First Bancorp - 10-Q quarterly report FY

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007

Commission File Number  0-15572

(Exact Name of Registrant as Specified in its Charter)

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.     ýYES     o NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.    oLarge Accelerated Filer     ý Accelerated Filer     o Non-Accelerated Filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  oYES     ý NO

The number of shares of the registrant's Common Stock outstanding on July 31, 2007 was 14,401,178.

Item 1 -Financial Statements

Note 1 – Basis of Presentation

In the opinion of the Company, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the consolidated financial position of the Company as of June 30, 2007 and 2006 and the consolidated results of operations and consolidated cash flows for the periods ended June 30, 2007 and 2006.  All such adjustments were of a normal, recurring nature.  Reference is made to the 2006 Annual Report on Form 10-K filed with the SEC for a discussion of accounting policies and other relevant information with respect to the financial statements.  The results of operations for the periods ended June 30, 2007 and 2006 are not necessarily indicative of the results to be expected for the full year.

Note 2 – Accounting Policies

Note 1 to the 2006 Annual Report on Form 10-K filed with the SEC contains a description of the accounting policies followed by the Company and discussion of recent accounting pronouncements.  The following paragraphs update that information as necessary.

In 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 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’s adoption of FIN 48 in the first quarter of 2007 did not impact the Company’s consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements” (Statement 157).  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 February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (Statement 159).  This statement permits, but does not require, entities to measure many financial instruments at fair value.  The objective is to provide entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.  Entities electing this option will apply it when the entity first recognizes an eligible instrument and will report unrealized gains and losses on such instruments in current earnings.  This statement 1) applies to all entities, 2) specifies certain election dates, 3) can be applied on an instrument-by-instrument basis with some exceptions, 4) is irrevocable and 5) applies only to entire instruments.  One exception is demand deposit liabilities, which are explicitly excluded as qualifying for fair value.  With respect to FASB Statement No. 115, available for sale and held to maturity securities at the effective date of Statement 159 are eligible for the fair value option at that date.  If the fair value option is elected for those securities at the effective date, cumulative unrealized gains and losses at that date will be included in the cumulative-effect adjustment and thereafter, such securities will be accounted for as trading securities.  Statement 159 is effective for the Company

on January 1, 2008.  Earlier adoption is permitted in 2007 if the Company also elects to apply the provisions of Statement 157.  The Company did not elect early adoption of  Statement 159 and believes that it is unlikely that it will expand its use of fair value accounting upon the January 1, 2008 effective date.

Note 3 – Reclassifications

Certain amounts reported in the period ended June 30, 2006 have been reclassified to conform to the presentation for June 30, 2007.  These reclassifications had no effect on net income or shareholders’ equity for the periods presented, nor did they materially impact trends in financial information.

Note 4 – Equity-Based Compensation Plans

     At June 30, 2007, the Company had the following equity-based compensation plans:  the First Bancorp 2007 Equity Plan, 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.  The First Bancorp 2007 Equity Plan became effective upon the approval of shareholders on May 2, 2007.  As of June 30, 2007, the First Bancorp 2007 Equity Plan was the only plan that had shares available for future grants.

The First Bancorp 2007 Equity Plan and its predecessor plans, the First Bancorp 2004 Stock Option Plan and the First Bancorp 1994 Stock Option Plan (“Predecessor Plans”), are 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.  The Predecessor Plans only provided for the ability to grant stock options, whereas the First Bancorp 2007 Equity Plan, in addition to providing for grants of stock options, also allows for grants of other types of equity-based compensation including stock appreciation rights, restricted stock, restricted performance stock, unrestricted stock, and performance units.  Since it became effective on May 2, 2007, the only grant of stock-based compensation under the First Bancorp 2007 Equity Plan has been the grant of 2,250 stock options to each of the Company’s non-employee directors on June 1, 2007.

 The Company’s historical practice has been that stock option grants to non-employee directors have had no vesting requirements, whereas, except as discussed below, stock option grants to employees have generally had five-year vesting schedules (20% vesting each year).  In April 2004, the Company’s Compensation Committee 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 three plans, options can have a term of no longer than ten years, and all options granted thus far under these plans have had a term of ten years.  Except for grants to directors (see below), the Company cannot estimate the amount of future stock option grants at this time.  In the past, stock option grants to employees have been irregular, generally falling into three categories - 1) to attract and retain new employees, 2) to recognize changes in responsibilities of existing employees, and 3) to periodically reward exemplary performance.  As it relates to directors, the Company has historically granted 2,250 stock options to each of the Company’s non-employee directors in June of each year, and expects to continue doing so for the foreseeable future.  At June 30, 2007, there were 597,336 options outstanding related to these three plans with exercise prices ranging from $9.75 to $22.12.  At June 30, 2007, there were 1,155,500 shares remaining available for grant under the First Bancorp 2007 Equity Plan.

The Company also has four stock option plans as a result of assuming plans of acquired companies.  At June 30, 2007, there were 33,921 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 APB Opinion No. 25, “Accounting for Stock Issued to Employees” (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 No. 123(R), “Share-Based Payment” (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) permitted 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 FASB Statement No. 123 for purposes of pro-forma disclosures.  The Company elected to adopt  Statement 123(R) under the “modified prospective” method and accordingly did 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); and the weighted-average expected life is based on the historical behavior of employees related to exercises, forfeitures and cancellations.

For the three month periods ended June 30, 2007 and 2006, the adoption of Statement 123(R) resulted in stock-based compensation expense of $156,000 and $244,000, respectively, which was classified as “salaries expense” on the Consolidated Statements of Income.  For the six months periods ended June 30, 2007 and 2006, the Company recorded stock-based compensation expense of $167,000 and $291,000, respectively.  The Company recognized income tax benefits in the income statement related to stock-based compensation of $56,000 and $78,000 for each of the three and six month periods ended June 30, 2007 and 2006, respectively.  The compensation expense recorded related to the vesting of several stock option grants made prior to January 1, 2006, as well as grants of 2,250 options to each non-employee director of the Company in June of each year with no vesting requirements.  This compensation expense was reflected as an adjustment to cash flows from operating activities on the Company’s Consolidated Statement of Cash Flows.  At June 30, 2007, the Company had $32,000 of unrecognized compensation costs related to unvested stock options.  The cost is expected to be amortized over a weighted-average life of 1.5 years, with $23,000 being expensed during the remainder of 2007, equally distributed among the two remaining 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, 2007 and expects to continue this grant on June 1 of each year.

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 that will ultimately vest.  Over the past five years, there have only been nine forfeitures or expirations, totaling 13,500 options, and therefore the Company assumes that all options granted will become vested.

The Company’s only option grants for the first six months of 2007 and 2006 were grants of 24,750 and 29,250 options to non-employee directors on June 1, 2007 and 2006, respectively (2,250 options per director).  The per share weighted-average fair value of options granted during the six months ended June 30, 2007 and June 30,

 2006, was $5.80, and $6.79, respectively, on the date of the grant using the following weighted-average assumptions:

The following table presents information regarding the activity during the first six months of 2007 related to all of the Company’s stock options outstanding:

The Company received $415,000 and $618,000 as a result of stock option exercises during the six months ended June 30, 2007 and 2006, respectively.  The intrinsic value of the stock options exercised during the six months ended June 30, 2007 and 2006 was $460,000 and $787,000, respectively.  The Company recorded $36,000 and $94,000 in associated tax benefits from the exercise of nonqualified stock options during the six months ended June 30, 2007 and 2006, respectively.

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:

For both the three and six month periods ended June 30, 2007, there were 214,980 options that were antidilutive because the exercise price exceeded the average market price for the period.  For both the three and six month periods ended June 30, 2006, there were 220,980 options that were antidilutive because the exercise price exceeded the average market price for the period.  Antidilutive options have been omitted from the calculation of diluted earnings per share for the respective periods.

Note 6 – Asset Quality Information

Nonperforming assets are defined as nonaccrual loans, loans past due 90 or more days and still accruing interest, restructured loans and other real estate.  Nonperforming assets are summarized as follows:

Note 7 – Deferred Loan Fees

Loans are shown on the Consolidated Balance Sheets net of net deferred loan costs (fees) of $44,000, $27,000, and ($64,000) at June 30, 2007, December 31, 2006, and June 30, 2006, respectively.

Note 8 – Goodwill and Other Intangible Assets

The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of June 30, 2007, December 31, 2006, and June 30, 2006, and the carrying amount of unamortized intangible assets as of those same dates.

Amortization expense totaled $94,000 and $60,000 for the three months ended June 30, 2007 and 2006, respectively.  Amortization expense totaled $188,000 and $121,000 for the six months ended June 30, 2007 and 2006, respectively.

The following table presents the estimated amortization expense for each of the five calendar years ending December 31, 2011 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.

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 $621,000 and $581,000 for the three months ended June 30, 2007 and 2006, respectively, related to the Pension Plan and the SERP Plan.  The following table contains the components of the pension expense.

The Company recorded pension expense totaling $1,137,000 and $1,162,000 for the six months ended June 30, 2007 and 2006, respectively, related to the Pension Plan and the SERP Plan.  The following table contains the components of the pension expense.

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 $1,000,000 during 2007.

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 $184,000 in 2007.

Note 10 – Pending Acquisition

On July 12, 2007, the Company announced that it had reached an agreement to acquire Great Pee Dee Bancorp, Inc. (“Great Pee Dee”), the holding company for a community bank headquartered in Cheraw, South Carolina with three branches and total assets of $219 million.  Under the terms of the agreement and subject to possible adjustment, each share of Great Pee Dee common stock issued and outstanding on the merger date will be converted into and exchanged for the right to receive 1.15 shares of the Company’s common stock.  Additional information is available in the press release and merger agreement filed with the SEC (www.sec.gov) on July 13, 2007.

Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition

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.

Due to the estimation process and the potential materiality of the amounts involved, the Company has identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to the Company’s consolidated financial statements.  The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio.

Management’s determination of the adequacy of the allowance is based primarily on a mathematical model that estimates the appropriate allowance for loan losses.  This model has two components.  The first component involves the estimation of losses on loans defined as “impaired loans.”  A loan is considered to be impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement.  The estimated valuation allowance is the difference, if any, between the loan balance outstanding and the value of the impaired loan as determined by either 1) an estimate of the cash flows that the Company expects to receive from the borrower, discounted at the loan’s effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral.

The second component of the allowance model is to estimate losses for all loans not considered to be impaired loans.  First, loans that have been risk graded by the Company as having more than “standard” risk but are not considered to be impaired are assigned estimated loss percentages generally accepted in the banking industry.  Loans that are classified by the Company as having normal credit risk are segregated by loan type, and estimated loss percentages are assigned to each loan type, based on the historical losses, current economic conditions, and operational conditions specific to each loan type.

The reserve estimated for impaired loans is then added to the reserve estimated for all other loans.  This becomes the Company’s “allocated allowance.”  In addition to the allocated allowance derived from the model, management also evaluates other data such as the ratio of the allowance for loan losses to total loans, net loan growth information, nonperforming asset levels and trends in such data.  Based on this additional analysis, the Company may determine that an additional amount of allowance for loan losses is necessary to reserve for probable losses.  This additional amount, if any, is the Company’s “unallocated allowance.”  The sum of the allocated allowance and the unallocated allowance is compared to the actual allowance for loan losses recorded on the books of the Company, and any adjustment necessary for the recorded allowance to equal the computed allowance is recorded as a provision for loan losses.  The provision for loan losses is a direct charge to earnings in the period recorded.

Although management uses the best information available to make evaluations, future adjustments may be necessary if economic, operational, or other conditions change.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses.  Such agencies may require the Company to recognize additions to the allowance based on the examiners’ judgment about information available to them at the time of their examinations.

For further discussion, see “Nonperforming Assets” and “Summary of Loan Loss Experience” below.

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.

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 intangibles have generally been estimated to have a life ranging from seven to ten years, 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 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.

See Note 2 to the Consolidated Financial Statements above as it relates to accounting standards that have been recently adopted by the Company.

Net income for the three months ended June 30, 2007 was $5,419,000, a 13.0% increase over the $4,795,000 reported for the corresponding period of 2006. Diluted earnings per share for the second quarter of 2007 amounted to $0.37, a 12.1% increase over the $0.33 reported for the second quarter of 2006.

For the six month period ended June 30, 2007, net income amounted to $10,305,000, a 5.3% increase over the $9,786,000 reported for the first half of 2006.  Diluted earnings per share amounted to $0.71 for the first six months of 2007, an increase of 4.4% over the $0.68 reported in the comparable period of 2006.

Total assets at June 30, 2007 amounted to $2.21 billion, 10.7% higher than a year earlier. Total loans at June 30, 2007 amounted to $1.80 billion, a 10.2% increase from a year earlier, and total deposits amounted to $1.80 billion at June 30, 2007, a 13.2% increase from a year earlier.

The increase in loans and deposits over the past twelve months resulted in an increase in the Company’s net interest income when comparing the three and six month periods of 2007 to comparable periods in 2006. Net interest income for the second quarter of 2007 amounted to $19.7 million, a 6.7% increase over the $18.4 million recorded in the second quarter of 2006. Net interest income for the six months ended June 30, 2007 amounted to $38.5 million, a 6.2% increase over the $36.3 million recorded in the same six month period in 2006.

The impact of the growth in loans and deposits on the Company’s net interest income was partially offset by a decline in the Company’s net interest margin (tax-equivalent net interest income divided by average earning assets). The Company’s net interest margin for the second quarter of 2007 was 4.03% compared to 4.22% for second quarter of 2006.  The Company’s net interest margin for the first six months of 2007 was 4.00% compared to 4.28% for the same six months of 2006.  The lower net interest margins realized in 2007 compared to 2006 were primarily due to deposit rates paid by the Company rising by more than loan and investment yields. This has been caused by 1) the flat interest rate yield curve that has prevailed in the marketplace for most of the past year, 2) customers shifting their funds from low cost deposits to higher cost deposits as rates have risen, and 3) intense competition in the Company’s market area for loans and deposits that has impacted loan and deposit pricing.

Although the Company’s 2007 net interest margins have been lower than in 2006, the second quarter of 2007 net interest margin of 4.03% was 6 basis points higher than the 3.97% net interest margin realized in the first quarter of 2007.  This was primarily due to the repricing of fixed rate loans that matured and renewed at higher interest rates during the quarter and the stabilization of the Company’s funding costs.  The average loan yield realized by the Company increased by 9 basis points from the first quarter of 2007, while the Company’s average rate paid on interest-bearing liabilities increased by only 4 basis points.  The relatively small increase in the average rate

paid on interest-bearing liabilities is primarily due to the short-term nature of the Company’s deposit portfolio coupled with the relatively stable interest rate environment that has been in effect since the last Federal Reserve interest rate increase that occurred in July 2006.

The Company’s provisions for loan losses did not vary significantly when comparing the three and six months ended June 30, 2007 to the comparable periods of 2006.  The provision for loan losses for the second quarter of 2007 was $1.3 million compared to $1.4 million for the second quarter of 2006.  The provision for loan losses for each of the six month periods ended June 30, 2007 and June 30, 2006 amounted to $2.4 million.  Factors that played an offsetting role in this comparison were i) lower 2007 loan growth, which generally results in a lower provision for loan losses, and ii) higher levels of nonperforming assets and net charge-offs in 2007, which generally increase the necessary provision for loan losses.  

 

Noninterest income amounted to $4.9 million in the second quarter of 2007, a 26.4% increase from the $3.8 million recorded in the second quarter of 2006.  Noninterest income for the six months ended June 30, 2007 amounted to $9.1 million, an increase of 16.6% from the $7.8 million recorded in the first half of 2006.  Securities gains were $487,000 in the second quarter of 2007 compared to $205,000 in the second quarter of 2006.  “Other gains (losses)” amounted to a net gain of $115,000 in the second quarter of 2007 compared to a net loss of $311,000 in the second quarter of 2006.  For the six months ended June 30, 2007, “Other gains (losses)” amounted to a net gain of $82,000 compared to a net loss of $378,000 in the first half of 2006.  The variances in “Other gains (losses)” in 2007 compared to 2006 relate primarily to a merchant credit card liability that the Company incurred in 2006.  The Company expensed $230,000 in the second quarter of 2006 related to this situation and another $1.67 million in the third quarter of 2006.  During 2007, the Company determined that its ultimate exposure to this loss is approximately $190,000 less than the original estimated total loss of $1.9 million that was reserved in 2006.  Accordingly, the Company reversed $50,000 of this loss during the first quarter of 2007 and the remaining $140,000 in the second quarter of 2007 by recording “other gains” to reduce this liability.

Noninterest expenses amounted to $14.5 million in the second quarter of 2007, an 11.1% increase over the $13.1 million recorded in the comparable period of 2006.  Noninterest expenses for the six months ended June 30, 2007 amounted to $28.6 million, an 11.0% increase from the $25.8 million recorded in the first six months of 2006.  The increases in noninterest expenses were primarily attributable to costs associated with the Company’s overall growth in loans, deposits and branch network.  Expense associated with the Company’s stock option plan amounted to $156,000 and $167,000 for the three and six months ended June 30, 2007, respectively, compared to $244,000 and $291,000 for the three and six months ended June 30, 2006, respectively.

The Company’s effective tax rate was approximately 38%-39% for each of the three and six month periods ended June 30, 2006 and 2007.

The Company’s annualized return on average assets for the second quarter of 2007 was 1.03% compared to 1.02% for the second quarter of 2006.  The Company’s annualized return on average assets for the six months ended June 30, 2007 was 0.99% compared to 1.07% for the first half of 2006.

The Company’s annualized return on average equity for the second quarter of 2007 was 12.85% compared to 11.83% for the second quarter of 2006.  The Company’s annualized return on average equity for the six months ended June 30, 2007 was 12.38% compared to 12.30% for the first half of 2006.

Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets.  Net interest income for the three month period ended June 30, 2007 amounted to $19,678,000, an increase of $1,234,000, or 6.7%, from the $18,444,000 recorded in the second quarter of 2006.  Net interest income on a taxable equivalent basis for the three months ended June 30, 2007 amounted to $19,818,000, an increase of $1,249,000, or 6.7%, from the $18,569,000 recorded in the second quarter of 2006.  Management believes that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest income amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods.

Net interest income for the six months ended June 30, 2007 amounted to $38,544,000, an increase of $2,247,000, or 6.2%, from the $36,297,000 recorded in the first six months of 2006.  Net interest income on a taxable equivalent basis for the six months ended June 30, 2007 amounted to $38,807,000, an increase of $2,259,000, or 6.2%, from the $36,548,000 recorded in the first six months of 2006.

There are two primary factors that cause changes in the amount of net interest income recorded by the Company - 1) growth in loans and deposits, and 2) the Company’s net interest margin.  For the three and six months ended June 30, 2007, the increases in net interest income over the comparable periods in 2006 were due to growth in loans and deposits, as the Company’s net interest margins in 2007 have been lower than in the comparable periods of 2006.  The Company’s net interest margin of 4.03% in the second quarter of 2007 was lower than the 4.22% recorded in the second quarter of 2006.  For the six months ended June 30, 2007 and 2006, the Company’s net interest margin was 4.00% and 4.28%, respectively.  The Company’s believes the primary reasons behind its decreasing net interest margin are 1) deposit rates paid by the Company rising by more than loan and investment yields, which is largely associated with the flat interest rate yield curve currently prevailing in the marketplace 2) the negative impact of the Company having more of its overall funding occurring in its highest cost funding sources, which is a result of needing to fund high loan growth, as well as customers shifting their funds from low cost deposits to higher cost deposits as interest rates have risen, and 3) intense competition in the Company’s market area for loans and deposits that has impacted loan and deposit pricing.

 The following tables present net interest income analysis on a taxable-equivalent basis for the three and six month periods ended June 30, 2007 and 2006.