First Bancorp - 10-Q quarterly report FY

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 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.      ý YES       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) .      o YES       ý NO

The number of shares of the registrant's Common Stock outstanding on July 31, 2008 was 16,511,778.

INDEX

FIRST BANCORP AND SUBSIDIARIES

Part I.  Financial Information

Item 1 - Financial Statements

See notes to consolidated financial statements.

First Bancorp and Subsidiaries

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.

First Bancorp and Subsidiaries

Consolidated Statements of Cash Flows

See notes to consolidated financial statements.

First Bancorp and Subsidiaries

Notes to Consolidated 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, 2008 and 2007 and the consolidated results of operations and consolidated cash flows for the periods ended June 30, 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 June 30, 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 a 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 11 for the disclosures required by Statement 157.  The Company is currently evaluating any potential impact of the adoption of the remainder of Statement 157.

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 the fair value option.  With respect to FASB Statement No. 115, available for sale and held to maturity securities held 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 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 requirement in Statement 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 for and reporting of acquisitions completted 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 3 – Reclassifications

Certain amounts reported in the period ended June 30, 2007 have been reclassified to conform to the presentation for June 30, 2008.  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, 2008, 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 three plans that were assumed from acquired entities.  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, 2008, 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 the First Bancorp 2007 Equity Plan became effective on May 2, 2007, the Company has granted the following stock-based compensation:  1) the grant of 2,250 stock options to each of the Company’s non-employee directors on June 1, 2007 and 2008, 2) the grant of 5,000 incentive stock options to an executive officer on April 1, 2008 in connection with a corporate acquisition, and 3) the grant of 262,599 stock options and 81,337 performance units to 19 senior officers on June 17, 2008. Each performance unit represents the right to acquire one share of the Company’s common stock upon satisfaction of the vesting conditions.

Prior to the June 17, 2008 grant, stock option grants to employees generally had five-year vesting schedules (20% vesting each year) and 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. Compensation expense associated with these types of grants is recorded pro-ratably over the vesting period.    

As it relates to directors, the Company has historically granted 2,250 immediately-vested 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.  Compensation expense associated with these director grants is recognized on the date of grant since there are no vesting conditions.

The June 17, 2008 grant of a combination of performance units and stock options has both performance conditions (earnings per share targets) and service conditions that must be met in order to vest.  The 262,599 stock options and 81,337 performance units represent the maximum amount of options and performance units that could vest if the Company achieves specified maximum goals for earnings per share during the three annual performance periods ending on December 31, 2008, 2009, and 2010.  Up to one-third of the total number of options and performance units granted will vest annually as of December 31 of each year beginning in 2010, if (1) the Company achieves specific EPS goals during the corresponding performance period and (2) the executive or key employee continues employment for a period of two years beyond the corresponding performance period.  Compensation expense for this grant will be recorded over the various service periods based on the estimated number of options and performance units that are probable to vest.  If the awards do not vest, no compensation cost will be recognized and any recognized compensation cost will be reversed.

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.  The Company’s options provide for immediate vesting if there is a change in control (as defined in the plans).

At June 30, 2008, there were 848,635 options outstanding related to the three First Bancorp plans with exercise prices ranging from $9.75 to $22.12.  At June 30, 2008, there were 777,313 shares remaining available for grant under the First Bancorp 2007 Equity Plan.  The Company also has three stock option plans as a result of assuming plans of acquired companies.  At June 30, 2008, there were 111,266 stock options outstanding in connection with these plans, with option prices ranging from $10.66 to $15.66.

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 June 30, 2008 and 2007, the Company recorded stock-based compensation expense of $142,000 and $156,000, respectively, most of which was classified as “other operating expenses” on the Consolidated Statements of Income.  For the six-month periods ended June 30, 2008 and 2007, the Company recorded stock-based compensation expense of $145,000 and $167,000, respectively.  The Company recognized income tax benefits in the income statement related to stock-based compensation of $53,000 and $56,000 for each of the three and six month periods ended June 30, 2008 and 2007, respectively.  The compensation expense recorded relates primarily to the grants of 2,250 options to each non-employee director of the Company in June of each year with no vesting requirements.  Stock-based compensation expense is reflected as an adjustment to cash flows from operating activities on the Company’s Consolidated Statement of Cash Flows.

None of the compensation expense discussed in the preceding paragraph relates to the June 17, 2008 option and performance unit grant because the Company has determined that it is not probable that any of the minimum performance targets required for vesting will be achieved.

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 ten forfeitures or expirations, totaling 22,500 options, and therefore the Company assumes that all options granted without performance conditions will become vested.

As discussed above, the Company’s share grants for the first six months of 2008 were grants of 1) 5,000 incentive stock options to an executive officer on April 1, 2008, 2) 29,250 stock options to non-employee directors on June 1, 2008 (2,250 options per director), and 3) 262,599 stock options and 81,337 performance units to 19 senior officers on June 17, 2008.  The per share weighted-average fair value for the stock option grants listed above was $5.09 on the date of the grant using the following weighted average assumptions:

The Company’s only option grants for the first six months of 2007 were grants of 24,750 options to non-employee directors on June 1, 2007 (2,250 options per director).  The per share weighted-average fair value of options granted during the six months ended June 30, 2007 was $5.80 on the date of the grant using the following assumptions:

The following table presents information regarding the activity during the first six months of 2008 for all of the Company’s stock options outstanding:

As discussed above, the Company granted 81,337 performance units to 19 senior officers on June 17, 2008.  Each performance unit represents the right to acquire one share of the Company’s common stock upon satisfaction of the vesting conditions (discussed above).  The fair market value of the Company’s common stock on the grant date was $16.53 per share.  The following table presents information regarding the activity during the first six months of 2008 related to the Company’s performance units outstanding:

At June 30, 2008, the Company had $30,000 of unrecognized compensation costs related to unvested stock options that have vesting requirements based solely on service conditions.  The cost is expected to be amortized over a weighted-average life of 3.6 years, with $9,000 being expensed in each of 2009 and 2010 and $6,000 being expensed in each of 2011 and 2012.  At June 30, 2008, the Company had $2.7 million in unrecognized compensation expense associated with the June 17, 2008 award grant that has both performance conditions and service conditions.  The Company does not currently believe that it is probable that any of these awards will vest because of failing to achieve the performance conditions, and therefore none of the unrecognized compensation cost is expected to be recognized.

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, 2008, there were 265,730 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, 2007, there were 214,980 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, and other real estate.  Nonperforming assets are summarized as follows:

 

The following table presents information related to impaired loans, as defined by Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan.”

(1)    The Company is committed to fund an additional $1.1 million for one of its impaired loan relationships (which is also on nonaccrual status).

(2)    Includes $4.1 million in net loans acquired in an acquisition that have already been written down by $4.7 million from a total loan balance of $8.8 million.  See the following paragraph for additional discussion.

As discussed in Note 12, the Company completed a corporate acquisition on April 1, 2008.  The Company determined that gross loan balances totaling $8.8 million were impaired on the date of acquisition.  The estimated fair value of these impaired loans was determined to be $4.1 million.  Accordingly, the Company wrote the gross balances down by $4.7 million in connection with the recording of the transaction.  All of these acquired impaired loans are on nonaccrual basis and are currently being accounted for under the cost recovery method of accounting, in which all payments received will be credited to the remaining carrying balance of the loan.  Since the date of acquisition, there have been no amounts received in excess of the initial carrying amount of any of these impaired loans.

All of the impaired loans noted in the table above were on nonaccrual status at each respective period end except that at June 30, 2008, a $4.0 million loan that is classified as an impaired loan due to a restructured interest rate was performing as agreed and was on accruing status.

 

Note 7 – Deferred Loan Costs

The amount of loans shown on the Consolidated Balance Sheets includes net deferred loan costs of approximately $233,000, $146,000, and $44,000 at June 30, 2008, December 31, 2007, and June 30, 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 June 30, 2008, December 31, 2007, and June 30, 2007, and the carrying amount of unamortized intangible assets as of those same dates.

Amortization expense totaled $123,000 and $94,000 for the three months ended June 30, 2008 and 2007, respectively.  Amortization expense totaled $202,000 and $188,000 for the six months ended June 30, 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 Plan”), which is for the benefit of certain senior management executives of the Company.

The Company recorded pension expense totaling $606,000 and $621,000 for the three months ended June 30, 2008 and 2007, 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 $1,212,000 and $1,137,000 for the six months ended June 30, 2008 and 2007, 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 expects that it will make a contribution to the Pension Plan of $1.4 million 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 – 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 June 30, 2008.

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

Securities— When quoted market prices are available in an active market, the securities are classified as Level 1 in the valuation hierarchy.  Level 1 securities for the Company include certain equity securities. If quoted market prices are not available, but fair values can be estimated by observing quoted prices of securities with similar characteristics, the securities are classified as Level 2 on the valuation hierarchy.  For the Company, Level 2 securities include mortgage backed securities, collateralized mortgage obligations, government sponsored entity securities, and corporate bonds.   In cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy.

Impaired loans —Statement 157 applies to loans that are measured for impairment using the practical expedients permitted by SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.”  Fair values for impaired loans in the above table are collateral dependent and are estimated based on underlying collateral values, which are then adjusted for the cost related to liquidation of the collateral.

     For the three and six months ended June 30, 2008, the decrease in the fair value of securities available for sale was $3,206,000 and $1,676,000, respectively, which is included in other comprehensive income (net of taxes of $1,250,000 and $654,000, respectively).  Fair value measurement methods at June 30, 2008 are consistent with those used in prior reporting periods.

Note 12 – Acquisition of Great Pee Dee Bancorp, Inc.

Great Pee Dee was the parent company of Sentry Bank and Trust (Sentry), a South Carolina community bank with one branch in Florence, South Carolina and two branches in Cheraw, South Carolina.  Great Pee Dee had $213 million in total assets as of the date of acquisition.  This acquisition represented a natural extension of the Company’s market area with Sentry’s Cheraw offices being in close proximity to the Company’s Rockingham, North Carolina branch and the Sentry’s Florence office being in close proximity to existing branches in Dillon and Latta, South Carolina.  The Company’s primary reason for the acquisition was to expand into a contiguous market with facilities, operations and experienced staff in place.  The Company agreed to a purchase price that resulted in recognition of goodwill primarily due to the reasons just noted, as well as the generally positive earnings of Great Pee Dee.  The terms of the agreement called for shareholders of Great Pee Dee to receive 1.15 shares of First Bancorp stock for each share of Great Pee Dee stock they owned.  The transaction was completed on April 1, 2008 with the Company issuing 2,059,091 shares of common stock that were valued at approximately $37.0 million and assuming employee stock options with a fair market value of approximately $0.6 million.  The value of the stock issued was determined using a Company stock price of $17.98, which was the average of the daily closing price of the Company’s stock for the five trading days closest to the July 12, 2007 announcement of the execution of the definitive merger agreement. The value of the employee stock options assumed was determined using the Black-Scholes option-pricing model.

 

This acquisition has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Great Pee Dee were recorded based on estimates of fair values as of April 1, 2008.  The table below is a condensed balance sheet disclosing the amount assigned to each major asset and liability category of Great Pee Dee on April 1, 2008, and the related fair value adjustments recorded by the Company to reflect the acquisition.  The $16.3 million in goodwill that resulted from this transaction is non-deductible for tax purposes.

The following unaudited pro forma financial information presents the combined results of the Company and Great Pee Dee as if the acquisition had occurred as of January 1, 2007, after giving effect to certain adjustments, including amortization of the core deposit intangible, and related income tax effects.  The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company and Great Pee Dee constituted a single entity during such period.

The above pro forma results for the six months ended June 30, 2008 include merger-related expenses and charges recorded by Great Pee Dee prior to the merger that are nonrecurring in nature and amounted to $2.9 million pretax, or $2.0 million after-tax ($0.12 per share).

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 June 30, 2008 was $5,278,000, or $0.32 per diluted share.  This represents decreases of 2.6% and 13.5% in net income and diluted earnings per share, respectively, from the $5,419,000, or $0.37 per diluted share, reported in the second quarter of 2007.  For the six month period ended June 30, 2008, net income amounted to $10,807,000, or $0.70 per diluted share.  This represents an increase in net income of 4.9% and a decrease in diluted earnings per share of 1.4% from the net income of $10,305,000, or $0.71 per diluted share, reported in the first half of 2007.  The 2008 earnings reflect the impact of the acquisition of Great Pee Dee Bancorp, which had $213 million in total assets as of the acquisition date of April 1, 2008, and resulted in the issuance of 2,059,091 shares of First Bancorp common stock.

During the second quarter of 2008, loans outstanding increased by $233 million while deposits increased by $95 million, with the acquisition of Great Pee Dee Bancorp accounting for the majority of the growth.  As of the April 1, 2008 acquisition, Great Pee Dee Bancorp had $189 million in loans and $148 million in deposits.  Internal loan growth (excluding Great Pee Dee) was $45 million, or 9.3% on an annualized basis, while internal deposits declined by $53 million, or 11.0% on an annualized basis.  The decrease in deposits during the quarter was concentrated in our time deposit categories, as we elected not to match competitor interest rates for many renewing time deposits.

Total assets at June 30, 2008 amounted to $2.6 billion, 18.8% higher than a year earlier.  Total loans at June 30, 2008 amounted to $2.2 billion, a 20.2% increase from a year earlier, and total deposits amounted to $2.0 billion at June 30, 2008, a 12.0% increase from a year earlier.

Growth in loans and deposits was the primary reason for an increase in our net interest income when comparing the three and six months of 2008 to comparable periods in 2007.  Net interest income for the second quarter of 2008 amounted to $21.5 million, a 9.3% increase over the $19.7 million recorded in the second quarter of 2007.  Net interest income for the six months ended June 30, 2008 amounted to $41.3 million, a 7.1% increase over the $38.5 million recorded in the same six month period in 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 for the second quarter of 2008 was 3.71%, a 32 basis point decline from the 4.03% margin realized in the second quarter of 2007 and an 8 basis point decline from the 3.79% margin realized in the first quarter of 2008.  Our net interest margin for the first six months of 2008 was 3.75% compared to 4.00% for the same six months of 2007.  Our net interest margin has been negatively impacted by the Federal Reserve lowering interest rates by a total of 325 basis points since September 2007.  

 

Our provision for loan losses amounted to $2,059,000 in the second quarter of 2008 compared to $1,322,000 in the second quarter of 2007.  The provision for loan losses for the six month period ended June 30, 2008 was $3,592,000 compared to $2,443,000 recorded in the first half of 2007.  The higher 2008 amounts were due to higher loan growth and negative trends in asset quality.

 

Noninterest income amounted to $5.3 million for the second quarter of 2008, a 9.9% increase from the $4.9 million recorded in the second quarter of 2007.  Noninterest income for the six months ended June 30, 2008 amounted to $10.7 million, an increase of 17.8% from the $9.1 million recorded in the first half of 2007.  The increases in noninterest income in 2008 primarily relate to increases 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. 

We realized securities losses of $16,000 for each of the three and six month periods ended June 30, 2008 compared to gains of $487,000 for each of the comparable periods in 2007.

We recorded “other gains” of $257,000 for the six months ended June 30, 2008, which relates primarily to a gain of $306,000 related to the VISA initial public offering that occurred in March 2008, which was partially offset by miscellaneous losses.

Noninterest expenses amounted to $16.3 million in the second quarter of 2008, a 12.6% increase over 2007.  Noninterest expenses for the six months ended June 30, 2008 amounted to $31.1 million, an 8.6% increase from the $28.6 million recorded in the first six months of 2007.  These increases are primarily attributable to our growth, including the April 1, 2008 acquisition of Great Pee Dee.  Additionally, we recorded FDIC insurance expense of $262,000 and $507,000 for the three and six month periods ended June 30, 2008, respectively, compared to none for the same periods in 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 and six month periods ended June 30, 2008 and 2007.

 

Our annualized return on average assets for the second quarter of 2008 was 0.85% compared to 1.03% for the second quarter of 2007.  Our annualized return on average assets for the six months ended June 30, 2008 was 0.91% compared to 0.99% for the first half of 2007.

Our annualized return on average equity for the second quarter of 2008 was 9.75% compared to 12.85% for the second quarter of 2007.  Our annualized return on average equity for the six months ended June 30, 2008 was 10.97% compared to 12.38% for the first half 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 June 30, 2008 amounted to $21,501,000, an increase of $1,823,000, or 9.3%, from the $19,678,000 recorded in the second quarter of 2007.  Net interest income on a taxable equivalent basis for the three months ended June 30, 2008 amounted to $21,664,000, an increase of $1,846,000, or 9.3%, from the $19,818,000 recorded in the second 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.

Net interest income for the six months ended June 30, 2008 amounted to $41,265,000, an increase of $2,721,000, or 7.1%, from the $38,544,000 recorded in the first six months of 2007.  Net interest income on a taxable equivalent basis for the six months ended June 30, 2008 amounted to $41,592,000, an increase of $2,785,000, or 7.2%, from the $38,807,000 recorded in the first six months of 2007.

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 and six months ended June 30, 2008, the increases in net interest income over the comparable periods in 2007 were due to growth in loans and deposits, as our net interest margins in 2008 have been lower than in the comparable periods of 2007.  Our net interest margin of 3.71% in the second quarter of 2008 was lower than the 4.03% recorded in the second quarter of 2007.  For the six months ended June 30, 2008 and 2007, our net interest margin was 3.75% and 4.00%, respectively.  Our net interest margin has been negatively impacted by the Federal Reserve lowering interest rates by a total of 325 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 325 basis point interest rate decrease due to competitive pressures.  Additionally, some of our deposit accounts had rates lower than 3.25% prior to the rate cuts, and thus could not be reduced by 325 basis points.

 The following tables present net interest income analysis on a tax-equivalent basis for the three and six month periods ended June 30, 2008 and 2007.