UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
OR
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-25051
PROSPERITY BANCSHARES, INC.®
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
Prosperity Bank Plaza
4295 San Felipe
Houston, Texas 77027
(Address of principal executive offices, including zip code)
(713) 693-9300
(Registrant’s telephone number, including area code)
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 12 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 a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer: ¨ Accelerated filer: x Non-accelerated filer: ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of May 1, 2006, there were 32,356,553 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.
PROSPERITY BANCSHARES, INC.® AND SUBSIDIARIES
INDEX TO FORM 10-Q
PART I - FINANCIAL INFORMATION
Item 1. Interim Consolidated Financial Statements
Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005 (unaudited)
Consolidated Statements of Income for the Three Months Ended March 31, 2006 and 2005 (unaudited)
Consolidated Statements of Shareholders’ Equity for the Year Ended December 31, 2005 and for the Three Months Ended March 31, 2006 (unaudited)
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005 (unaudited)
Notes to Interim Consolidated Financial Statements (unaudited)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits
Signatures
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PART I – FINANCIAL INFORMATION
ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS
PROSPERITY BANCSHARES, INC®. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
March 31,
2006
December 31,
2005
(Dollars in thousands, except
share data)
Cash and due from banks
Federal funds sold
Total cash and cash equivalents
Interest bearing deposits in financial institutions
Available for sale securities, at fair value (amortized cost of $402,863 and $416,425, respectively)
Held to maturity securities, at cost (fair value of $1,124,330, and $1,135,694, respectively
Loans held for investment
Less allowance for credit losses
Loans, net
Accrued interest receivable
Goodwill
Core deposit intangibles, net of accumulated amortization of $7.8 million and $6.7 million, respectively
Bank premises and equipment, net
Other real estate owned
Bank Owned Life Insurance (BOLI), net
Leased assets
Other assets
TOTAL ASSETS
LIABILITIES:
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Other borrowings
Securities sold under repurchase agreements
Accrued interest payable
Other liabilities
Junior subordinated debentures
Total liabilities
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 20,000,000 shares authorized; none issued or outstanding
Common stock, $1 par value; 50,000,000 shares authorized; 27,906,282 and 27,857,887 shares issued at March 31, 2006 and December 31, 2005, respectively; 27,869,194 and 27,820,799 shares outstanding at March 31, 2006 and December 31, 2005, respectively
Capital surplus
Retained earnings
Accumulated other comprehensive loss — net unrealized loss on available for sale securities, net of tax benefit of $2,229 and $2,122, respectively
Less treasury stock, at cost, 37,088 shares
Total shareholders’ equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See notes to interim consolidated financial statements.
PROSPERITY BANCSHARES, INC. ® AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended
INTEREST INCOME:
Loans, including fees
Securities:
Taxable
Nontaxable
70% nontaxable preferred dividends
Deposits in other financial institutions
Total interest income
INTEREST EXPENSE:
Deposits
Note payable and other borrowings
Total interest expense
NET INTEREST INCOME
PROVISION FOR CREDIT LOSSES
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
NONINTEREST INCOME:
Customer service fees
Other
Total noninterest income
NONINTEREST EXPENSE:
Salaries and employee benefits
Net occupancy expense
Depreciation expense
Data processing
Communications expense
Core deposit intangibles amortization
Total noninterest expense
INCOME BEFORE INCOME TAXES
PROVISION FOR INCOME TAXES
NET INCOME
EARNINGS PER SHARE
Basic
Diluted
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Total
Shareholders’Equity
BALANCE AT JANUARY 1, 2005
Comprehensive Income:
Net income
Net change in unrealized loss on available for sale securities
Add: Reclassification adjustment for net losses included in net income, net of tax benefit of $28
Total comprehensive income
Sale of common stock in connection with the exercise of stock options
Common stock issued in connection with restricted stock awards
Common stock issued in connection with the First Capital acquisition
Common stock issued in connection with the Grapeland acquisition
Stock based compensation expense
Cash dividends declared, $0.35 per share
BALANCE AT DECEMBER 31, 2005
Comprehensive income:
Cash dividends declared, $0.10 per share
BALANCE AT MARCH 31, 2006
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CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Provision for credit losses
Net amortization of discount/premium on investments
Gain on sale of other real estate
Loss on sale of premises and equipment
(Increase) decrease in other assets and accrued interest receivable
Increase (decrease) in accrued interest payable and other liabilities
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal paydowns of held to maturity securities
Purchase of held to maturity securities
Proceeds from maturities and principal paydowns of available for sale securities
Purchase of available for sale securities
Proceeds from sales of available for sale securities
Net (increase) decrease in loans
Purchase of Grapeland Bancshares, Inc.
Purchase of First Capital Bankers, Inc.
Cash and cash equivalents acquired in the purchase of First Capital Bankers, Inc.
Purchase of bank premises and equipment
Net decrease in interest-bearing deposits in financial institutions
Net proceeds from sale of bank premises, equipment, and other real estate
Net cash (used in) provided by investing activities
(Table continued on following page)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in noninterest-bearing deposits
Net decrease in interest-bearing deposits
Net repayments of lines of credit
Net (repayments) proceeds from securities sold under repurchase agreements
Redemption of Paradigm Capital Trust II, net
Proceeds from exercise of stock options
Payments of cash dividends
Net cash used in financing activities
NET DECREASE IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
CASH AND CASH EQUIVALENTS, END OF PERIOD
NONCASH ACTIVITIES:
Stock issued in connection with the First Capital Bankers, Inc. acquisition
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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2006
( (UNAUDITED)
1. BASIS OF PRESENTATION
The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc. ® (the “Company”) and its wholly-owned subsidiaries, Prosperity Bank ®(the “Bank”) and Prosperity Holdings of Delaware, LLC. All significant inter-company transactions and balances have been eliminated.
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. 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, the statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis, and all such adjustments are of a normal recurring nature. These financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Operating results for the three month period ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.
2. INCOME PER COMMON SHARE
The following table illustrates the computation of basic and diluted earnings per share:
Net income available to shareholders
Weighted average shares outstanding
Potential dilutive shares
Weighted average shares and equivalents outstanding
Basic earnings per share
Diluted earnings per share
3. NEW ACCOUNTING STANDARDS
SFAS No. 123(R), “Share-Based Payment (Revised 2004).” SFAS 123(R) establishes standards for the accounting for transactions in which an entity (i) exchanges its equity instruments for goods or services, or (ii) incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of the equity instruments. SFAS 123(R) eliminates the ability to account for stock-based compensation using Accounting Pronouncements Board (“APB”) 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the date of the grant. SFAS 123(R) applies to new awards, modified awards and to awards cancelled after January 1, 2006. SFAS 123(R) was effective on January 1, 2006 and its adoption did not have a material impact on the Company’s financial statements. The Company had previously adopted SFAS No. 123 on January 1, 2003. The Company recorded $172,000 in stock based compensation expense for the three months ended March 31, 2006. There was no income tax benefit recorded for the stock based compensation.
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On March 29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 107 to provide public companies additional guidance in applying the provisions of SFAS No. 123(R). Among other things, SAB 107 describes the SEC staff’s expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of SFAS 123(R) with certain existing SEC guidance. The guidance is also beneficial to users of financial statements in analyzing the information provided under SFAS 123(R). SAB 107 was applied upon the adoption of SFAS 123(R).
4. GOODWILL AND CORE DEPOSIT INTANGIBLES
Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for the three months ended March 31, 2006 were as follows:
Balance as of December 31, 2005
Amortization
Acquisition of Grapeland Bancshares, Inc.
Acquisition of First Capital Bankers, Inc.
Acquisitions prior to December 31, 2004 (deferred taxes)
Balance as of March 31, 2006
Gross core deposit intangibles outstanding were $28.9 million at March 31, 2006 and $29.2 million at December 31, 2005. Purchase accounting adjustments to prior year acquisitions were made to adjust deferred tax asset and liability balances. Goodwill is recorded on the acquisition date of each entity. The Company may record subsequent adjustments to goodwill for amounts undeterminable at acquisition date, such as deferred taxes, and therefore the goodwill amounts reflected in the table above may change accordingly. The Company initially records the total premium paid on acquisitions as goodwill. After a third party valuation, core deposit intangibles are identified and reclassified from goodwill to core deposit intangibles on the balance sheet. This reclassification had no effect on total assets, liabilities, shareholders’ equity, net income or cash flows.
5. STOCK BASED COMPENSATION
The Company had two stock-based employee compensation plans at March 31, 2006 and four stock option plans assumed in connection with acquisitions under which no additional options will be granted. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The Company adopted SFAS 123(R) on January 1, 2006. The Company recorded $172,000 and $130,000 in stock-based compensation expense for the three months ended March 31, 2006 and 2005, respectively. There was no income tax benefit recorded for the stock-based compensation expense for the same periods.
Stock options are issued at the current market price on the date of the grant, subject to a pre-determined vesting period with a contractual term of 10 years. Options assumed in connection with acquisitions also have a contractual term of 10 years from date of acquisition. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. Stock-based compensation expense is recognized ratably over the requisite service period for all awards.
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The fair value of options was estimated using an option-pricing model with the following weighted average assumptions:
Expected life
Risk free interest rate
Volatility
Dividend yield
A summary of changes in outstanding options during the three months ended March 31, 2006 is set forth below:
Options outstanding, beginning of period
Options granted
Options forfeited
Options exercised
Options outstanding, end of period
Options exercisable, end of period
The weighted-average grant-date fair value of the options granted during 2005 was $5.62. No options were granted during the three months ended March 31, 2006. The total intrinsic value of the options exercised during the three month periods ended March 31, 2006 and 2005 was $772.2 million and $361.8 million, respectively. The total fair value of shares vested during the three month period ended March 31, 2006 was $4,920.
A summary of changes in non-vested options is set forth below:
Non-vested options outstanding, beginning of period
Non-vested options forfeited
Options vested
Non-vested options outstanding, end of period
The Company received $689,000 and $76,000 in cash from the exercise of stock options during the three month periods ended March 31, 2006 and 2005, respectively. There was no tax benefit realized from option exercises of the share-based payment arrangements during the three month periods ended March 31, 2006 and 2005.
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As of March 31, 2006, there was $2.1 million of total unrecognized compensation expense related to non-vested stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.56 years.
6. SUBSEQUENT EVENTS
On April 1, 2006, the Company completed its acquisition of SNB Bancshares, Inc. (“SNB”), Sugar Land, Texas. Under the terms of the merger agreement, SNB was merged into the Company and subsequently, SNB’s wholly owned subsidiary, Southern National Bank of Texas, was merged into the Bank. The Company issued approximately 4.448 million shares of its common stock and approximately $93.3 million in cash for all of the issued and outstanding capital stock of SNB. In addition, options to acquire 762,950 shares of SNB common stock were converted into options to acquire approximately 468,000 shares of Company common stock. All remaining options to acquire SNB common stock were cancelled and redeemed for cash. In connection with the merger, the Company assumed $30.9 million in junior subordinated debentures issued to three subsidiary trusts. SNB was publicly traded and operated five (5) banking offices in Fort Bend County, Houston and Katy, Texas and two (2) stand alone motor banks in Houston, Texas. At the time of acquisition, SNB had an additional banking office under construction in Katy, Texas, which will become a full-service banking center of the Company upon completion. As of December 31, 2005, SNB had, on a consolidated basis, total assets of $1.025 billion, loans (including loans held for sale) of $652.8 million, deposits of $892.0 million and shareholders’ equity of $82.5 million.
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Special Cautionary Notice Regarding Forward-Looking Statements
Statements and financial discussion and analysis contained in this quarterly report on Form 10-Q that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond the Company’s control. Many possible events or factors could affect the future financial results and performance of the Company and could cause such results or performance to differ materially from those expressed in the forward-looking statements. These possible events or factors include, without limitation:
A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material.
The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.
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Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of the Company’s interim consolidated financial statements and accompanying notes. This section should be read in conjunction with the Company’s interim consolidated financial statements and accompanying notes included elsewhere in this report and with the consolidated financial statements and accompanying notes and other detailed information appearing in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
COMPLETION OF ACQUISITION OF SNB BANCSHARES, INC.
On April 1, 2006, the Company completed its acquisition of SNB Bancshares, Inc. (“SNB”), Sugar Land, Texas. Under the terms of the merger agreement, SNB was merged into the Company and subsequently, SNB’s wholly owned subsidiary, Southern National Bank of Texas, was merged into the Bank. The Company issued approximately 4.448 million shares of its common stock and approximately $93.3 million in cash for all of the issued and outstanding capital stock of SNB. In addition, options to acquire 762,950 shares of SNB common stock were converted into options to acquire approximately 468,000 shares of Company common stock. All remaining options to acquire SNB common stock were cancelled and redeemed for cash. In connection with the merger, the Company assumed $30.9 million in junior subordinated debentures issued to subsidiary trusts. SNB was publicly traded and operated five (5) banking offices in Fort Bend County, Houston and Katy, Texas and two (2) stand alone motor banks in Houston, Texas. At the time of acquisition, SNB had an additional banking office under construction in Katy, Texas, which will become a full-service banking center of the Company upon completion. As of December 31, 2005, SNB had, on a consolidated basis, total assets of $1.025 billion, loans (including loans held for sale) of $652.8 million, deposits of $892.0 million and shareholders’ equity of $82.5 million.
OVERVIEW
The Company was formed in 1983 as a vehicle to acquire the former Allied First Bank in Edna, Texas which was chartered in 1949 as The First National Bank of Edna. The Company is a registered financial holding company that derives substantially all of its revenues and income from the operation of its bank subsidiary, Prosperity Bank® (“Prosperity Bank®” or the “Bank”). The Bank provides a wide array of financial products and services to small and medium-sized businesses and consumers. At March 31, 2006, the Bank operated eighty-five (85) full-service banking locations; with thirty-three (33) in the Greater Houston Consolidated Metropolitan Statistical Area (“CMSA”), seventeen (17) in fifteen contiguous counties situated south and southwest of Houston and extending into South Texas, six (6) in the Austin, Texas area, sixteen (16) in the Corpus Christi, Texas area, two (2) in East Texas and eleven (11) in the Dallas/Fort Worth, Texas area. The Greater Houston CMSA includes Austin, Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, Montgomery, San Jacinto and Waller counties. The Company’s headquarters are located at Prosperity Bank Plaza, 4295 San Felipe in Houston, Texas and its telephone number is (713) 693-9300. The Company’s website address is www.prosperitybanktx.com. Information contained on the Company’s website is not incorporated by reference into this quarterly report on Form 10-Q and is not part of this or any other report.
The Company generates the majority of its revenues from interest income on loans, service charges on customer accounts and income from investment in securities. The revenues are partially offset by interest expense paid on deposits and other borrowings and non-interest expenses such as administrative and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings which are used to fund those assets. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and margin. The Company has recognized increased net interest income partially due to the yield earned on interest-earning assets increasing at a greater rate that the increase in rates paid on interest bearing liabilities and an increase in the volume of interest-earning assets.
Three principal components of the Company’s growth strategy are internal growth, stringent cost control practices and strategic merger transactions. The Company focuses on continual internal growth. Each banking center is operated as a separate profit center, maintaining separate data with respect to its net interest income, efficiency ratio, deposit growth, loan growth and overall profitability. Banking center presidents and managers are accountable for performance in these areas and compensated accordingly. The Company also focuses on maintaining stringent cost control practices and policies. The Company has invested significantly in the infrastructure required to centralize many of its critical operations, such as data processing and loan processing. Management believes that this centralized infrastructure can accommodate substantial additional growth while enabling the Company to minimize operational costs through certain economies of scale. The Company also intends to continue to seek expansion opportunities. On March 1, 2005, the Company acquired First Capital Bankers, Inc. (the “First Capital acquisition”) which added an additional twenty seven (27) banking centers, and on December 1, 2005, the Company acquired Grapeland Bancshares, Inc. (the “Grapeland acquisition”) which added two additional banking centers.
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Total assets were $3.57 billion at March 31, 2006 compared with $3.59 billion at December 31, 2005, a decrease of $14.4 million or 0.40%. Total loans were $1.56 billion at March 31, 2006 compared with $1.54 billion at December 31, 2005, an increase of $19.3 million or 1.3%. Total deposits were $2.92 billion at March 31, 2006 compared with $2.92 billion December 31, 2005, a decrease of $5.0 million or 0.17%. Shareholders’ equity increased $10.7 million or 2.3%, to $475.5 million at March 31, 2006 compared with $464.7 million at December 31, 2005.
CRITICAL ACCOUNTING POLICIES
The Company’s accounting policies are integral to understanding the financial results reported. Accounting policies are described in detail in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity:
Allowance for Credit Losses—The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Management has established an allowance for credit losses which it believes is adequate for estimated losses in the Company’s loan portfolio. Based on an evaluation of the loan portfolio, management presents a monthly review of the allowance for credit losses to the Bank’s Board of Directors, indicating any change in the allowance since the last review and any recommendations as to adjustments in the allowance. In making its evaluation, management considers factors such as historical loan loss experience, industry diversification of the Company’s commercial loan portfolio, the amount of nonperforming assets and related collateral, the volume, growth and composition of the Company’s loan portfolio, current economic changes that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the Company’s loan portfolio through its internal loan review process and other relevant factors. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. Charge-offs occur when loans are deemed to be uncollectible. The allowance for credit losses includes allowance allocations calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS 118 and allowance allocations determined in accordance with SFAS No. 5, Accounting for Contingencies.
Goodwill—Goodwill and intangible assets that have indefinite useful lives are subject to at least an annual impairment test and more frequently if circumstances indicate their value may not be recoverable. Goodwill is tested for impairment using a two-step process that begins with an estimation of the fair value of each of the Company’s reporting units compared with its carrying value. If the carrying amount exceeds the fair value of a reporting unit, a second step test is completed comparing the implied fair value of the reporting unit’s goodwill to its carrying value to measure the amount of impairment. Intangible assets that are not amortized will be tested for impairment at least annually by comparing the fair values of those assets to their carrying values. Other identifiable intangible assets that are subject to amortization are amortized on an accelerated basis over the years expected to be benefited, which the Company believes is eight years. These amortizable intangible assets are reviewed for impairment if circumstances indicate their value may not be recoverable based on a comparison of fair value to carrying value. Based on the Company’s annual goodwill impairment test as of September 30, 2005, management does not believe any of its goodwill is impaired as of March 31, 2006. While the Company believes no impairment existed at March 31, 2006 under accounting standards applicable at that date, different conditions or assumptions, or changes in cash flows or profitability, if significantly negative or unfavorable, could have a material adverse effect on the outcome of the Company’s impairment evaluation and financial condition or future results of operations.
Stock-Based Compensation—The Company adopted the provisions of SFAS No. 123(R) “Share-Based Payment (Revised 2004),” on January 1, 2006 and its adoption did not have a material impact on the Company’s financial statements. The Company had previously adopted SFAS No. 123 on January 1, 2003. Among other things, SFAS No. 123(R) eliminates the ability to account for stock-based compensation using the intrinsic value based method of accounting and requires that such transactions be recognized as compensation expense in the income statement based on their fair values on the date of the grant. SFAS No. 123(R) requires that management make assumptions including stock price volatility and employee turnover that are utilized to measure compensation expense. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions.
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RESULTS OF OPERATIONS
Net income available to shareholders was $12.9 million ($0.46 per common share on a diluted basis) for the quarter ended March 31, 2006 compared with $10.6 million ($0.43 per common share on a diluted basis) for the quarter ended March 31, 2005, an increase of $2.3 million or 21.9%. The Company posted returns on average common equity of 10.92% and 12.87%, returns on average assets of 1.43% and 1.42% and efficiency ratios of 46.80% and 51.06% for the quarters ended March 31, 2006 and 2005, respectively.
Net Interest Income
The Company’s net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.”
Net interest income before the provision for credit losses was $29.2 million for the quarter ended March 31, 2006 compared with $24.5 million for the quarter ended March 31, 2005, an increase of $4.7 million or 19.3%. Net interest income increased primarily as a result of an increase in average interest-earning assets to $3.14 billion for the quarter ended March 31, 2006 compared with $2.64 billion for the quarter ended March 31, 2005, an increase of $501.9 million or 19.0%.
The average rate paid on interest-bearing liabilities increased 91 basis points from 1.85% for the quarter ended March 31, 2005 to 2.76% for the quarter ended March 31, 2006, while the average yield on interest-earning assets increased 67 basis points from 5.23% for the quarter ended March 31, 2005 compared with 5.90% for the quarter ended March 31, 2006. The average volume of interest-bearing liabilities increased $330.8 million and the average volume of interest-earning assets increased $501.9 million for the same period.
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The following table sets forth, for each major category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest earned or paid on such amounts, and the average rate earned or paid for the quarters ended March 31, 2006 and 2005. The table also sets forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.
Assets
Interest-earning assets:
Loans
Securities(1)
Federal funds sold and other temporary investments
Total interest-earning assets
Total interest-earning assets, net of allowance
Noninterest-earning assets
Total assets
Liabilities and shareholders’ equity
Interest-bearing liabilities:
Interest-bearing demand deposits
Savings and money market accounts
Certificates of deposit
Federal funds purchased and other borrowings
Total interest-bearing liabilities
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits
Shareholders’ equity
Total liabilities and shareholders’ equity
Net interest rate spread
Net interest income and margin (2)
Net interest income and margin (tax-equivalent basis) (3)
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The following table presents the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to higher outstanding balances and the changes in interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.
Increase
(Decrease)
Due to
Securities
Total increase in interest income
Total increase in interest expense
Increase (decrease) in net interest income
Provision for Credit Losses
Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review function and other relevant factors.
Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.
The Company made a $120,000 provision for credit losses for the quarter ended March 31, 2006 and for the quarter ended March 31, 2005. For the quarter ended March 31, 2006, net charge-offs were $11,000 compared with net recoveries of $106,000 for the quarter ended March 31, 2005.
Noninterest Income
The Company’s primary sources of recurring noninterest income are service charges on deposit accounts and other banking service related fees. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method. Banking related service fees include check cashing fees, official check fees, safe deposit box rent and currency handling fees. Noninterest income totaled $7.7 million for the three months ended March 31, 2006 compared with $6.5 million for the same period in 2005, an increase of $1.1 million or 17.4%. The increase was primarily due to an increase in insufficient funds charges and customer service charges which resulted from an increase in the number of accounts due to the First Capital acquisition on March 1, 2005 and the Grapeland acquisition on December 1, 2005. As of March 31, 2006, approximately 45,000 deposit accounts and over 10,000 debit cards were attributed to these two acquisitions.
Brokered mortgage income increased $59,000, from $124,000 for the quarter ended March 31, 2005 compared with $183,000 for the quarter ended March 31, 2006. The increase was primarily due to additional mortgage loan originations resulting from the mortgage division associated with First Capital that was acquired in March 2005.
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Income from leased assets and bank owned life insurance increased $180,000 and $83,000, respectively, for the quarter ended March 31, 2006 compared with the quarter ended March 31, 2005. Both leased assets and bank owned life insurance were acquired in the First Capital acquisition. The expiration dates of the leased assets range from 2009 to 2011 and related depreciation expense for the leased assets was $189,000 and $90,000 for the quarters ended March 31, 2006 and 2005, respectively.
Other noninterest income decreased $99,000 or 20.4% from $486,000 for the first quarter of 2005 compared with $387,000 for the same period in 2006. The decrease was primarily due to a one time $225,000 distribution related to the Pulse EFT Association merger in the first quarter of 2005.
The following table presents, for the periods indicated, the major categories of noninterest income:
Three months ended
Service charges on deposit accounts
Banking related service fees
Brokered mortgage income
Trust and investment income
Income from leased assets
Bank owned life insurance income (BOLI)
Gain on sale of assets, net
Gain on held for sale loans
Other noninterest income
Noninterest Expense
Noninterest expense totaled $17.2 million for the quarter ended March 31, 2006 compared with $15.8 million for the quarter ended March 31, 2005, an increase of $1.4 million or 8.9%. This increase was principally due to increases in salaries and employee benefits, net occupancy and equipment expense and core deposit intangibles amortization partially offset by a decrease in advertising expense.
The following table presents, for the periods indicated, the major categories of noninterest expense:
Salaries and employee benefits (1)
Non-staff expenses:
Net occupancy and equipment expense
Depreciation
Advertising
Professional fees
Regulatory assessments and FDIC insurance
Ad valorem and franchise taxes
Total non-staff expenses
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Salaries and employee benefit expenses were $9.2 million for the quarter ended March 31, 2006 compared with $8.5 million for the quarter ended March 31, 2005, an increase of $664,000 or 7.8%. The increase was principally due to additional staff associated with the full effect of the First Capital acquisition on March 1, 2005, the Grapeland acquisition in December 2005 and annual merit increases and bonuses. The number of full-time equivalent (FTE) associates employed by the Company decreased from 926 at March 31, 2005 to 844 at March 31, 2006.
Non-staff expenses increased $751,000, or 10.3%, to $8.1 million for the quarter ended March 31, 2006 compared with $7.3 million during the same period in 2005. The increase was principally due to additional general and administrative expenses associated with the First Capital and Grapeland acquisitions, increases in core deposit intangibles amortization related to such acquisitions and increases in net occupancy and equipment expenses related to the addition of twenty-seven (27) banking centers on March 1, 2005 in connection with the First Capital acquisition and two banking centers in connection with the Grapeland acquisition on December 1, 2005, partially offset by a decrease in advertising expense. In 2005, the Company launched an advertising campaign to increase name recognition that did not continue in 2006.
Income Taxes
Income tax expense increased $2.1 million to $6.6 million for the quarter ended March 31, 2006 compared with $4.5 million for the same period in 2005. The increase was primarily attributable to higher pretax net earnings for the quarter ended March 31, 2006 compared with the same period in 2005 and by a non-recurring tax benefit of approximately $540,000 that occurred during the first quarter of 2005.
FINANCIAL CONDITION
Loan Portfolio
Total loans were $1.56 billion at March 31, 2006, an increase of $19.3 million or 1.3% compared with $1.54 billion at December 31, 2005. The increase was primarily due to internal growth. Period end loans comprised 49.7% of average earning assets for the quarter ended March 31, 2006 compared with 49.9% of average earning assets for the quarter ended December 31, 2005.
The following table summarizes the loan portfolio of the Company by type of loan as of March 31, 2006 and December 31, 2005:
Commercial and industrial
Real estate:
Construction and land development
1-4 family residential
Home equity
Commercial mortgages
Farmland
Multifamily residential
Agriculture
Consumer (net of unearned discount)
Total loans
Nonperforming Assets
The Company had $1.3 million in nonperforming assets at March 31, 2006 and $1.4 million in nonperforming assets at December 31, 2005, a decrease of $141,000 or 10.0%.
The Company generally places a loan on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. The Company generally charges off all loans before attaining nonaccrual status.
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The following table presents information regarding past due loans and nonperforming assets as of the dates indicated:
Nonaccrual loans
Restructured loans
Accruing loans 90 or more days past due
Total nonperforming loans
Repossessed assets
Other real estate
Total nonperforming assets
Nonperforming assets to total loans and other real estate
Allowance for Credit Losses
Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. The allowance for credit losses is a reserve established through charges to earnings in the form of a provision for credit losses. Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the allowance for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations. As of March 31, 2006, the allowance for credit losses amounted to $17.3 million or 1.11% of total loans compared with $17.2 million or 1.12% of total loans at December 31, 2005.
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Set forth below is an analysis of the allowance for credit losses for the three months ended March 31, 2006 and the year ended December 31, 2005:
Average loans outstanding
Gross loans outstanding at end of period
Allowance for credit losses at beginning of period
Balance acquired with the First Capital and Grapeland acquisitions
Charge-offs:
Real estate and agriculture
Consumer
Recoveries:
Net charge-offs
Allowance for credit losses at end of period
Ratio of allowance to end of period loans
Ratio of net charge-offs to average loans
Ratio of allowance to end of period nonperforming loans
Securities totaled $1.56 billion at March 31, 2006 compared with $1.57 billion at December 31, 2005, a decrease of $17.6 million or 1.1%. At March 31, 2006, securities represented 43.5% of total assets compared with 43.9% of total assets at December 31, 2005.
The following table summarizes the amortized cost of securities as of the dates shown (available-for-sale securities are not adjusted for unrealized gains or losses):
U.S. Treasury securities and obligations of U.S. government agencies
70% non taxable preferred stock
States and political subdivisions
Corporate debt securities
Collateralized mortgage obligations
Mortgage-backed securities
Qualified Zone Academy Bond (QZAB)
Equity securities
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Premises and Equipment
Premises and equipment, net of accumulated depreciation, totaled $48.3 million and $49.2 million at March 31, 2006 and December 31, 2005, respectively, a decrease of $928,000 or 1.9%.
Total deposits were $2.92 billion at March 31, 2006 compared with $2.92 billion at December 31, 2005, a decrease of $5.0 million or 0.2%. At March 31, 2006, noninterest-bearing deposits accounted for approximately 23.8% of total deposits compared with 23.1% of total deposits at December 31, 2005. Interest-bearing demand deposits totaled $2.22 billion or 76.2% of total deposits at March 31, 2006 compared with $2.25 billion or 76.9% of total deposits at December 31, 2005.
The following table summarizes the daily average balances and weighted average rates paid on deposits for the periods indicated below:
Three Months EndedMarch 31,
Year EndedDecember 31,
Interest-bearing demand
Regular savings
Money market savings
Time deposits
Total interest-bearing deposits
Noninterest-bearing deposits
Other Borrowings
The Company utilizes borrowings to supplement deposits to fund its lending and investment activities. Borrowings consist of funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. FHLB advances are considered short-term, overnight borrowings. At March 31, 2006, the Company had $38.2 million in FHLB borrowings all of which consisted of long-term FHLB notes payable compared with $55.4 million in FHLB borrowings at December 31, 2005, which consisted of $38.4 million in long-term FHLB notes payable and $17.0 million in FHLB advances. The $17.2 million decrease was primarily attributable to the payoff of $17.0 million in FHLB advances during the first quarter of 2006. The maturity dates on the FHLB notes payable range from the years 2006 to 2028 and have interest rates ranging from 2.79% to 8.80%. The highest outstanding balance of FHLB advances during the first quarter of 2006 was $50.0 million compared with $39.0 million during the year ended December 31, 2005. The Company had no federal funds purchased at March 31, 2006 or December 31, 2005.
At March 31, 2006, the Company had $47.0 million in securities sold under repurchase agreements compared with $47.0 million at December 31, 2005, a decrease of $28,000 or 0.06%.
Junior Subordinated Debentures
At March 31, 2006 and December 31, 2005, the Company had outstanding $69.6 million and $75.8 million, respectively, in junior subordinated debentures issued to the Company’s subsidiary trusts. The decrease of $6.2 million was due to the Company’s redemption of $6.2 million in junior subordinated debentures held by Paradigm Capital Trust II on February 28, 2006.
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A summary of pertinent information related to the Company’s five issues of junior subordinated debentures outstanding at March 31, 2006 is shown in the table below:
Description
Issuance Date
Interest Rate (1)
JuniorSubordinatedDebt Owed
to Trusts
Maturity
Date (2)
Prosperity Statutory Trust II
3-month LIBOR
+ 3.58%, not to exceed 12.50%
Prosperity Statutory Trust III
Prosperity Statutory Trust IV
First Capital Statutory Trust I (5)
+3.60%
First Capital Statutory Trust II (5)
+3.40%
Liquidity
Liquidity involves the Company’s ability to raise funds to support asset growth or reduce assets to meet deposit withdrawals and other payment obligations, to maintain reserve requirements and otherwise to operate the Company on an ongoing basis. The Company’s liquidity needs have primarily been met by growth in core deposits and the issuance of junior subordinated debentures. Although access to purchased funds from correspondent banks is available and has been utilized on occasion to take advantage of investment opportunities, the Company does not generally rely on these external funding sources. The cash and federal funds sold position, supplemented by amortizing investment and loan portfolios, have generally created an adequate liquidity position.
Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of March 31, 2006, the Company had cash and cash equivalents of $83.0 million compared with $97.4 million at December 31, 2005.
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Contractual Obligations
The following table summarizes the Company’s contractual obligations and other commitments to make future payments as of March 31, 2006 (other than deposit obligations). The Company’s future cash payments associated with its contractual obligations pursuant to its junior subordinated debentures, FHLB notes payable and operating leases as of March 31, 2006 are summarized below. Payments for FHLB notes payable include interest of $7.8 million that will be paid over the future periods presented. Payments related to leases are based on actual payments specified in underlying contracts.
Remaining
Fiscal 2006
Fiscal
2007-2008
2009-2010
Federal Home Loan Bank notes payable
Operating leases
Off-Balance Sheet Items
In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States, are not included in its consolidated balance sheets. The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.
The Company’s commitments associated with outstanding standby letters of credit and commitments to extend credit as of March 31, 2006 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:
Standby letters of credit
Commitments to extend credit
Capital Resources
Total shareholders’ equity was $475.5 million at March 31, 2006 compared with $464.7 million at December 31, 2005, an increase of $10.7 million or 2.3%. The increase was due primarily to net earnings of $12.9 million, partially offset by dividends paid of $2.8 million for the three months ended March 31, 2006.
Both the Board of Governors of the Federal Reserve System, with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”), with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. As of March 31, 2006, the Company’s Tier 1 risk-based capital, total risk-based capital and leverage capital ratios were 15.65%, 16.69% and 7.86%, respectively. As of March 31, 2006, the Bank’s risk-based capital ratios were above the levels required for the Bank to be designated as “well capitalized” by the FDIC, with Tier-1 risk-based capital, total risk-based capital and leverage capital ratios of 15.45%, 16.50% and 7.75%, respectively.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company manages market risk, which for the Company is primarily interest rate risk, through its Asset Liability Committee which is composed of senior officers of the Company, in accordance with policies approved by the Company’s Board of Directors.
The Company uses simulation analysis to examine the potential effects of market changes on net interest income and market value. The Company considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See the Company’s Annual Report on Form 10-K, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed on March 15, 2006 for further discussion.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported to the Company’s management within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Changes in internal control over financial reporting. During the quarter ended March 31, 2006, , there were no significant changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II – OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Neither the Company nor the Bank is currently a party to any material legal proceeding.
ITEM 1A. RISK FACTORS
There have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
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ITEM 6. EXHIBITS
Description of Exhibit
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.
PROSPERITY BANCSHARES, INC. ®
(Registrant)
Date: 05/10/06
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