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: Commission File No. June 30, 2004 0-26589 FIRST NATIONAL LINCOLN CORPORATION (Exact name of registrant as specified in its charter) MAINE 01-0404322 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No) MAIN STREET, DAMARISCOTTA, MAINE 04543 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (207) 563 - 3195 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. Yes [X] No[ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No[ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at August 5, 2004 Common Stock, Par One Cent 7,347,743 FIRST NATIONAL LINCOLN CORPORATION INDEX PART 1 Financial Information Page No. Selected Financial Data .................................... 1 Item 1: Financial Statements (Unaudited) Independent Accountants' Review Report ..................... 2 Financial Statements Consolidated Balance Sheets - June 30, 2004, June 30, 2003 and December 31, 2003 3 - 4 Consolidated Statements of Income - for the six months ended June 30, 2004 and June 30, 2003 .................... 5 Consolidated Statements of Income - for the three months ended June 30, 2004 and June 30, 2003 .................... 6 Consolidated Statements of Changes in Shareholders' Equity - for the six months ended June 30, 2004 and June 30, 2003 7 - 8 Consolidated Statements of Cash Flows - for the six months ended June 30, 2004 and June 30, 2003 .................... 9 - 10 Notes to Consolidated Financial Statements ................. 11 - 15 Item 2: Management's discussion and analysis of financial condition and results of operations .......... 16 - 25 Item 3: Quantitative and qualitative disclosures about market risk ...................................... 26 - 28 Item 4: Controls and Procedures ................................ 29 PART II Other Information Item 1: Legal Proceedings ...................................... 30 Item 2: Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities .................. 31 Item 3: Defaults Upon Senior Securities ........................ 32 Item 4: Submission of Matters to a Vote of Security Holders .... 33 Item 5: Other Information ...................................... 34 Item 6: Exhibits and reports on Form 8-K ....................... 35 Signatures .......................................................... 36 Exhibits .......................................................... 37 - 40 PART I. FINANCIAL INFORMATION FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY SELECTED FINANCIAL DATA (Unaudited) - ----------------------------------------------------------------------------- For the six months For the quarters Dollars in thousands, ended June 30, ended June 30, except for per share amounts 2004 2003 2004 2003 - ----------------------------------------------------------------------------- Summary of Operations Operating Income $16,760 $16,105 $8,537 $8,014 Operating Expense 11,190 11,373 5,660 5,622 Net Interest Income 10,185 8,264 5,233 4,164 Provision for Loan Losses 480 450 240 225 Net Income 3,981 3,408 2,056 1,729 - ----------------------------------------------------------------------------- Per Common Share Data(b) Basic Earnings per Share $0.54 $0.47 $0.28 $0.24 Diluted Earnings per Share 0.53 0.46 0.28 0.23 Cash Dividends Declared 0.21 0.18 0.11 0.09 Book Value 6.74 6.28 6.74 6.28 Market Value 19.50 13.06 19.50 13.06 - ----------------------------------------------------------------------------- Financial Ratios Return on Average Equity (a) 16.37% 15.68% 16.58% 15.60% Return on Average Assets (a) 1.39% 1.35% 1.41% 1.35% Average Equity to Average Assets 8.47% 8.63% 8.51% 8.67% Net Interest Margin Tax-Equivalent (a) 3.92% 3.65% 3.97% 3.63% Dividend Payout Ratio 39.51% 39.01% 39.29% 39.44% Allowance for Loan Losses to Total Loans 1.03% 1.08% 1.03% 1.08% Non-Performing Loans to Total Loans 0.35% 0.30% 0.35% 0.30% Non-Performing Assets to Total Assets 0.27% 0.23% 0.27% 0.23% Efficiency Ratio (c) 48.91% 49.06% 48.60% 48.70% - ----------------------------------------------------------------------------- At Period End Total Assets 613,972 531,127 613,972 531,127 Total Loans 443,433 367,915 443,433 367,915 Total Investment Securities 141,301 128,291 141,301 128,291 Total Deposits 386,573 359,010 386,573 359,010 Total Shareholders' Equity 49,515 45,602 49,515 45,602 - ----------------------------------------------------------------------------- (a) Annualized using a 365-day basis (b) Adjusted for a three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. (c) The Company uses the following formula in calculating its efficiency ratio: Non-Interest Expense - Loss on Securities Sales - ------------------------------------------------------------------------------ Tax-Equivalent Net Interest Income + Non-Interest Income - Gains on Securities - ------------------------------------------------------------------------------ Page 1 ITEM 1. FINANCIAL STATEMENTS INDEPENDENT ACCOUNTANTS' REVIEW REPORT The Board of Directors and Shareholders First National Lincoln Corporation We have reviewed the accompanying interim consolidated financial information of First National Lincoln Corporation and Subsidiary as of June 30, 2004 and 2003, and for the three-month and six-month periods then ended. These financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is to express an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the accompanying financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. Berry, Dunn, McNeil & Parker Portland, Maine August 4, 2004 Page 2 FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (Unaudited) - ------------------------------------------------------------------------------ (000 OMITTED except per share data June 30, June 30, December 31, and number of shares) 2004 2003 2003 - ------------------------------------------------------------------------------ Assets Cash and due from banks $ 13,777 $ 12,973 $ 17,087 Overnight funds sold - 6,100 - ------- ------- ------- Cash and cash equivalents 13,777 19,073 17,087 ------- ------- ------- Investments: Available for sale at market value 53,642 64,339 57,445 Held to maturity at cost (market values $87,248 at 6/30/04, $66,204 at 6/30/03 and $80,820 at 12/31/03) 87,659 63,952 79,244 Loans held for sale (fair value approximates cost) - 1,162 982 Loans 443,433 367,915 398,895 Less: allowance for loan losses 4,580 3,987 4,200 ------- ------- ------- Net loans 438,853 363,928 394,695 ------- ------- ------- Accrued interest receivable 3,055 2,922 2,743 Premises and equipment at cost, net of accumulated depreciation 8,843 7,659 9,007 Other real estate owned 44 75 51 Other assets 8,099 8,017 7,558 ------- ------- ------- Total Assets $ 613,972 $ 531,127 $ 568,812 ======= ======= ======= Page 3 CONSOLIDATED BALANCE SHEETS CONTINUED - ------------------------------------------------------------------------------- June 30, June 30, December 31, 2004 2003 2003 - ------------------------------------------------------------------------------- Liabilities Demand deposits $ 27,504 $ 27,035 $ 28,874 NOW deposits 55,938 49,985 52,161 Money market deposits 78,233 86,566 80,586 Savings deposits 65,336 64,735 63,356 Certificates of deposit 76,170 69,867 69,880 Certificates $100,000 and over 83,392 60,822 64,220 ------- ------- ------- Total deposits 386,573 359,010 359,077 ------- ------- ------- Borrowed funds 173,661 121,933 157,822 Other liabilities 4,223 4,582 4,195 ------- ------- ------- Total Liabilities 564,457 485,525 521,094 ------- ------- ------- Shareholders' Equity Common stock 74 74 74 Additional paid-in capital 3,721 4,638 4,650 Retained earnings 44,006 40,399 42,988 Net unrealized gain on securities available for sale 1,714 2,919 2,497 Treasury stock - (2,428) (2,491) ------- ------- ------- Total Shareholders' Equity 49,515 45,602 47,718 ------- ------- ------- Total Liabilities & Shareholders' Equity $ 613,972 $ 531,127 $ 568,812 ======= ======= ======= - ------------------------------------------------------------------------------- Number of shares authorized 18,000,000 18,000,000 18,000,000 Number of shares issued 7,342,690 7,443,810 7,443,810 Number of shares outstanding 7,342,690 7,266,255 7,264,140 Book value per share $6.74 $6.28 $6.57 - ------------------------------------------------------------------------------- Share and per share data have been adjusted to reflect the three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. - ------------------------------------------------------------------------------- See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. Page 4 FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (Unaudited) - ------------------------------------------------------------------------------ (000 OMITTED except per share data For the six months ended June 30, and number of shares) 2004 2003 - ------------------------------------------------------------------------------ Interest and dividend income Interest and fees on loans $ 11,298 $ 10,591 Interest on deposits with other banks 3 48 Interest and dividends on investments 3,237 3,033 -------- -------- Total interest and dividend income 14,538 13,672 -------- -------- Interest expense Interest on deposits 2,526 3,282 Interest on borrowed funds 1,827 2,126 -------- -------- Total interest expense 4,353 5,408 -------- -------- Net interest income 10,185 8,264 Provision for loan losses 480 450 -------- -------- Net interest income after provision for loan losses 9,705 7,814 -------- -------- Non-interest income: Fiduciary income 430 374 Service charges on deposit accounts 580 565 Mortgage origination and servicing income 250 490 Other operating income 962 1,004 -------- -------- Total other operating income 2,222 2,433 -------- -------- Non-interest expense: Salaries and employee benefits 3,303 2,831 Occupancy expense 428 393 Furniture and equipment expense 754 701 Other 1,872 1,590 -------- -------- Total other operating expenses 6,357 5,515 -------- -------- Income before income taxes 5,570 4,732 Applicable income taxes 1,589 1,324 -------- -------- NET INCOME $ 3,981 $ 3,408 ======== ======== - ----------------------------------------------------------------------------- Earnings per common share Basic earnings per share $0.54 $0.47 Diluted earnings per share $0.53 $0.46 Cash dividends declared per share $0.21 $0.18 Weighted average number of shares outstanding 7,310,150 7,260,078 Incremental shares 147,768 185,370 Share and per share data have been adjusted to reflect the three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. - ----------------------------------------------------------------------------- See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. Page 5 FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (Unaudited) - ------------------------------------------------------------------------------ (000 OMITTED except per share data For the quarters ended June 30, and number of shares) 2004 2003 - ------------------------------------------------------------------------------ Interest and dividend income Interest and fees on loans $ 5,745 $ 5,326 Interest on deposits with other banks - 5 Interest and dividends on investments 1,672 1,473 -------- -------- Total interest and dividend income 7,417 6,804 -------- -------- Interest expense Interest on deposits 1,265 1,578 Interest on borrowed funds 919 1,062 -------- -------- Total interest expense 2,184 2,640 -------- -------- Net interest income 5,233 4,164 Provision for loan losses 240 225 -------- -------- Net interest income after provision for loan losses 4,993 3,939 -------- -------- Non-interest income: Fiduciary income 216 185 Service charges on deposit accounts 310 298 Mortgage origination and servicing income 85 198 Other operating income 509 529 -------- -------- Total other operating income 1,120 1,210 -------- -------- Non-interest expense: Salaries and employee benefits 1,640 1,419 Occupancy expense 216 201 Furniture and equipment expense 389 343 Other 991 794 -------- -------- Total other operating expenses 3,236 2,757 -------- -------- Income before income taxes 2,877 2,392 Applicable income taxes 821 663 -------- -------- NET INCOME $ 2,056 $ 1,729 ======== ======== - ----------------------------------------------------------------------------- Earnings per common share Basic earnings per share $0.28 $0.24 Diluted earnings per share $0.28 $0.23 Cash dividends declared per share $0.11 $0.09 Weighted average number of shares outstanding 7,320,965 7,263,795 Incremental shares 151,025 189,507 Share and per share data have been adjusted to reflect the three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. - ----------------------------------------------------------------------------- See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. Page 6 FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) <table> <caption> - ---------------------------------------------------------------------------------------------- For the six months ended June 30, 2004 - ---------------------------------------------------------------------------------------------- (000 omitted except for share data) Net unrealized gain Total Number of Additional on securities share- common Common paid-in Retained available Treasury holders' shares stock capital earnings for sale stock equity <s> <c> <c> <c> <c> <c> <c> <c> - ---------------------------------------------------------------------------------------------- Balance at December 31, 2003 7,264,140 $74 $4,650 $42,988 $2,497 $(2,491) $47,718 --------- --- ------ ------- ----- ------- ------- Net income - - - 3,981 - - 3,981 Net unrealized gain (loss) on securities available for sale, net of tax benefit of $403 - - - - (783) - (783) --------- --- ------ ------ ------ ------- ------- Comprehensive income - - - 3,981 (783) - 3,198 Cash dividends declared - - - (1,567) - - (1,567) Treasury stock purchases (24,345) - - - - (404) (404) Treasury stock sales 102,895 - (877) - - 1,447 570 Retirement of treasury stock - - (52) (1,396) - 1,448 - --------- --- ------ ------- ------ ------- -------- Balance at June 30, 2004 7,342,690 $74 $3,721 $44,006 $1,714 $ - $49,515 ========= === ====== ======= ====== ======= ======= - ---------------------------------------------------------------------------------------------- Share and per share data have been adjusted to reflect the three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. Page 7 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY, CONTINUED - --------------------------------------------------------------------------------------------- For the six months ended June 30, 2003 - ---------------------------------------------------------------------------------------------- (000 omitted except for share data) Net unrealized gain Total Number of Additional on securities share- common Common paid-in Retained available Treasury holders' shares stock capital earnings for sale stock equity - ---------------------------------------------------------------------------------------------- Balance at December 31, 2002 7,244,079 $74 $4,638 $38,322 $2,170 $(2,509) $42,695 --------- --- ------ ------- ----- ------- ------- Net income - - - 3,408 - - 3,408 Net unrealized gain on securities available for sale, net of taxes of $386 - - - - 749 - 749 --------- --- ------ ------ ------ ------- ------- Comprehensive income - - - 3,408 749 - 4,157 Cash dividends declared - - - (1,331) - - (1,331) Treasury stock purchases (15,042) - - - - (170) (170) Treasury stock sales 37,218 - - - - 251 251 --------- --- ------ ------- ------ ------- -------- Balance at June 30, 2003 7,266,255 $74 $4,638 $40,399 $2,919 $(2,428) $45,602 ========= === ====== ======= ====== ======= ======= - ---------------------------------------------------------------------------------------------- Share and per share data have been adjusted to reflect the three-for-one stock split, in the form of a 200% stock dividend, payable June 1, 2004, to shareholders of record on May 12, 2004. See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. </table> Page 8 FIRST NATIONAL LINCOLN CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) - ------------------------------------------------------------------------------- For the six months ended June 30, (000 omitted) 2004 2003 - ------------------------------------------------------------------------------- Cash flows from operating activities Net income $ 3,981 $ 3,408 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 522 498 Provision for loan losses 480 450 Loans originated for resale (8,372) (32,742) Proceeds from sales and transfers of loans 9,354 34,193 Net gain on sale of other real estate owned - (24) Net increase in other assets and accrued interest (515) (1,525) Net increase in other liabilities 431 362 Net amortization (accretion) of premiums (discounts) on investments 94 81 ------ ------ Net cash provided by operating activities 5,975 4,701 ------ ------ Cash flows from investing activities Proceeds from maturities, payments and calls of securities available for sale 3,415 8,526 Proceeds from maturities, payments and calls of securities to be held to maturity 26,863 21,567 Proceeds from sales of other real estate owned 7 204 Purchases of securities available for sale (823) (15,311) Purchases of securities to be held to maturity (35,347) (19,946) Net increase in loans (44,638) (36,004) Capital expenditures (780) (324) ------ ------ Net cash used in investing activities (51,303) (41,288) ------ ------ Cash flows from financing activities Net increase in demand deposits, savings, money market and club accounts 2,034 15,522 Net increase in certificates of deposit 25,462 9,264 Advances on long-term borrowings 8,216 25,000 Repayment on long-term borrowings (16,000) (12,000) Net increase (decrease) in short-term borrowings 23,623 (4,432) Payment to repurchase common stock (404) (170) Proceeds from sale of treasury stock 570 251 Dividends paid (1,483) (1,281) ------ ------ Net cash provided by financing activities 42,018 32,154 ------ ------ Page 9 CONSOLIDATED STATEMENTS OF CASH FLOWS CONTINUED - ------------------------------------------------------------------------------- For the six months ended June 30, 2004 2003 - ------------------------------------------------------------------------------- Net decrease in cash and cash equivalents (3,310) (4,433) Cash and cash equivalents at beginning of period 17,087 23,506 ------ ------ Cash and cash equivalents at end of period $13,777 $19,073 ====== ====== - ------------------------------------------------------------------------------- Interest paid $ 4,314 $ 5,501 Income taxes paid 1,607 1,139 Non-cash transactions Change in net unrealized gain on available for sale securities (1,186) 1,135 - ------------------------------------------------------------------------------- See Independent Accountants' Review Report. The accompanying notes are an integral part of these consolidated financial statements. Page 10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION First National Lincoln Corporation (the Company) is a financial holding company that owns all of the common stock of The First National Bank of Damariscotta (the Bank). The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of Management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. All significant intercompany transactions and balances are eliminated in consolidation. The income reported for the 2004 period is not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2003. NOTE 2 - COMMON STOCK On April 27, 2004, the Company's Board of Directors declared a three-for-one split of the Company's common stock payable in the form of a 200% stock dividend to shareholders of record on May 12, 2004, with a payment date of June 1, 2004. All share and per share data included in the consolidated financial statements and elsewhere in this report have been restated to reflect the stock split. A summary of the status of the Company's Stock Option Plan as of June 30, 2004, and changes during the six months then ended, is presented below. - ------------------------------------------------------------------------------- Number of Weighted Average Shares Exercise Price - ------------------------------------------------------------------------------- Balance at December 31, 2003 294,600 $4.41 Granted during the period 0 0 Exercised during the period (86,100) 3.41 Forfeited during the period (3,000) 6.17 ------- ------ Balance at June 30, 2004 205,500 $4.81 ======= ====== - ------------------------------------------------------------------------------- Page 11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 3 - EARNINGS PER SHARE The following table sets forth the computation of basic and diluted earnings per share for the six months ended June 30, 2004 and 2003: - ----------------------------------------------------------------------------- For the six months ended June 30, 2004 - ----------------------------------------------------------------------------- In thousands, except for number of Income Shares Per-Share shares and per share data (Numerator) (Denominator) Amount - ----------------------------------------------------------------------------- Net income as reported $ 3,981 ------- Basic EPS: Income available to common shareholders $ 3,981 7,310,150 $ 0.54 Effect of dilutive securities: incentive stock options 147,768 ------- --------- ------ Diluted EPS: Income available to common shareholders plus assumed conversions $ 3,981 7,457,918 $ 0.53 ======= ========= ====== - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- For the six months ended June 30, 2003 - ----------------------------------------------------------------------------- In thousands, except for number of Income Shares Per-Share shares and per share data (Numerator) (Denominator) Amount - ----------------------------------------------------------------------------- Net income as reported $ 3,408 ------- Basic EPS: Income available to common shareholders $ 3,408 7,260,078 $ 0.47 Effect of dilutive securities: incentive stock options 185,370 ------- --------- ------ Diluted EPS: Income available to common shareholders plus assumed conversions $ 3,408 7,445,448 $ 0.46 ======= ========= ====== - ----------------------------------------------------------------------------- All earnings per share calculations have been made using the weighted average number of shares outstanding during the period. All of the dilutive securities are incentive stock options granted to certain key members of Management. The dilutive number of shares has been calculated using the treasury method, assuming that all granted options were exercisable at the end of each period. Page 12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED The following table sets forth the computation of basic and diluted earnings per share for the three months ended June 30, 2004 and 2003: - ----------------------------------------------------------------------------- For the three months ended June 30, 2004 - ----------------------------------------------------------------------------- In thousands, except for number of Income Shares Per-Share shares and per share data (Numerator) (Denominator) Amount - ----------------------------------------------------------------------------- Net income as reported $ 2,056 ------- Basic EPS: Income available to common shareholders $ 2,056 7,320,965 $ 0.28 Effect of dilutive securities: incentive stock options 151,025 ------- --------- ------ Diluted EPS: Income available to common shareholders plus assumed conversions $ 2,056 7,471,990 $ 0.28 ======= ========= ====== - ----------------------------------------------------------------------------- - ----------------------------------------------------------------------------- For the three months ended June 30, 2003 - ----------------------------------------------------------------------------- In thousands, except for number of Income Shares Per-Share shares and per share data (Numerator) (Denominator) Amount - ----------------------------------------------------------------------------- Net income as reported $ 1,729 ------- Basic EPS: Income available to common shareholders $ 1,729 7,263,795 $ 0.24 Effect of dilutive securities: incentive stock options 189,507 ------- --------- ------ Diluted EPS: Income available to common shareholders plus assumed conversions $ 1,729 7,453,302 $ 0.23 ======= ========= ====== - ----------------------------------------------------------------------------- All earnings per share calculations have been made using the weighted average number of shares outstanding during the period. All of the dilutive securities are incentive stock options granted to certain key members of Management. The dilutive number of shares has been calculated using the treasury method, assuming that all granted options were exercisable at the end of each period. Page 13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 4 - COMPREHENSIVE INCOME Total comprehensive income for the six months ended June 30, 2004 and 2003 is as follows: - ----------------------------------------------------------------------------- For the six months ended June 30, Dollars in thousands 2004 2003 - ----------------------------------------------------------------------------- Net income $ 3,981 $ 3,408 Net unrealized gain (loss) on securities available for sale, net of deferred tax benefit of $403 in 2004 and deferred taxes of $386 in 2003 (783) 749 ------- ------ Comprehensive income $ 3,198 $ 4,157 ======= ====== - ----------------------------------------------------------------------------- NOTE 5 - TREASURY STOCK A revision to the Maine Business Corporation Act requires that stock reacquired by a corporation be classified as "authorized but unissued", effectively eliminating a corporation's ability to hold treasury stock. In order to recognize the effect of the revision, the Company retired its treasury stock as of June 30, 2004. The 101,120 shares so retired are available for reissuance as authorized, but unissued shares. NOTE 6 - POST RETIREMENT BENEFIT PLANS The Bank sponsors two post retirement benefit plans. One plan provides health insurance benefits to employees hired prior to June 30, 1988 and who retired before June 30, 1996. The other plan provides life insurance coverage to employees who retired prior to December 31, 2002. The Bank also provides health insurance for retired directors. None of these plans are pre-funded. The Bank elected to recognize the accumulated postretirement benefit obligation as of January 1, 1993 of $578,000 as a component of net periodic post retirement benefit cost over a 20-year period. In December 2003, the President signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) into law. The Act includes the following two new features to Medicare (Medicare Part D) that could affect the measurement of the accumulated postretirement benefit obligation (APBO) and net periodic postretirement benefit cost for the Plan: a subsidy to plan sponsors that is based on 28% of an individual beneficiary's annual prescription drug costs between $250 and $5,000 and the opportunity for a retiree to obtain a prescription drug benefit under Medicare. The effects of the Act on the APBO or net periodic postretirement benefit cost are not reflected in the financial statements or accompanying notes. Pending specific authoritative guidance on the accounting for the federal subsidy could require the Company to change previously reported information when the guidance is issued. The following tables set forth the net periodic pension cost: Page 14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- For the six months For the three months ended June 30, ended June 30, In thousands of dollars 2004 2003 2004 2003 - ------------------------------------------------------------------------------- Components of net periodic benefit cost Service cost $ 4 $ 2 $ 2 $ 1 Interest cost 16 18 8 9 Amortization of unrecognized transition obligation 14 14 7 7 Amortization of prior service cost 2 (2) 1 (1) Amortization of accumulated gains 2 2 1 1 --- --- --- --- Net periodic benefit cost $38 $34 $19 $17 === === === === - ------------------------------------------------------------------------------- A weighted average discount rate of 7.0% was used in determining both the accumulated benefit obligation and the net benefit cost. The measurement date for benefit obligations was as of year-end for both years presented. The estimated amount of related benefit expense in 2004 is $76,000. NOTE 7 - RECENT ACCOUNTING DEVELOPMENTS In May 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) No. 106-2. The FSP supersedes FSP No. 106-1, which was issued to address the accounting impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act). The Act includes a prescription drug benefit under Medicare Part D and a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FSP No. 106-2 applies only to sponsors of single-employer plans for which (1) the employer concludes that prescription drug benefits under the plan are actuarially equivalent to Medicare Part D and thus qualify for the subsidy, and (2) the expected amount of the subsidy will offset or reduce the employer- sponsor's share of the plan's prescription drug coverage. The FSP provides accounting guidance and required disclosures. For public companies, the FSP is effective for the first interim or annual period beginning after June 15, 2004. Management has not determined the effect of FSP 106-2 on the Company's Consolidated Financial Statements. Page 15 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES Management's discussion and analysis of the Company's financial condition is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such financial statements requires Management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, Management evaluates its estimates, including those related to the allowance for loan losses. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about the carrying values of assets that are not readily apparent from other sources. Actual results could differ from the amount derived from Management's estimates and assumptions under different assumptions or conditions. Management believes the allowance for loan losses is a critical accounting policy that requires the most significant estimates and assumptions used in the preparation of the consolidated financial statements. The allowance for loan losses is based on Management's evaluation of the level of the allowance required in relation to the estimated loss exposure in the loan portfolio. Management believes the allowance for loan losses is a significant estimate and therefore regularly evaluates it for adequacy by taking into consideration factors such as prior loan loss experience, the character and size of the loan portfolio, business and economic conditions and Management's estimation of potential losses. The use of different estimates or assumptions could produce different provisions for loan losses. The valuation of mortgage servicing rights is also a critical accounting policy which requires significant estimates and assumptions. The Bank often sells mortgage loans it originates and retains the ongoing servicing of such loans, receiving a fee for these services, generally 0.25% of the outstanding balance of the loan per annum. Mortgage servicing rights are recognized when they are acquired through sale of loans and are reported in other assets. They are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Management uses an independent firm which specializes in the valuation of mortgage servicing rights to determine the fair value which is recorded on the balance sheet. This includes an evaluation for impairment based upon the fair value of the rights, which can vary depending upon current interest rates and prepayment expectations, as compared to amortized cost. Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms. The use of different assumptions could produce a different valuation for both mortgage servicing rights and impairment. Page 16 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED EXECUTIVE SUMMARY Net income for the six months ended June 30, 2004 was $3,981,000 an increase of 16.8% over net income of $3,408,000 in the comparable period of 2003. The Company's increase in net income for the first six months of 2004 in comparison to 2003 was the result of a 23.2% increase in net interest income due to wider margins and growth in earning assets. In addition to a decline in non-interest income due to decreased mortgage origination activity, the Company saw a controlled level of increase in operating expenses in line with growth in revenues. Fully diluted earnings per share for the first six months of 2004 were $0.53, a 15.2% increase over the $0.46 reported for the first six months of 2003. Net income for the three months ended June 30, 2004 was $2,056,000, an increase of 18.9% over net income of $1,729,000 in the comparable period of 2003. The Company's increase in net income for the three months ended June 30, 2004 in comparison to 2003 was the result of a 25.7% increase in net interest income due to wider margins and growth in earning assets. In addition to a decline in non-interest income due to decreased mortgage origination activity, the Company saw a controlled level of increase in operating expenses in line with growth in revenues. Fully diluted earnings per share for the three months ended June 30, 2004 were $0.28, a 21.7% increase over the $0.23 reported for the second quarter of 2003. NET INTEREST INCOME Total interest income of $14,538,000 for the six months ended June 30, 2004 is a 6.3% increase from total interest income of $13,672,000 in the comparable period of 2003. While the low interest rate climate resulted in lower asset yields, this was more than offset by increased interest income from strong growth in the level of earning assets and lower liability costs. Total interest expense of $4,353,000 for the first six months of 2004 is a 19.5% decrease from total interest expense of $5,408,000 for the first six months of 2003. This was a direct result of the low interest rate climate. The combination of lower interest rates and asset growth resulted in net interest income of $10,185,000 for the six months ended June 30, 2004, a 23.2% increase from the $8,264,000 reported for the same period in 2003. The Company's net interest margin on a tax-equivalent basis increased from 3.65% in the first six months of 2003 to 3.92% in the first six months of 2004. Tax-exempt interest income amounted to $1,008,000 and $909,000 for the six months ended June 30, 2004 and 2003, respectively. Tax equivalency is calculated using a 35% effective tax rate. These results are consistent with the widening which occurred in the Company's net interest margin beginning in the third quarter of 2003 after repricing a significant amount of liabilities in the second and third quarters of 2003. Total interest income of $7,417,000 for the three months ended June 30, 2004 is a 9.0% increase from total interest income of $6,804,000 in the comparable period of 2003. While the low interest rate climate resulted in lower asset yields, this was more than offset by increased interest income from strong gowth in the level of earning assets and lower lisability costs. At the same time, total interest expense of $2,184,000 for the three months ended June 30, 2004 is a 17.3% decrease from total interest expense of $2,640,000 for the second quarter of 2003. This was a direct result of the low interest rate climate brought on by Federal Reserve Board actions. Page 17 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED The combination of a wider net interest margin and asset growth resulted in net interest income of $5,233,000 for the three months ended June 30, 2004, a 25.7% increase from the $4,164,000 reported for the same period in 2003. The Company's net interest margin on a tax-equivalent basis increased from 3.63% in the three months ended June 30, 2003 to 3.97% for the three months ended June 30, 2004. Tax-exempt interest income amounted to $521,000 and $482,000 for the three months ended June 30, 2004 and 2003, respectively. Tax equivalency is calculated using a 35% effective tax rate. These results are consistent with the widening which occurred in the Company's net interest margin beginning in the third quarter of 2003 after repricing a significant amount of liabilities in the second and third quarters of 2003. The following table presents the effect of tax-exempt income on the calculation of the net interest margin: - ------------------------------------------------------------------------------ For the six months For the three months ended June 30, ended June 30, (in thousands) 2004 2003 2004 2003 - ------------------------------------------------------------------------------ Net interest income as presented $10,185 $ 8,264 $ 5,233 $ 4,164 Effect of tax-exempt income 543 490 281 259 ----- ----- ----- ----- Net interest income, tax equivalent $10,728 $ 8,754 $ 5,514 $ 4,423 ===== ===== ===== ===== - ------------------------------------------------------------------------------ PROVISION FOR LOAN LOSSES A $480,000 provision to the allowance for loan losses was made during the first six months of 2004, a $30,000 increase from the $450,000 provision made for the same period of 2003. The slightly higher level of provision in 2004 compared to 2003 is in line with the Company's loan growth and is not indicative of a decline in overall asset quality. NON-INTEREST INCOME Non-interest income was $2,222,000 for the six months ended June 30, 2004, a decrease of 8.7% from the $2,433,000 reported for the first six months of 2003. The decrease in non-interest income was due primarily to a decline in income related to mortgage sales. While demand for residential mortgages remained strong in the first six months of 2004, much of new mortgage production was in variable-rate loans and the Bank opted to retain a significant amount in its portfolio given the opportunity to increase earning assets without taking on substantial interest rate risk. Non-interest income was $1,120,000 for the three months ended June 30, 2004, a decrease of 7.4% from the $1,210,000 reported for the same period in 2003. The decrease in non-interest income was due primarily to a decline in income related to mortgage sales. Page 18 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED NON-INTEREST EXPENSE Non-interest expense of $6,357,000 for the six months ended June 30, 2004, is an increase of 15.3% over non-interest expense of $5,515,000 for the first six months of 2003. This increase is primarily due to higher personnel and premises costs to provide more comprehensive and competitive services for customers, as well as increased costs for supplies and professional fees, in line with the Company's revenue and asset growth. Non-interest expense of $3,236,000 for the three months ended June 30, 2004, is an increase of 17.4% over non-interest expense of $2,757,000 for the same period in 2003. This level of increase in non-interest expense for the quarter was for the same reasons cited above. INCOME TAXES Income taxes on operating earnings increased to $1,589,000 for the first six months of 2004 from $1,324,000 for the same period a year ago. The increase is in line with the increase in pre-tax income. Page 19 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED AVERAGE DAILY BALANCE SHEET The following table shows the Company's average daily balance sheets for the six-month periods ended June 30, 2004 and 2003 - -------------------------------------------------------------------------- Six-Month Periods ended June 30, Dollars in thousands 2004 2003 - -------------------------------------------------------------------------- Cash and due from banks $ 11,343 $ 9,396 Overnight funds sold 836 9,927 Investments U.S. Treasury securities & government agencies 59,181 47,437 Obligations of states & political subdivisions 33,319 27,695 Other securities 42,680 48,228 --------- --------- Total investments 135,180 123,360 --------- --------- Loans held for sale - 2,145 --------- --------- Loans Commercial 143,064 128,379 Consumer 26,027 26,748 State and municipal 8,757 11,850 Real estate 235,549 181,826 --------- --------- Total loans 413,397 348,803 Allowance for loan losses (4,334) (3,804) --------- --------- Net loans 409,063 344,999 --------- --------- Bank premises and equipment, net 9,001 7,832 Other assets 10,420 10,000 --------- --------- Total assets $575,843 $ 507,659 ========= ========= Deposits Demand $ 26,898 $ 24,115 NOW 52,796 48,233 Money market 80,739 87,441 Savings 63,508 60,808 Certificates of deposit 75,011 69,615 Certificates of deposit over $100,000 81,242 51,412 --------- --------- Total deposits 380,194 341,624 --------- --------- Borrowed funds 142,270 117,912 Other liabilities 4,607 4,306 --------- --------- Total liabilities 527,071 463,842 --------- --------- Common stock 74 74 Additional paid-in capital 4,319 4,638 Retained earnings 43,849 39,307 Net unrealized gain on securities available for sale 2,620 2,254 Treasury stock (2,090) (2,456) --------- --------- Total shareholders' equity 48,772 43,817 --------- --------- Total liabilities and shareholders' equity $575,843 $ 507,659 ========= ========= MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED INVESTMENTS The Company's investment portfolio increased by $4.6 million or 3.4% between December 31, 2003, and June 30, 2004. A portion of the portfolio consists of callable securities, some of which were called by issuers and replaced at lower yields. At June 30, 2004, the Company's available-for-sale portfolio had an unrealized gain, net of taxes, of $1.7 million, which is in line with the interest rate climate. LOANS Loans grew by $44.5 million or 11.2% during the first six months of 2004. The growth in commercial loans was $12.4 million or 9.0% and municipal loans increased $4.1 million or 45.2%. The residential mortgage portfolio increased by $20.9 million or 12.0%, and home equity lines of credit grew $6.7 million or 12.8% year-to-date. Between June 30, 2003 and June 30, 2004, the loan portfolio increased $75.5 million or 20.5%, as a result of strong customer demand. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses represents the amount available for credit losses inherent in the Company's loan portfolio. Loans are charged off when they are deemed uncollectible, after giving consideration to factors such as the customer's financial condition, underlying collateral and guarantees, as well as general and industry economic conditions. In general, the Company determines the appropriate overall reserve for loan losses based upon periodic, systematic reviews of its portfolio to identify inherent losses and Management's judgment about various qualitative factors. These reviews result in the identification and quantification of loss factors, which are used in determining the amount of the allowance for loan losses. The Company periodically evaluates prevailing economic and business conditions, industry concentrations, changes in the size and characteristics of the portfolio and other pertinent factors. Portions of the allowance for loan losses are quantified to cover the estimated losses inherent in each loan category based on the results of this detailed review process. Commercial loans are individually reviewed and assigned a credit risk rating from "1" (low risk of loss) to "8" (high risk of loss). For non-impaired loans with a credit risk rating of "1" to "7", estimated loss factors based on historical loss experience (ranging from two to five years) are used to calculate a loan loss reserve for each credit risk rating classification. Qualitative adjustments are also made based upon Management's assessment of prevailing economic conditions, trends in volumes and terms of loans, levels and trends in delinquencies and non-accruals, and the effect of changes in lending policies. A specific allocation is made for impaired loans (loans on non-accrual status, as well as loans with a credit risk rating of "8"), which are measured at the net present value of future cash flows, discounted at the loan's effective interest rate, or at fair market value of collateral if the loan is collateral dependent. The combination of these analyses is the basis for the determination of the commercial loan portion of the allowance for loan losses. Consumer loans, which include residential mortgages, home equity loans/lines, and direct/indirect loans, are generally evaluated as a group based on product type. The determination of the consumer loan portion of the allowance for loan losses is based on a five-year average of annual historical losses, adjusted for the qualitative factors noted above. Page 21 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED The results of the analyses are reviewed and discussed by the Directors' Loan Committee. An integral component of the Company's risk management process is to ensure the proper quantification of the allowance for loan losses based upon an analysis of risk characteristics, demonstrated losses, loan segmentations, and other factors. Allowance methodology is reviewed on a periodic basis and modified as appropriate. The unallocated component of the allowance for loan losses represents Management's view that, given the complexities of the loan portfolio, there are estimable losses that have been incurred within the portfolio but not yet specifically identified. Based on this analysis, including the aforementioned assumptions, the Company believes that the allowance for loan losses is adequate as of June 30, 2004. As of that date, the balance of $4,580,000 was 1.03% of total loans, compared to 1.05% at December 31, 2003 and 1.08% at June 30, 2003. Loans considered to be impaired according to SFAS 114/118 totalled $1,566,000 at June 30, 2004, compared to $1,537,000 at December 31, 2003. The portion of the allowance for loan losses allocated to impaired loans at June 30, 2004, was $240,000 compared to $204,000 at December 31, 2003. DEPOSITS During the first six months of 2004, deposits increased by $27.5 million or 7.7% over December 31, 2003. Core deposits (demand, NOW, savings and money market accounts) increased by $2.0 million or 0.9% in the first six months of 2004, which is in line with the regular seasonal pattern experienced in the first quarter. During the same period, certificates of deposit increased $25.5 million, primarily due to pricing strategies which resulted in attracting low- cost short-term time deposits. Between June 30, 2003, and June 30, 2004, deposits grew by 7.7%, or $27.6 million. Demand deposits grew $0.5 million, NOW accounts $6.0 million, savings $0.6 million, and money market accounts decreased $8.3 million, while certificates of deposit increased $28.9 million. The increase in certificates of deposit was primarily from wholesale and brokered CD's. BORROWED FUNDS The Company's funding includes borrowings from the Federal Home Loan Bank, the Federal Reserve System, and repurchase agreements, enabling it to grow its balance sheet and, in turn, grow its revenues. They may also be used to carry out interest rate risk management stategies, and are increased to replace or supplement other sources of funding, including core deposits and certificates of deposit. During the six months ended June 30, 2004, borrowed funds increased by $15.8 million or 10.0% from December 31, 2003. Between June 30, 2003 and June 30, 2004, borrowed funds increased $51.7 million or 42.4% to fund the level of asset growth which exceeded the level of deposit growth. SHAREHOLDERS' EQUITY Shareholders' equity as of June 30, 2004 was $49.5 million, compared to $47.7 million as of December 31, 2003. The Company's strong earnings performance in the first six months of 2004 provided a significant addition to retained earnings. The net unrealized gain on available-for-sale securities, presented in accordance with SFAS 115, has decreased by $0.8 million since December 31, 2003, as a result of a recent rise in interest rates. Page 22 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED On April 27, 2004, the Company's Board of Directors declared a three-for- one split of the Company's common stock payable in the form of a 200% stock dividend to shareholders of record on May 12, 2004, with a payment date of June 1, 2004. All share and per share data included in the consolidated financial statements and elsewhere in this report have been restated to reflect the stock split. During 2003, the Company increased its dividend each quarter to end the year at a quarterly dividend rate of 10.0 cents per share. In 2004, a cash dividend of 10.3 cents per share was declared in the first quarter compared to 9.0 cents in the first quarter of 2003, and a cash dividend of 11.0 cents per share was declared in the second quarter of 2004 compared to 9.3 cents in the second quarter of 2003. Regulatory leverage capital ratios for the Company were 7.95% and 8.06% at June 30, 2004 and December 31, 2003, respectively. The Company had a tier one risk-based capital ratio of 11.51% and tier two risk-based capital ratio of 12.62% at June 30, 2004, compared to 11.82% and 12.92%, respectively, at December 31, 2003. These are comfortably above the standards to be rated "well- capitalized" by regulatory authorities -- qualifying the Company for lower deposit-insurance premiums. On September 23, 2002, the Company announced that its Board of Directors authorized the repurchase of up to 5.0% of the outstanding shares of the Company's common stock, or slightly more than 360,000 shares. The Company expects such repurchases to be effected from time to time, in the open market, in private transactions or otherwise, during a period of up to 24 months. The amount and timing of shares to be purchased will be subject to market conditions and will be based on several factors, including the price of the Company's stock and the level of stock issuances under the Company's employee stock plans. No assurance can be given as to the specific timing of the share repurchases or as to whether and to what extent the share repurchase will be consummated. In Management's opinion, the Company has adequate capital resources to undertake this repurchase plan. As of June 30, 2004, the Company had repurchased 131,778 shares under the 2002 repurchase plan - including 24,345 shares in the first six months of 2004. A revision to the Maine Business Corporation Act requires that stock reacquired by a corporation be classified as "authorized but unissued", effectively eliminating a corporation's ability to hold treasury stock. In order to recognize the effect of the revision, the Company retired its treasury stock as of June 30, 2004. The 101,120 shares so retired are available for reissuance as authorized, but unissued shares. Page 23 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED CONTRACTUAL OBLIGATIONS The following table sets forth the contractual obligations of the Company as of June 30, 2004: - ------------------------------------------------------------------------------- Less than 1-3 4-5 More than Dollars in thousands Total 1 Year Years Years 5 Years - ------------------------------------------------------------------------------- Borrowed funds $ 151,687 101,971 22,000 - 27,716 Operating leases 204 80 94 30 - Certificates of deposit 159,562 129,048 27,020 3,494 - ------- ------- ------ ------ ------ Total $ 311,453 231,099 49,114 3,524 27,716 ======= ======= ====== ====== ====== Commitments to extend credit and unused lines of credit $ 84,806 84,806 - - - - ------------------------------------------------------------------------------- LIQUIDITY MANAGEMENT As of June 30, 2004 the Bank had primary sources of liquidity of $58.6 million and an additional $108.1 million of secondary sources. It is Management's opinion that this is adequate. In its Asset/Liability policy, the Bank has adopted guidelines for liquidity. The Company is not aware of any recommendations by the regulatory authorities which, if they were to be implemented, would have a material effect on the Corporation's liquidity, capital resources or results of operations. NON-PERFORMING ASSETS At June 30, 2004, loans on non-accrual status totaled $1.6 million, which compares to non-accrual loans of $1.5 million as of December 31, 2003. In addition to loans on non-accrual status at June 30, 2004, loans past due 90 days or more and accruing (calculated on a constant 30-day month basis) totaled $241,000, which compares to $378,000 as of December 31, 2003. The Company continues to accrue interest on these loans because it believes collection of the interest is reasonably assured. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS No material off-balance sheet risk exists that requires a separate liability presentation. SALE OF LOANS No recourse obligations have been incurred in connection with the sale of loans. Page 24 MANAGEMENT'S DISCUSSION AND ANALYSIS, CONTINUED FORWARD-LOOKING STATEMENTS Certain disclosures in Management's Discussion and Analysis of Financial Condition and Results of Operations contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). In preparing these disclosures, Management must make assumptions, including, but not limited to, the level of future interest rates, prepayments on loans and investment securities, required levels of capital, needs for liquidity, and the adequacy of the allowance for loan losses. These forward-looking statements may be subject to significant known and unknown risks uncertainties, and other factors, including, but not limited to, those matters referred to in the preceding sentence. Although First National Lincoln Corporation believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results discussed in these forward-looking statements. Readers are cautioned not to place undue reliance on these forward looking statements, which speak only as of the date hereof. The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Readers are also urged to carefully review and consider the various disclosures made by the Company which attempt to advise interested parties of the facts which affect the Company's business. Page 25 Item 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK MANAGEMENT Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. First National Lincoln Corporation's market risk is composed primarily of interest rate risk. The Bank's Asset/Liability Committee (ALCO) is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. All guidelines and policies established by ALCO have been approved by the Board of Directors. ASSET/LIABILITY MANAGEMENT The primary goal of asset/liability management is to maximize net interest income within the interest rate risk limits set by ALCO. Interest rate risk is monitored through the use of two complementary measures: static gap analysis and earnings simulation modeling. While each measurement has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap analysis measures the amount of repricing risk embedded in the balance sheet at a point in time. It does so by comparing the differences in the repricing characteristics of assets and liabilities. A gap is defined as the difference between the principal amount of assets and liabilities which reprice within a specified time period. The Bank's cumulative one-year gap, at June 30, 2004, was -6.8% of total assets. ALCO's policy limit for the one-year gap is plus or minus 20% of total assets. Core deposits with non-contractual maturities are presented based upon historical patterns of balance attrition and pricing behavior which are reviewed at least annually. The gap repricing distributions include principal cash flows from residential mortgage loans and mortgage-backed securities in the time frames in which they are expected to be received. Mortgage prepayments are estimated by applying industry median projections of prepayment speeds to portfolio segments based on coupon range and loan age. Page 26 QUANTITATIVE AND QUALITATIVE MARKET RISK, CONTINUED A summary of the Bank's static gap, as of June 30, 2004, is presented in the following table: - ------------------------------------------------------------------------------- 0-90 91-365 1-5 5+ Dollars in thousands days days years years - ------------------------------------------------------------------------------- Investment securities at amortized cost $ 19,178 25,083 62,724 31,039 Loans held for sale - - - - Loans 171,057 75,468 153,410 43,498 Other interest-earning assets 4,737 - - - Non-rate-sensitive assets - - - 27,798 -------- -------- -------- -------- Total assets $ 194,972 100,551 216,134 102,335 -------- -------- -------- -------- Interest-bearing deposits 141,624 67,944 30,514 118,987 Borrowed funds 93,653 30,292 22,000 27,716 Non-rate-sensitive liabilities and equity 829 2,857 20,804 56,772 -------- -------- -------- -------- Total liabilities and equity $ 236,106 101,093 73,318 203,475 -------- -------- -------- -------- Period gap $ (41,134) (542) 142,816 (101,140) ========= ======== ======== ======== Percent of total assets -6.70% -0.09% 23.26% -16.47% Cumulative gap (current) $ (41,134) (41,676) 101,140 - Percent of total assets -6.70% -6.79% 16.47% 0.0% - ------------------------------------------------------------------------------- The earnings simulation model forecasts captures the impact of changing interest rates on one-year and two-year net interest income. The modeling process calculates changes in interest income received and interest expense paid on all interest-earning assets and interest-bearing liabilities reflected on the Company's balance sheet. None of the assets used in the simulation are held for trading purposes. The modeling is done for a variety of scenarios that incorporate changes in the absolute level of interest rates as well as basis risk, as represented by changes in the shape of the yield curve and changes in interest rate relationships. Management evaluates the effects on income of alternative interest rate scenarios against earnings in a stable interest rate environment. This analysis is also most useful in determining the short-run earnings exposures to changes in customer behavior involving loan payments and deposit additions and withdrawals. The Bank's most recent simulation model projects net interest income would increase by approximately 1.50% of stable-rate net interest income if rates fall gradually by one percentage point over the next year, and decrease by approximately 6.14% if rates rise gradually by two percentage points. Both scenarios are well within ALCO's policy limit of a decrease in net interest income of no more than 10.0% given a 2.0% move in interest rates, up or down. Management believes this reflects a reasonable interest rate risk position. In year two, and assuming no additional movement in rates, the model forecasts that net interest income would be higher than that earned in a stable rate environment by 4.88% in a falling-rate scenario and decrease by 10.44% in a rising rate scenario when compared to the year-one base scenario. Page 27 QUANTITATIVE AND QUALITATIVE MARKET RISK, CONTINUED A summary of the Bank's interest rate risk simulation modeling, as of June 30, 2004 is presented in the following table: - ------------------------------------------------------------- Changes in Net Interest Income 2004 - ------------------------------------------------------------- Year 1 Projected change if rates decrease by 1.0% +1.50% Projected change if rates increase by 2.0% -6.14% - ------------------------------------------------------------- Year 2 Projected change if rates decrease by 1.0% +4.88% Projected change if rates increase by 2.0% -10.44% - ------------------------------------------------------------- This dynamic simulation model includes assumptions about how the balance sheet is likely to evolve through time and in different interest rate environments. Loans and deposits are projected to maintain stable balances. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in similar assets. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Non-contractual deposit volatility and pricing are assumed to follow historical patterns. The sensitivities of key assumptions are analyzed annually and reviewed by ALCO. The information for static gap and changes in net interest income presented in this section pertains to the Bank only and does not include a small volume of assets and liabilities owned by the Company and included in its consolidated financial statements as of June 30, 2004. In Management's opinion, the Bank-only information would not be materially different than that for the Company's consolidated balances. This sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including, among others, the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/ replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change. INTEREST RATE RISK MANAGEMENT A variety of financial instruments can be used to manage interest rate sensitivity. These may include investment securities, interest rate swaps, and interest rate caps and floors. Frequently called interest rate derivatives, interest rate swaps, caps and floors have characteristics similar to securities but possess the advantages of customization of the risk-reward profile of the instrument, minimization of balance sheet leverage and improvement of liquidity. As of June 30, 2004, the Company was not using any derivative instruments for interest rate risk management. The Company engages an independent consultant to periodically review its interest rate risk position, as well as the effectiveness of simulation modeling and reasonableness of assumptions used. As of June 30, 2004, there were no significant differences between the views of the independent consultant and Management regarding the Company's interest rate risk exposure. Management expects interest rates may rise in the second half of 2004 and believes that the current level of interest rate risk is acceptable. Page 28 Item 4: Controls and Procedures As required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the Company's management conducted an evaluation with the participation of the Company's Chief Executive Officer and Chief Financial Officer, regarding the effectiveness of the Company's disclosure controls and procedures, as of the end of the last fiscal quarter. In designing and evaluating the Company's disclosure controls and procedures, the Company and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only a reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that they believe the Company's disclosure controls and procedures are reasonably effective to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. We intend to continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, and we may from time to time make changes to the disclosure controls and procedures to enhance their effectiveness and to ensure that our systems evolve with our business. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Page 29 PART II ITEM 1. LEGAL PROCEEDINGS The Company was not involved in any legal proceedings requiring disclosure under Item 103 of Regulation S-K during the reporting period. Page 30 ITEM 2. CHANGES IN SECURITIES, USE OF PROECEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES The Company issues shares to the Bank's 401k Investment and Savings Plan pursuant to an exemption from registration under the Securities Act of 1933, as amended (the "Securities Act"), contained in Section 3(a)(11) thereof and Rule 147 promulgated thereunder. During the first six months of 2004, 4,893 shares were issued pursuant to this Plan, as presented in the following table: - ------------------------------------------- Month Number of Shares - ------------------------------------------- January 2004 1,460 February 2004 534 March 2004 777 April 2004 1,640 May 2004 243 June 2004 238 ------ 4,893 ====== - ------------------------------------------- Page 31 ITEM 3. DEFAULT UPON SENIOR SECURITIES None. Page 32 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Four proposals were submitted to a vote of security holders at the Company's Annual Meeting of Shareholders, held on Tuesday, April 27, 2004, at 11:00 a.m. Eastern Daylight Time. Only shareholders of record as of the close of business on February 17, 2003 (the "Voting Record Date") were entitled to vote at the Annual Meeting. On the Voting Record Date, there were 7,302,858 shares of Common Stock of the Company, one cent par value, issued and outstanding, and the Company had no other class of equity securities outstanding. Each share of Common Stock was entitled to one vote at the Annual Meeting on all matters properly presented thereat. PROPOSAL 1: To ratify the Board of Directors' vote to fix the number of Directors at ten. The Articles of Incorporation of the Company provide that the Board of Directors shall consist of not fewer than five nor more than twenty-five persons as determined by the Board prior to each Annual Meeting, with Directors serving for "staggered terms" of three years. A resolution of the Board of Directors adopted pursuant to the Company's Articles of Incorporation has established the number of Directors at ten. The results of the shareholder voting had 6,178,011 shares in favor, 23,763 shares against, 19,317 shares withheld voting, and 1,081,767 shares not voting. PROPOSAL 2: To elect as directors of the Company, as proposed by the Board of Directors Nominating Committee, the three persons listed for a three-year term: Malcolm E. Blanchard has served as a Director of the Company since its organization in 1985 and as a Director of The First National Bank of Damariscotta (the "Bank"), the Company's wholly owned subsidiary, since 1976. Mr. Blanchard has been actively involved, either as sole proprietor or as a partner, in real estate development since 1970. Randy A. Nelson has served as a Director of the Company and the Bank since 2004. Prior to joining the faculty of Colby College in 1987, he taught for eight years in the business school at the University of Delaware. He currently is the Douglas Professor of Economics and Finance at Colby, where he teaches corporate finance and economics. Stuart G. Smith has served as a Director of the Company and the Bank since 1997. A resident of Camden, he and his wife own and operate Maine Sport Outfitters in Rockport and Lord Camden Inn and Bayview Landing in Camden, Maine. Mr. Smith is also on the board and part owner of the Mid Coast Recreation Center in Rockport an indoor tennis and ice-skating facility. In addition, Mr. Smith serves as the Chairperson of the MSAD #28 Elementary School New School Site Selection Committee. The results of the shareholder voting had 6,133,836 shares in favor, 63,735 shares against, 22,520 withheld voting, and 1,087,767 shares not voting. PROPOSAL 3: To approve the increase of the number of shares of authorized common stock to 18,000,000. The results of the shareholder voting had 5,861,916 shares in favor, 353,040 shares against, 6,135 withheld voting, and 1,087,767 shares not voting. PROPOSAL 4: To ratify the Board of Directors Audit Committee's selection of Berry, Dunn, McNeil & Parker as independent auditors for the Company for 2004. The results of the shareholder voting had 6,197,352 shares in favor, 22,950 shares against, 789 withheld voting, and 1,087,767 shares not voting. Page 33 ITEM 5: Other Information None. Page 34 ITEM 6: Exhibits, Financial Statement Schedules, and reports on Form 8-K A. EXHIBITS 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO RULE 13a-14(a) OF THE SECURITIES EXCHANGE ACT OF 1934 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO RULE 13a-14(a) OF THE SECURITIES EXCHANGE ACT OF 1934 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PERSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PERSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 B. REPORTS ON FORM 8-K The Company's press release announcing the first quarter 2004 earnings was filed on Form 8-K under item 5 on April 21, 2004. The Company's press release announcing the second quarter 2004 dividend declaration was filed on Form 8-K under item 5 on June 17, 2004. Page 35 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FIRST NATIONAL LINCOLN CORPORATION August 9, 2004 /s/ Daniel R. Daigneault Date Daniel R. Daigneault President & Chief Executive Officer August 9, 2004 /s/ F. Stephen Ward Date F. Stephen Ward Treasurer & Chief Financial Officer Page 36