the Company for all funds advanced, and began making repayments to the Company. At June 30, 2006, the Company recorded a $230,000 loss to reserve for this situation. During the third quarter of 2006, the furniture store's financial condition deteriorated significantly. Accordingly, the Company determined that it should fully reserve for the entire $1.9 million exposure associated with this situation, which resulted in recording an additional loss of $1,670,000. The owners of the furniture store continue to state their intent to repay the Company, but at this time their ability to do so is uncertain. During the third quarter of 2006, the Company completed a review of all merchant credit card customers and concluded that this situation appears to be an isolated event that is not likely to recur. Noninterest income was positively impacted in 2006 as a result of higher "other service charges, commissions, and fees." This category of noninterest income includes items such as credit card interchange income related to merchants and customers, debit card interchange income, ATM charges, safety deposit box rentals, fees from sales of personalized checks, and check cashing fees. This category of income grew primarily because of increases in these activity-related fee services as a result of the increased acceptance and popularity of debit cards, as well as the overall growth in the Company's total customer base. Other service charges, commissions and fees amounted to $1,102,000 in the third quarter of 2006, a Page 24
14.7% increase from the $961,000 recorded in the third quarter of 2005. Other service charges, commissions and fees amounted to $3,426,000 for the first nine months of 2006, a 16.1% increase from the $2,950,000 recorded through September 30, 2005. Noninterest income for the nine months ended September 30, 2006 was negatively impacted by a decrease in data processing income, which declined by $130,000 when comparing the first nine months of 2006 to the comparable period in 2005. 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 impacting noninterest income were securities gains in the amount of $205,000 in 2006 and $2,000 in 2005, each of which was recorded in the second quarter of the respective year. Noninterest expenses amounted to $13.5 million in the third quarter of 2006, a 17.8% increase over the $11.5 million recorded in the third quarter of 2005. Noninterest expenses for the nine months ended September 30, 2006 amounted to $39.3 million, a 10.9% increase from the $35.5 million recorded in the first nine 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. Since January 1, 2005, the Company's loans and deposits have increased by 24% and 20%, respectively. Additionally, in accordance with the new accounting requirements regarding stock-based compensation (FASB Statement 123(R)) that were effective on January 1, 2006, the Company recorded stock option expense of $22,000 ($22,000 after-tax effect) and $314,000 ($235,000 after-tax effect) for the three and nine month periods ended September 30, 2006, respectively. As permitted by previous accounting standards, no stock option expense was recorded by the Company in 2005, or any prior periods. Noninterest expenses for the nine months ended September 30, 2005 were also impacted by approximately $500,000 in the following miscellaneous expenses, all of which were recorded in the second quarter of 2005: immediately vested post-retirement benefits granted to the Company's CEO totaling $196,000, external Sarbanes-Oxley costs related to the prior year Sarbanes-Oxley 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 Company's effective tax rate was approximately 35% and 37% for the three and nine month periods ended September 30, 2006, respectively. The Company recorded a tax benefit of $182,000 in the third quarter of 2006 related to several nonrecurring adjustments that reduced otherwise reported income tax expense. The Company's income tax expense for the three and nine months ended September 30, 2005 includes a loss accrual related to income tax exposure amounting to $6,320,000 (after-tax), or $0.44 per diluted share, which was recorded in the third quarter of 2005. As discussed more fully in the Company's 2005 Form 10-K filed with the Securities and Exchange Commission, during the third quarter of 2005, the Company recorded a $6,320,000 loss accrual to reserve for an audit issue raised by the North Carolina Department of Revenue related to the Company's operating structure that the Department of Revenue deemed to result in improper "income shifting." This reserve was subsequently reduced in the fourth quarter of 2005 by $1,982,000, or $0.14 per diluted share, as a result of a "Settlement Initiative" offered by the North Carolina Department of Revenue that offered companies with certain transactions, including those that applied to the Company, the opportunity to resolve such matters with reduced penalties by agreeing to participate in the initiative. The Company continues to participate in the initiative and expects the matter to be resolved and all amounts paid by March 15, 2007. The aspects of the Company's operating structure that gave rise to this issue were discontinued effective January 1, 2005, and thus the Company does not believe it has any additional exposure related to this item beyond the amount of the accrual, other than ongoing interest on the unpaid taxes amounting to $65,000 per quarter (after-tax). The Consolidated Statements of Comprehensive Income reflect "Other Comprehensive Income" of $955,000 during the third quarter of 2006 and "Other Comprehensive Loss" of $208,000 for the nine months ended September 30, 2006, compared to "Other Comprehensive Loss" of $502,000 for the third quarter of 2005 and "Other Comprehensive Loss" of $817,000 for the nine months ended September 30, 2005. The primary Page 25
component of other comprehensive income/loss for the periods presented relates to changes in unrealized holding gains/losses of the Company's available for sale securities. The Company's available for sale securities portfolio is predominantly comprised of fixed rate bonds that increase in value when market yields for fixed rate bonds decrease and decline in value when market yields for fixed rate bonds increase. FINANCIAL CONDITION Total assets at September 30, 2006 amounted to $2.08 billion, 18.2% higher than a year earlier. Total loans at September 30, 2006 amounted to $1.70 billion, a 17.3% increase from a year earlier, and total deposits amounted to $1.66 billion at September 30, 2006, a 12.8% increase from a year earlier. The following tables present information regarding the nature of the Company's growth since September 30, 2005. <TABLE> <CAPTION> Balance at Balance at Total Percentage growth, October 1, 2005 to beginning of Internal Growth from end of percentage excluding September 30, 2006 period Growth Acquisitions period growth acquisitions - ------------------------------ ------------ ------------ ------------ ------------ ------------ -------------- <S> <C> <C> <C> <C> <C> <C> ($ in thousands) Loans $ 1,446,185 244,901 5,749 1,696,835 17.3% 16.9% ============ ============ ============ ============ Deposits - Noninterest bearing $ 192,399 15,136 4,974 212,509 10.5% 7.9% Deposits - Savings, NOW, and Money Market 460,709 24,497 11,891 497,097 7.9% 5.3% Deposits - Time>$100,000 349,620 56,759 4,799 411,178 17.6% 16.2% Deposits - Time<$100,000 472,800 49,005 22,313 544,118 15.1% 10.4% ------------ ------------ ------------ ------------ Total deposits $ 1,475,528 145,397 43,977 1,664,902 12.8% 9.9% ============ ============ ============ ============ January 1, 2006 to September 30, 2006 - ------------------------------ Loans $ 1,482,611 208,475 5,749 1,696,835 14.4% 14.1% ============ ============ ============ ============ Deposits - Noninterest bearing $ 194,051 13,484 4,974 212,509 9.5% 6.9% Deposits - Savings, NOW, and Money Market 458,221 26,985 11,891 497,097 8.5% 5.9% Deposits - Time>$100,000 356,281 50,098 4,799 411,178 15.4% 14.1% Deposits - Time<$100,000 486,024 35,781 22,313 544,118 12.0% 7.4% ------------ ------------ ------------ ------------ Total deposits $ 1,494,577 126,348 43,977 1,664,902 11.4% 8.5% ============ ============ ============ ============ </TABLE> As noted in the tables above, a portion of the loan and deposit growth can be attributed to the two branch acquisitions that were completed during the third quarter of 2006. The Company obtained a total of $44 million in deposits and $6 million in loans from the two branch acquisitions. The Company experienced solid internal loan and deposit growth during the first nine months of 2006, with loans increasing by $208 million, or 18.7% on an annualized basis, and deposits increasing by $126 million, or 11.3% on an annualized basis. For the twelve months ended September 30, 2006, the Company's loans grew internally by $245 million, or 16.9%, and deposits increased internally by $145 million, or 9.9%. The Company opened two de novo branches and two loan production offices in 2005, while in the first half of 2006, the Company opened one loan production office and upgraded one loan production office to a full service branch. Each of these new offices has contributed to the internal growth. In the fourth quarter of 2006, the Company plans to convert two loan production offices to full service branches and to open two additional full service branches, with all four new branches being located in the southeastern coastal region of North Carolina. The mix of the Company's loan portfolio remains substantially the same at September 30, 2006 compared to Page 26
December 31, 2005, with approximately 87% of the Company's loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 4% being consumer installment loans. The majority of the Company's real estate loans are personal and commercial loans where real estate provides additional security for the loan. Nonperforming Assets Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate. Nonperforming assets are summarized as follows: <TABLE> <CAPTION> September 30, December 31, September 30, ($ in thousands) 2006 2005 2005 - ----------------------------------------------------------------------------------------------- <S> <C> <C> <C> Nonperforming loans: Nonaccrual loans $ 5,170 1,640 3,330 Restructured loans 11 13 14 Accruing loans > 90 days past due -- -- -- ------------- ------------- ------------- Total nonperforming loans 5,181 1,653 3,344 Other real estate 1,799 1,421 2,023 ------------- ------------- ------------- Total nonperforming assets $ 6,980 3,074 5,367 ============= ============= ============= Nonperforming loans to total loans 0.31% 0.11% 0.23% Nonperforming assets as a percentage of loans and other real estate 0.41% 0.21% 0.37% Nonperforming assets to total assets 0.34% 0.17% 0.31% Allowance for loan losses to total loans 1.09% 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 September 30, 2006, December 31, 2005, and September 30, 2005 totaled $5,181,000, $1,653,000, and $3,344,000, respectively. Nonperforming loans as a percentage of total loans amounted to 0.31%, 0.11%, and 0.23%, at September 30, 2006, December 31, 2005, and September 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 its 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. The largest nonaccrual relationship at September 30, 2006 amounted to $461,000. At September 30, 2006, December 31, 2005, and September 30, 2005, the recorded investment in loans considered to be impaired was $1,591,000, $338,000, and $1,364,000, respectively, all of which were on nonaccrual status. At September 30, 2006, December 31, 2005, and September 30, 2005, the related allowance for loan losses for all impaired loans was $291,000, $100,000, and $620,000, respectively. At September 30, 2006, December 31, 2005, and September 30, 2005, there was $844,000, $0, and $182,000 in impaired loans for which there was no related allowance. The average recorded investments in impaired loans during the nine month period ended September 30, 2006, the year ended December 31, 2005, and the nine months ended September 30, 2005 were approximately $1,090,000 $1,474,000, and $1,758,000, respectively. For the same periods, the Company recognized no interest income on those loans during the period that they were considered to be impaired. The Company's other real estate owned did not vary materially among the periods presented, amounting to Page 27
$1,799,000, $1,421,000, and $2,023,000 at September 30, 2006, December 31, 2005 and September 30, 2005, respectively. The Company's management has reviewed recent appraisals of its other real estate and believes that their fair values, less estimated costs to sell, equal or exceed their respective carrying values at the dates presented. Summary of Loan Loss Experience The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance in the period in which such loans, in management's opinion, become uncollectible. The recoveries realized during the period are credited to this allowance. The Company has no foreign loans, few agricultural loans and does not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of the Company's real estate loans are primarily various personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within the Company's principal market area. The provision for loan losses recorded by the Company for the three and nine months ended September 30, 2006, amounted to $1,215,000 in the third quarter of 2006 compared to $690,000 in the third quarter of 2005, and $3,630,000 for the first nine months of 2006 compared to $2,115,000 for the first nine 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. Net internal loan growth was $55 million in the third quarter of 2006 compared to $20 million in the third quarter of 2005, while net internal loan growth was $208 million for the first nine months of 2006 compared to $79 million for the first nine months of 2005. The Company's ratios of annualized net charge-offs to average loans were 11 basis points and 8 basis points for the three and nine month periods in 2006, respectively, compared to 12 basis points and 9 basis points for the three and nine month periods in 2005, respectively. The Company's level of nonperforming assets to total assets was 0.34% at September 30, 2006 compared to 0.31% a year earlier. At September 30, 2006, the allowance for loan losses amounted to $18,465,000, compared to $15,716,000 at December 31, 2005 and $15,879,000 at September 30, 2005. The allowance for loan losses as a percentage of total loans did not vary significantly among the periods presented, amounting to 1.09% at September 30, 2006, 1.06% at December 31, 2005, and 1.10% at September 30, 2005. Management believes the Company's reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. See "Critical Accounting Policies - Allowance for Loan Losses" above. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and value of other real estate. Such agencies may require the Company to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations. Page 28
For the periods indicated, the following table summarizes the Company's balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries, and additions to the allowance for loan losses that have been charged to expense. <TABLE> <CAPTION> Nine Months Twelve Months Nine Months Ended Ended Ended September 30, December 31, September 30, ($ in thousands) 2006 2005 2005 ------------ ------------ ------------ <S> <C> <C> <C> Loans outstanding at end of period $ 1,696,835 1,482,611 1,446,185 ============ ============ ============ Average amount of loans outstanding $ 1,592,983 1,422,419 1,408,736 ============ ============ ============ Allowance for loan losses, at beginning of period $ 15,716 14,717 14,717 Total charge-offs (1,135) (2,363) (1,171) Total recoveries 202 322 218 ------------ ------------ ------------ Net charge-offs (933) (2,041) (953) ------------ ------------ ------------ Additions recorded related to loans acquired in branch purchase 52 -- -- Additions to the allowance charged to expense 3,630 3,040 2,115 ------------ ------------ ------------ Allowance for loan losses, at end of period $ 18,465 15,716 15,879 ============ ============ ============ Ratios: Net charge-offs (annualized) as a percent of average loans 0.08% 0.14% 0.09% Allowance for loan losses as a percent of loans at end of period 1.09% 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 September 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 $415 million line of credit with the Federal Home Loan Bank (of which $133 million was outstanding at September 30, 2006), 2) a $50 million overnight federal funds line of credit with a correspondent bank (none of which was outstanding at September 30, 2006), and 3) an approximately $72 million line of credit through the Federal Reserve Bank of Richmond's discount window (none of which was outstanding at September 30, 2006). The Company's liquidity decreased slightly from December 31, 2005 to September 30, 2006, as a result of loan growth that exceeded deposit growth during the first nine months of the year. Loans increased during the first nine months of 2006 by $214 million compared to deposit growth of $170 million. The Company's loan to deposit ratio was 101.9% at September 30, 2006 compared to 99.2% at December 31, 2005. The higher growth in loans Page 29
compared to deposits is the primary factor in the Company increasing its outstanding borrowings from $100 million at December 31, 2005 to $200 million at September 30, 2006. 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 derivative activities through September 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. Page 30
In addition to the risk-based capital requirements described above, the Company is subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets of 3.00% to 5.00%, depending upon the institution's composite ratings as determined by its regulators. The FED has not advised the Company of any requirement specifically applicable to it. At September 30, 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> September 30, December 31, September 30, 2006 2005 2005 -------------- -------------- -------------- <S> <C> <C> <C> Risk-based capital ratios: Tier I capital to Tier I risk adjusted assets 10.13% 10.52% 10.42% Minimum required Tier I capital 4.00% 4.00% 4.00% Total risk-based capital to Tier II risk-adjusted assets 11.77% 11.51% 11.46% Minimum required total risk-based capital 8.00% 8.00% 8.00% Leverage capital ratios: Tier I leverage capital to adjusted most recent quarter average assets 8.69% 8.62% 8.49% Minimum required Tier I leverage capital 4.00% 4.00% 4.00% </TABLE> In April 2006, the Company issued an additional $25 million in trust preferred securities, which qualify as regulatory capital and helped maintain the Company's regulatory capital ratios at acceptable levels during the recent periods of high growth and the two branch purchases. The Company's bank subsidiary is also subject to similar capital requirements as those discussed above. The bank subsidiary's capital ratios do not vary materially from the Company's capital ratios presented above. At September 30, 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. The Company made no share repurchases during the first or third quarters of 2006. At September 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." Page 31
Item 3 - Quantitative and Qualitative Disclosures About Market Risk INTEREST RATE RISK (INCLUDING QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK) Net interest income is the Company's most significant component of earnings. Notwithstanding changes in volumes of loans and deposits, the Company's level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to the various categories of earning assets and interest-bearing liabilities. It is the Company's policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations. The Company's exposure to interest rate risk is analyzed on a regular basis by management using standard GAP reports, maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of "shock" interest rates. Over the years, the Company has been able to maintain a fairly consistent yield on average earning assets (net interest margin). Over the past five calendar years the Company's net interest margin has ranged from a low of 4.23% (realized in 2001) to a high of 4.58% (realized in 2002). During that five year period the prime rate of interest has ranged from a low of 4.00% to a high of 9.50%. Using stated maturities for all instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are included in the period of their expected call), at September 30, 2006 the Company had $447 million more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets. This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment. However, this method of analyzing interest sensitivity only measures the magnitude of the timing differences and does not address earnings, market value, or management actions. Also, interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. In addition to the effects of "when" various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products. For example, included in interest-bearing liabilities at September 30, 2006 subject to interest rate changes within one year are deposits totaling $497 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 September 30, 2006, the interest rate on three-month treasury bills rose by 331 basis points, whereas the interest rate for seven-year treasury notes Page 32
increased by just 25 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 2006), 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 customers shifting their funds from low cost deposits to higher cost deposits as rates have risen. The factors just discussed are the primary reasons for the Company experiencing a decline in its net interest margin for the third 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, 4.22% in the second quarter of 2006, and 4.12% in the third quarter of 2006. Based on rate projections the Company has reviewed, the Company expects its net interest margin to continue to experience compression for the fourth quarter 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 Factor" section of the Company's 2005 Annual Report on Form 10-K. Page 33
Part II. Other Information Item 2 - Unregistered Sales of Equity Securities and Use of Proceeds <TABLE> <CAPTION> Issuer Purchases of Equity Securities - ------------------------------------------------------------------------------------------------------------------------------ Total Number of Shares Maximum Number of Purchased as Part of Shares that May Yet Be Total Number of Average Price Paid per Publicly Announced Purchased Under the Period Shares Purchased Share Plans or Programs Plans or Programs (1) - ---------------------------- --------------------- ----------------------- ----------------------- ----------------------- <S> <C> <C> <C> <C> July 1, 2006 to July 31, 2006 -- -- -- 262,015 August 1, 2006 to August 31, 2006 -- -- -- 262,015 September 1, 2006 to September 30, 2006 -- -- -- 262,015 --------------------- ----------------------- ----------------------- ----------------------- Total -- -- -- 262,015 ===================== ======================= ======================= ======================= </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 options exercised during the periods shown. Item 6 - Exhibits The following exhibits are filed with this report or, as noted, are incorporated by reference. Management contracts, compensatory plans and arrangements are marked with an asterisk (*). 3.a. Copy of Articles of Incorporation of the Company and amendments thereto were filed as Exhibits 3.a.i through 3.a.v to the Company's Quarterly Report on Form 10-Q for the period ended June 30, 2002, and are incorporated herein by reference. 3.b Copy of the Amended and Restated Bylaws of the Company was filed as Exhibit 3.b to the Company's Annual Report on Form 10-K for the year ended December 31, 2003, and is incorporated herein by reference. 4 Form of Common Stock Certificate was filed as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, and is incorporated herein by reference. 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. Page 34
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 November 8, 2006 BY: James H. Garner --------------------------- James H. Garner President, Chief Executive Officer (Principal Executive Officer), Treasurer and Director November 8, 2006 BY: Anna G. Hollers --------------------------- Anna G. Hollers Executive Vice President, Chief Operating Officer and Secretary November 8, 2006 BY: Eric P. Credle --------------------------- Eric P. Credle Senior Vice President and Chief Financial Officer Page 35