First Bancorp - 10-Q quarterly report FY

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 March 31, 2008

Commission File Number  0-15572

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, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one)

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 April 30, 2008 was 16,466,839.

 

INDEX

FIRST BANCORP AND SUBSIDIARIES

Part I.  Financial Information

Item 1 - Financial Statements

See notes to consolidated financial statements

First Bancorp and Subsidiaries

Consolidated Statements of Income

See notes to consolidated financial statements.

First Bancorp and Subsidiaries

Consolidated Statements of Comprehensive Income

See notes to consolidated financial statements.

First Bancorp and Subsidiaries

Consolidated Statements of Shareholders’ Equity

See notes to consolidated financial statements.

See notes to consolidated financial statements.

First Bancorp and Subsidiaries

Notes to Consolidated Financial Statements

In the opinion of the Company, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the consolidated financial position of the Company as of March 31, 2008 and 2007 and the consolidated results of operations and consolidated cash flows for the periods ended March 31, 2008 and 2007.  All such adjustments were of a normal, recurring nature.  Reference is made to the 2007 Annual Report on Form 10-K filed with the SEC for a discussion of accounting policies and other relevant information with respect to the financial statements.  The results of operations for the periods ended March 31, 2008 and 2007 are not necessarily indicative of the results to be expected for the full year.

Note 2 – Accounting Policies

Note 1 to the 2007 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 September 2006, the Financial Accounting Standards Board (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.  As it relates to financial assets and liabilities, Statement 157 became effective for the Company as of January 1, 2008.  For nonfinancial assets and liabilities, Statement 157 will become effective for the Company on January 1, 2009.  The Company’s January 1, 2008 adoption of Statement 157 as it relates to financial assets and liabilities had no impact on the Company’s financial statements.  See Note 12 for the disclosures required by Statement 157.  The Company does not expect the adoption of the remainder of Statement 157 to 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 shall be included in the cumulative-effect adjustment and thereafter, such securities will be accounted for as trading securities.  Statement 159 became effective for the Company on January 1, 2008.  Upon adoption, the Company elected not to expand its use of fair value accounting.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (Statement 141(R)) which replaces Statement 141, “Business Combinations.”  Statement 141(R) retains the fundamental requirements in Statement No. 141 that the acquisition method of accounting (formerly referred to as purchase method) be used for

all business combinations and that an acquirer be identified for each business combination.  Statement 141(R) defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as of the date that the acquirer achieves control.  Statement 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values.  This Statement requires the acquirer to recognize acquisition-related costs and restructuring costs separately from the business combination as period expense.  This Statement is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The adoption of this statement will impact the Company’s accounting and reporting of acquisitions after January 1, 2009.

In April 2008, the FASB issued FASB Staff Position No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.”  The intent of FSP 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R), “Business Combinations,” and other U.S. generally accepted accounting principles.  FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and early adoption is prohibited.  Accordingly, FSP 142-3 is effective for the Company on January 1, 2009.  The Company does not believe the adoption of FSP 142-3 will have a material impact on its financial position, results of operations or cash flows.

 

Note 4 – Equity-Based Compensation Plans

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.  However, in 2008 the Company expects to grant a combination of performance units and stock options to approximately twenty employees.  It is expected that these grants will have both performance (earnings per share targets) and service conditions in order to vest.

The Company’s practice has been that stock option grants to non-employee directors have had no vesting requirements, whereas, except as discussed below, historically 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 the Predecessor Plans and the 2007 Equity Plan, 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.  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 noted above, the Company expects in 2008 to grant stock options and performance units with specific incentive-based features to certain employees.  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 March 31, 2008, there were 570,411 options outstanding related to the Predecessor Plans and the 2007 Equity Plan, with exercise prices ranging from $9.75 to $22.12.  At March 31, 2008, there were 1,155,500 shares remaining available for grant under the 2007 Equity Plan.

The Company also has two stock option plans as a result of assuming plans of acquired companies.  At March 31, 2008, there were 27,477 stock options outstanding in connection with these plans, with option prices ranging from $10.69 to $11.49.

The Company issues new shares when options are exercised.

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 March 31, 2008 and 2007, the adoption of Statement 123(R) resulted in stock-based compensation expense of $3,000 and $12,000, respectively, which was classified as “salaries expense” on the Consolidated Statements of Income.  The Company recognized no income tax benefits in the income statement related to stock-based compensation for the three month periods ended March 31, 2008 and 2007.  The compensation expense recorded related to the vesting of several stock option grants made prior to January 1, 2006. This compensation expense was reflected as an adjustment to cash flows from operating activities on the Company’s Consolidated Statement of Cash Flows.  At March 31, 2008, the Company had $6,000 of unrecognized

compensation costs related to unvested stock options.  The cost is expected to be amortized over a weighted-average life of 2 years, with approximately $3,000 being expensed in both 2009 and 2010.

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 10 forfeitures or expirations, totaling 22,500 options, and therefore the Company assumes that all options granted will become vested.

Note 7 – Deferred Loan Fees

The amount of loans shown on the Consolidated Balance Sheets includes net deferred loan costs of approximately $222,000, $146,000, and $9,000 at March 31, 2008, December 31, 2007, and March 31, 2007, respectively.

Note 8 – Goodwill and Other Intangible Assets

The following is a summary of the gross carrying amount and accumulated amortization of amortizable intangible assets as of March 31, 2008, December 31, 2007, and March 31, 2007 and the carrying amount of unamortized intangible assets as of those same dates.

Amortization expense totaled $79,000 and $94,000 for the three months ended March 31, 2008 and 2007, respectively.

The following table presents the estimated amortization expense for each of the five calendar years ending December 31, 2012 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”), which is for the benefit of certain senior management executives of the Company.

The Company recorded pension expense totaling $606,000 and $516,000 for the three months ended March 31, 2008 and 2007, respectively, related to the Pension Plan and the SERP.  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 expects that it will not make a contribution to the Pension Plan in 2008.

The Company’s funding policy with respect to the SERP is to fund the related benefits from the operating cash flow of the Company.  The Company expects to make SERP benefit payments of $104,000 during 2008.

Note 10 – Comprehensive Income

Comprehensive income is defined as the change in equity during a period for non-owner transactions and is divided into net income and other comprehensive income.  Other comprehensive income includes revenues, expenses, gains, and losses that are excluded from earnings under current accounting standards.  The components of accumulated other comprehensive income for the Company are as follows:

Note 11 – Subsequent Event – Completion of Acquisition

On April 1, 2008, the Company completed its merger acquisition of Great Pee Dee Bancorp, Inc. (“Great Pee Dee”).  Great Pee Dee was the holding company for Sentry Bank & Trust, a community bank headquartered in Cheraw, South Carolina with three branches and total assets of $222 million.  In accordance with the terms of the agreement, each share of Great Pee Dee common stock issued and outstanding on the merger date was converted into and exchanged for the right to receive 1.15 shares of the Company’s common stock, which resulted in the Company issuing a total of 2,059,091 shares of common stock.  Additional information about this merger is

available in the registration statement that was filed with the SEC (www.sec.gov) on February 5, 2008.  The Company plans to merge Sentry Bank & Trust into First Bank, its bank subsidiary, on May 16, 2008.

Note 12 – Fair Value

As discussed in Note 2, on January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (Statement 157), as it applies to financial assets and liabilities.  Statement 157 provides enhanced guidance for measuring assets and liabilities using fair value and applies to situations where other standards require or permit assets or liabilities to be measured at fair value.  Statement 157 also requires expanded disclosure of items that are measured at fair value, the information used to measure fair value and the effect of fair value measurements on earnings.

Statement 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1:  Quoted prices (unadjusted) of identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2:  Quoted prices for similar instrument in active or non-active markets and model-derived valuations in which all significant inputs are observable in active markets.

Level 3:  Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

     The following table summarizes the Company’s financial instruments that were measured at fair value on a recurring basis at March 31, 2008.

     The following is a description of the valuation methodologies used for instruments measured at fair value.

based on underlying collateral values, which are then adjusted for the cost related to liquidation of the collateral.

     For the three months ended March 31, 2008, the increase in the fair value of securities available for sale was $1,530,000, which is included in other comprehensive income (net of taxes of $597,000).  Fair value measurement methods at March 31, 2008 are consistent with those used in prior reporting periods.

 

 

 

 

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

CRITICAL ACCOUNTING POLICIES

We follow and apply accounting principles that 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 our best assumptions at the time of the estimation.  We have identified two policies as being more sensitive in terms of judgments and estimates, taking into account their overall potential impact to our consolidated financial statements – 1) the allowance for loan losses and 2) intangible assets.

Allowance for Loan Losses

Due to the estimation process and the potential materiality of the amounts involved, we have identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to our 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.

Our 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 we 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 we expect 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 an estimate of losses for all loans not considered to be impaired loans.  First, loans that we have risk graded 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 we have classified 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 our “allocated allowance.”  In addition to the allocated allowance derived from the model, we also evaluate 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, we may determine that an additional amount of allowance for loan losses is necessary to reserve for probable losses.  This additional amount, if any, is our “unallocated allowance.”  The sum of the allocated allowance and the unallocated allowance is compared to the actual allowance for loan losses recorded on our books 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 we use the best information available to make evaluations, future material 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 our allowance for loan losses.  Such agencies may require us 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.

Intangible Assets

Due to the estimation process and the potential materiality of the amounts involved, we have also identified the accounting for intangible assets as an accounting policy critical to our consolidated financial statements.

When we complete 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.  We 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 our 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.

The primary identifiable intangible asset we typically record in connection with a whole bank or bank branch acquisition is the value of the core deposit intangible, whereas when we acquire 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.  We typically engage 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, we amortize 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 our reporting units to their related carrying value, including goodwill (our community banking operation is our only material reporting unit).  At our last evaluation, the fair value of our community banking operation exceeded its carrying value, including goodwill.  If the carrying value of a reporting unit were ever to exceed its fair value, we 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.

We review identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.  Our 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 for information about accounting standards that we have recently adopted.

RESULTS OF OPERATIONS

Overview

Net income for the three months ended March 31, 2008 was $5,529,000, or $0.38 per diluted share, which represents a 13.2% increase in net income and an 11.8% increase in diluted earnings per share from the net income of $4,886,000, or $0.34 per diluted share, reported for the first quarter of 2007.

During the first quarter of 2008, we experienced substantial growth in loans and deposits.  Loans outstanding grew by $40 million, or 8.4% on an annualized basis, while deposits grew by $83 million, or 18.2% on an annualized basis. Approximately $27 million of the deposit growth was attributable to a single customer and we expect this to remain with us only temporarily. Excluding that account, our deposit growth would have been $56 million, or 12.2% on an annualized basis.

Total assets at March 31, 2008 amounted to $2.4 billion, 9.3% higher than a year earlier. Total loans at March 31, 2008 amounted to $1.93 billion, an 8.9% increase from a year earlier, and total deposits amounted to $1.92 billion at March 31, 2008, a 10.1% increase from a year earlier.

The growth in loans and deposits was the primary reason for an increase in our net interest income when comparing the first quarter of 2008 to the first quarter of 2007.  Net interest income for the first quarter of 2008 amounted to $19.8 million, a 4.8% increase over the $18.9 million recorded in the first quarter of 2007.

The impact of the growth in loans and deposits on our net interest income was partially offset by a decline in our net interest margin (tax-equivalent net interest income divided by average earning assets).  Our net interest margin in the first quarter of 2008 was 3.79%, an 18 basis point decline from the 3.97% margin realized in the first quarter of 2007 and a 19 basis point decline from the 3.98% margin realized in the fourth quarter of 2007.  Our net interest margin has been negatively impacted by the Federal Reserve lowering interest rates by a total of 300 basis points since September 2007.  When interest rates are lowered, our net interest margin declines, at least temporarily, as most of our adjustable rate loans reprice downward immediately, while rates on our customers’ time deposits are fixed, and thus do not adjust downward until they mature.

Our provision for loan losses amounted to $1,533,000 in the first quarter of 2008 compared to $1,121,000 in the first quarter of 2007. The primary reason for the higher provision is a negative trend in asset quality.  Although we have no subprime exposure, consistent with current economic conditions, we have experienced modest increases in delinquencies and classified assets.  The ratio of annualized net charge-offs to average loans was 0.18% in the first quarter of 2008 compared to 0.14% in the first quarter of 2007.  Our ratio of nonperforming assets to total assets was 0.51% at March 31, 2008 compared to 0.38% at March 31, 2007.

Noninterest expenses amounted to $14.8 million in the first quarter of 2008, a 4.5% increase over 2007.  This increase is primarily attributable to our growth.  Additionally, we recorded FDIC insurance expense of $245,000 in the first quarter of 2008 compared to none in the first quarter of 2007 as a result of the FDIC recently beginning to charge for FDIC insurance again in order to replenish its reserves.

Our effective tax rate was 37%-38% for each of the three month periods ended March 31, 2008 and 2007.

Our annualized return on average assets for the first quarter of 2008 was 0.99% compared to 0.95% for the first quarter of 2007.  Our annualized return on average equity for the first quarter of 2008 was 12.45% compared to 11.89% for the first quarter of 2007.

Components of Earnings

Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets.  Net interest income for the three month period ended March 31, 2008 amounted to $19,764,000, an increase of $898,000, or 4.8% from the $18,866,000 recorded in the first quarter of 2007.  Net interest income on a taxable equivalent basis for the three month period ended March 31, 2008 amounted to $19,928,000, an increase of $938,000, or 4.9% from the $18,990,000 recorded in the first quarter of 2007.  We believe 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.

There are two primary factors that cause changes in the amount of net interest income we record - 1) growth in loans and deposits and 2) our net interest margin.  For the three months ended March 31, 2008, the increase in net interest income was caused by growth in loans and deposits, as our net interest margin of 3.79% in the first quarter of 2008 was lower than the 3.97% recorded in the first quarter of 2007.  Our net interest margin has been negatively impacted by the Federal Reserve lowering interest rates by a total of 300 basis points since September 2007.  When interest rates are lowered, our net interest margin declines, at least temporarily, as most of our adjustable rate loans reprice downward immediately by the amount of the Federal Reserve cut, while rates on our customers’ time deposits are fixed, and thus do not adjust downward until they mature.  Also, for many of our deposit products, including time deposits that have recently matured, we have been unable to lower the interest rates we pay our customers by the full 300 basis point interest rate decrease due to competitive pressures.  Additionally, some of our deposit accounts had rates lower than 3.00% prior to the rate cuts, and thus could not be reduced by 300 basis points.

      The following table presents net interest income analysis on a taxable-equivalent basis.

 

Average loans outstanding for the first quarter of 2008 were $1.915 billion, which was 9.0% higher than the average loans outstanding for the first quarter of 2007 ($1.757 billion).  The mix of our loan portfolio remained substantially the same at March 31, 2008 compared to December 31, 2007, with approximately 86% of our loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans.  The majority of our real estate loans are personal and commercial loans where real estate provides additional security for the loan.

Average deposits outstanding for the first quarter of 2008 were $1.858 billion, which was 8.5% higher than the

average amount of deposits outstanding in the first quarter of 2007 ($1.713 billion).  Generally, we 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.

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 2008.

As derived from the table above, in comparing first quarter 2008 to first quarter 2007, the yield earned on loans, our primary earning asset, decreased by 54 basis points (from 7.67% to 7.13%) while the average rate paid on other time deposits, our largest deposit category, only decreased by 19 basis points (from 4.63% to 4.44%).  The difference in these decreases negatively impacted our net interest margin and was due to both the lag in the ability to reprice time deposits until they mature, and competitive pressures that prevented us from lowering the interest rate paid on maturing time deposits by the full amount of the Federal Reserve interest rate cuts (as discussed above).

See additional information regarding net interest income in the section entitled “Interest Rate Risk.”

Our provision for loan losses increased in 2008 compared to 2007, amounting to $1,533,000 in the first quarter of 2008 versus $1,121,000 in the first quarter of 2007.  The primary reason for the higher provision was a negative trend in asset quality.  Consistent with current economic conditions, we have experienced modest increases in delinquencies and classified assets.  In the first quarter of 2008, we recorded $865,000 in net charge-offs compared to $590,000 in the first quarter of 2007.  Our nonperforming loans have increased from $5,879,000 at March 31, 2007 to $8,804,000 at March 31, 2008.

Noninterest income amounted to $5,375,000 for the first quarter of 2008, a 26.9% increase from the $4,236,000 recorded in the first quarter of 2007.  The primary reason for the increase was a 41% increase in service charges on deposit accounts. These higher service charges were primarily associated with our customer overdraft protection program – we expanded the program in the fourth quarter of 2007 to include debit card purchases and ATM withdrawals. Previously the overdraft protection program, in which we charge a fee for honoring payments on overdrawn accounts, only applied to written checks. Additionally, the line item “Other gains (losses)” was positively impacted when we recorded a gain of $306,000 related to the VISA initial public offering that occurred in March 2008.  We were a member/owner of VISA and received a portion of VISA’s offering proceeds.

Noninterest expenses amounted to $14.8 million in the first quarter of 2008, a 4.5% increase over 2007.  This increase is primarily attributable to our growth. Additionally, we recorded FDIC insurance expense of $245,000 in the first quarter of 2008 compared to none in the first quarter of 2007 as a result of the FDIC recently beginning to charge for FDIC insurance again in order to replenish its reserves.

The provision for income taxes was $3,306,000 in the first quarter of 2008, an effective tax rate of 37.4%, compared to $2,965,000 in the first quarter of 2007, an effective tax rate of 37.8%.  We expect our effective tax rate to remain at approximately 37-38% for the foreseeable future.

The Consolidated Statements of Comprehensive Income reflect “Other Comprehensive Income” of $995,000 and $218,000 during the first quarters of 2008 and 2007, respectively.  The primary component of other comprehensive income/loss for the periods presented was changes in unrealized holding gains/losses of our available for sale securities.  Our 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.  Interest rates declined significantly in the first quarter of 2008, which resulted in unrealized gains of $1,530,000 compared to only $265,000 in the first quarter of 2007.

FINANCIAL CONDITION

Total assets at March 31, 2008 amounted to $2.38 billion, 9.3% higher than a year earlier.  Total loans at March 31, 2008 amounted to $1.93 billion, an 8.9% increase from a year earlier, and total deposits amounted to $1.92 billion at March 31, 2008, a 10.1% increase from a year earlier.

The following tables present information regarding the nature of our growth for the twelve months ended March 31, 2008 and for the first quarter of 2008.

We experienced strong loan and deposit growth during the first quarter of 2008, with loans increasing by $40 million, or 2.1% (8.4% on an annualized basis), and deposits increasing by $83 million, or 4.5% (18.2% on an annualized basis).  The increase in the “Savings” category for both time periods shown was impacted by a $27 million deposit that was made by a single customer in March 2008 and is expected to remain in our bank only temporarily.  Excluding that account, our deposits would have increased by $148.9 million, or 8.5%, for the twelve months ended March 31, 2008, and our deposits would have increased $56.2 million, or 3.1% (12.3% on an annualized basis) during the first quarter of 2008.

The mix of our loan portfolio remains substantially the same at March 31, 2008 compared to December 31, 2007, with approximately 86% of our loans being real estate loans, 9% being commercial, financial, and agricultural loans, and the remaining 5% being consumer installment loans.  The majority of our real estate loans are personal and commercial loans where real estate provides additional security for the loan.

The following table provides additional information regarding our mix of loans.

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:

We have reviewed the collateral for the nonperforming assets, including nonaccrual loans, and have included this review among the factors considered in the evaluation of the allowance for loan losses discussed below.

The variances in nonperforming loans among the periods presented has been primarily due to changes in nonaccrual loans, as restructured loans have not changed significantly.  Both nonaccrual loans and other real estate have experienced modest increases over the past year due to the current economic conditions.  At March 31, 2008, our largest nonaccrual loan relationship amounted to $529,000, and the largest carrying amount of any single piece of other real estate amounted to $425,500.

The following table presents information related to our loans that our considered to be impaired in accordance with Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan.”

All of the impaired loans noted in the table above were on nonaccrual status at each respective period end.  For the periods noted above, we recognized no interest income on any impaired loans during the period that they were considered to be impaired.

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.

We have no foreign loans, few agricultural loans and do not engage in significant lease financing or highly leveraged transactions.  Commercial loans are diversified among a variety of industries.  The majority of our real estate loans are primarily personal and commercial loans where real estate provides additional security for the loan.  Collateral for virtually all of these loans is located within our principal market area.

Our provision for loan losses amounted to $1,533,000 in the first quarter of 2008 compared to $1,121,000 in the first quarter of 2007. The primary reason for the higher provision is a negative trend in asset quality.  Although we have no subprime exposure, consistent with current economic conditions, we have experienced modest increases in our trends in delinquencies and classified assets.  In the first quarter of 2008, we recorded $865,000 in net charge-offs, which amounted to 0.18% annualized net charge-offs to average loans, compared to $590,000 (0.14%) in the first quarter of 2007.  Our nonperforming loans have increased from $5,879,000 at March 31, 2007 to $8,804,000 at March 31, 2008.  Our ratio of nonperforming assets to total assets was 0.51% at March 31, 2008 compared to 0.38% at March 31, 2007.

At March 31, 2008, the allowance for loan losses amounted to $21,992,000, compared to $21,324,000 at December 31, 2007 and $19,478,000 at March 31, 2007.  The allowance for loan losses as a percentage of total loans was 1.14% at March 31, 2008, 1.13% at December 31, 2007, and 1.10% at March 31, 2007.

We believe our 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 our procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans.  No assurance can be given that we 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 our allowance for loan losses and value of other real estate.  Such agencies may require us 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.

 

For the periods indicated, the following table summarizes our 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.