UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
Commission File No. 0-10587
FULTON FINANCIAL CORPORATION
(717) 291-2411
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 þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Common Stock, $2.50 Par Value – 125,704,000 shares outstanding as of April 30, 2005.
FULTON FINANCIAL CORPORATIONFORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2005
INDEX
2
3
4
5
6
NOTE A – Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes 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. Operating results for the three-month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.
NOTE B – Net Income Per Share
The Corporation’s basic net income per share is calculated as net income divided by the weighted average number of shares outstanding. For diluted net income per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Corporation’s common stock equivalents consist solely of outstanding stock options.
A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows:
NOTE C – Subsequent Events
5-for-4 Stock Split - The Corporation declared a 5-for-4 stock split on April 13, 2005. The stock split will be paid in the form of a 25% stock dividend on June 8, 2005 to shareholders of record as of May 17, 2005. Share and per-share information presented in this report have not been restated to reflect the impact of this stock split as the market price of the Corporation’s stock will not adjust until after the issuance of this report. The following table presents share and per-share information on a pro-forma basis, as restated for the impact of the stock split.
7
Authorized Shares - On April 13, 2005, the shareholders of the Corporation approved an amendment to the Articles of Incorporation to increase the number of authorized shares of common stock from 400 million to 600 million shares.
Branch Sales - On April 22, 2005 the Corporation sold two branches in New Jersey, including deposits totaling approximately $23.3 million. As a result of this transaction, a total gain of approximately $1.1 million will be recognized in the second quarter of 2005.
The Corporation has entered into a contract for the sale of a branch in Maryland, including deposits totaling approximately $19.2 million at March 31, 2005. Per the terms of the contract, the deposits will be sold at a premium of 8% and the real property will be sold at net book value. This sale is expected to be completed during the second or third quarter of 2005, pending the receipt of certain regulatory approvals.
Accelerated Share Repurchase Plan – On May 4, 2005, the Corporation purchased 3.5 million shares of its common stock from an investment bank at a total cost of $73.6 million under an “Accelerated Share Repurchase” program (ASR), which allowed the shares to be repurchased immediately rather than over time. The investment bank, in turn, is repurchasing shares on the open market over a period that is determined by the average daily trading volume of our shares, among other factors. The Corporation expects to settle its position with the investment bank at the end of the ASR by paying or receiving cash in an amount representing the difference between the initial price and the actual price of the shares repurchased. The Corporation expects the ASR to be completed during 2005.
NOTE D – Disclosures about Segments of an Enterprise and Related Information
The Corporation does not have any operating segments, which require disclosure of additional information. While the Corporation owns thirteen separate banks, each engages in similar activities and provides similar products and services. The Corporation’s non-banking activities are immaterial and therefore, separate information has not been disclosed.
NOTE E – Stock-Based Compensation
The Corporation accounts for its stock-based compensation, consisting primarily of stock options, in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”
8
(APB 25). As such, no compensation expense has been recognized in the Consolidated Statements of Income as stock options are granted with an exercise price equal to the fair market value of the Corporation’s stock. Pro-forma disclosures of the impact of stock-based compensation on the Corporation’s net income and net income per share, had compensation expense been recognized under the provisions of Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (Statement 123), are as follows:
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (Statement 123R). Statement 123R is a revision to the original Statement 123 which disallows the APB 25 method of accounting for stock options and requires public companies to recognize compensation expense related to stock-based compensation in their income statements. Companies can adopt Statement 123R using either “modified prospective application” or “modified retrospective application”. Modified retrospective application also results in restatement of prior period results, based on the amounts previously disclosed in prior period financial statements.
The effective date of Statement 123R was originally the beginning of the first fiscal quarter after June 15, 2005. In April 2005 the Securities and Exchange Commission delayed the effective date to the beginning of the first fiscal year after June 15, 2005, or January 1, 2006 for the Corporation. Early adoption is permissible. The Corporation expects to adopt the provisions of Statement 123R in the third quarter of 2005, using modified retrospective application.
NOTE F – Employee Benefit Plans
The Corporation maintains a defined benefit pension plan (Pension Plan) for certain employees. Contributions to the Pension Plan are actuarially determined and funded annually. Pension Plan assets are invested in money markets, fixed income securities, including corporate bonds, U.S. Treasury securities and common trust funds, and equity securities, including common stocks and common stock mutual funds. The Pension Plan has been closed to new participants, but existing participants continue to accrue benefits according to the terms of the plan. The Corporation expects to contribute approximately $2.3 million to the Pension Plan in 2005.
The Corporation currently provides medical and life insurance benefits under a post-retirement benefits plan (Post-Retirement Plan) to certain retired full-time employees who were employees of the Corporation prior to January 1, 1998. Other certain full-time employees may become eligible for these discretionary benefits if they reach retirement age while working for the Corporation. Benefits are based on a graduated scale for years of service after attaining the age of 40.
The net periodic benefit cost for the Corporation’s Pension Plan and Post-Retirement Plan, as determined by consulting actuaries, consisted of the following components for the quarters ended March 31:
9
NOTE G – New Accounting Standards
Accounting for Certain Loans or Debt Securities Acquired in a Transfer: In December 2003, the Accounting Standards Executive Committee issued Statement of Position 03-3 (SOP 03-3), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer”. SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer, including business combinations, if those differences are attributable, at least in part, to credit quality.
SOP 03-3 became effective for the Corporation on January 1, 2005. No loans or debt securities meeting the scope of SOP 03-3 were acquired during the quarter ended March 31, 2005. The Corporation does not expect SOP 03-3 to have a material effect on the Corporation’s consolidated financial statements in the future.
Other Than Temporary Impairment: In 2004, the Emerging Issues Task Force (EITF) released EITF Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (EITF 03-01), which provides guidance for evaluating whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments.
In September 2004, the FASB delayed the effective date of the measurement and recognition guidance of EITF 03-01 from the third calendar quarter of 2004 to a date to be determined upon the issuance of a final FASB Staff Position. The Corporation continues to apply the measurement and recognition criteria of existing authoritative literature in evaluating its investments for other than temporary impairment. Management does not expect EITF 03-01 to have a material impact on its financial condition or results of operations.
NOTE H – Acquisitions
Completed Acquisitions
On December 31, 2004, the Corporation acquired all of the outstanding common stock of First Washington FinancialCorp (First Washington), of Windsor, New Jersey. First Washington was a $490 million bank holding company whose primary subsidiary was First Washington State Bank, which operates sixteen community-banking offices in Mercer, Monmouth, and Ocean Counties in New Jersey. This acquisition enabled the Corporation to expand and enhance its existing New Jersey franchise.
The total purchase price was $125.8 million including $125.2 million in stock issued and options assumed and $610,000 in First Washington stock purchased for cash and other direct acquisition costs. The Corporation issued 1.35 shares of its stock for each of the 4.3 million shares of First Washington outstanding on the acquisition date. The purchase price was determined based on the value of the Corporation’s stock on the date when the final terms of the acquisition were agreed to and announced.
10
On April 1, 2004, the Corporation acquired all of the outstanding common stock of Resource Bankshares Corporation (Resource), an $890 million financial holding company, and its primary subsidiary, Resource Bank. The total purchase price was $195.7 million, including $185.9 million in stock issued and options assumed, and $9.8 million in Resource stock purchased for cash and other direct acquisition costs. The Corporation issued 1.54 shares of its stock for each of the 5.9 million shares of Resource outstanding on the acquisition date. The purchase price was determined based on the value of the Corporation’s stock on the date when the final terms of the acquisition were agreed to and announced.
Resource Bank is located in Virginia Beach, Virginia, and operates six community-banking offices in Newport News, Chesapeake, Herndon, Virginia Beach, and Richmond, Virginia and fourteen loan production and residential mortgage offices in Virginia, North Carolina, Maryland and Florida. This acquisition allowed the Corporation to enter a new geographic market.
The following table summarizes unaudited pro-forma information assuming the acquisitions of Resource and First Washington State Bank had occurred on January 1, 2004. This pro-forma information includes certain adjustments, including amortization related to fair value adjustments recorded in purchase accounting (in thousands, except per-share information):
Pending Acquisition
On January 11, 2005, the Corporation entered into a merger agreement to acquire SVB Financial Services, Inc. (SVB), of Somerville, New Jersey. SVB is a $475 million bank holding company whose primary subsidiary is Somerset Valley Bank, which operates eleven community-banking offices in Somerset, Hunterdon and Middlesex Counties in New Jersey.
Under the terms of the merger agreement, each of the approximately 4.1 million shares of SVB’s common stock will be acquired based on a “cash election merger” structure. Each SVB shareholder will have the ability to elect to receive 100% of the merger consideration in stock, 100% in cash, or a combination of FFC stock and cash. Their elections will be subject to prorating to achieve a result where a minimum of 20% and a maximum of 40% of SVB’s outstanding shares will receive cash consideration. Those shares that will be converted into FFC stock would be exchanged based on a fixed exchange ratio of 0.9519 shares of FFC stock for each share of SVB stock. Those shares of SVB stock that will be converted into cash will be converted into a per share amount of cash based on a fixed price of $21.00 per share of SVB stock. In addition, each of the options to acquire SVB’s stock will be converted to options to purchase the Corporation’s stock.
The acquisition is subject to approval by both the SVB shareholders and applicable bank regulatory authorities. The acquisition is expected to be completed during the third quarter of 2005. As a result of the acquisition, SVB will be merged into the Corporation and Somerset Valley Bank will become a wholly owned subsidiary.
11
The acquisition will be accounted for as a purchase. Purchase accounting requires the Corporation to allocate the total purchase price of the acquisition to the assets acquired and liabilities assumed, based on their respective fair values at the acquisition date, with any remaining acquisition cost being recorded as goodwill. Resulting goodwill balances are then subject to an impairment review on at least an annual basis. The results of SVB’s operations will be included in the Corporation’s financial statements prospectively from the date of the acquisition.
The total purchase price is estimated to be approximately $87.7 million, which includes cash expected to be paid, the value of the Corporation’s stock expected to be to be issued, SVB’s options to be converted and certain acquisition related costs. The net assets of SVB as of March 31, 2005 were $30.5 million and, accordingly, the purchase price exceeds the carrying value of the net assets by $57.2 million as of this date. The total purchase price will be allocated to the net assets acquired as of the merger effective date, based on fair market values at that date. The Corporation expects to record a core deposit intangible asset and goodwill as a result of the acquisition accounting.
Note I – Derivative Financial Instruments – Interest Rate Swaps
As of March 31, 2005, interest rate swaps with a notional amount of $240 million were used to hedge certain long-term fixed rate certificate of deposit liabilities held at one of the Corporation’s affiliate banks. The terms of the certificates of deposit and the interest rate swaps mirror each other and were committed to simultaneously. Under the terms of the swap agreements, the Corporation is the fixed rate receiver and the floating rate payer (generally tied to the three month London Interbank Offering Rate, or LIBOR, a common index used for setting rates between financial institutions). The combination of the interest rate swaps and the issuance of the certificates of deposit generates long-term floating rate funding for the Corporation. The interest rate swaps are classified as a cash flow hedge and the fair values of the derivatives are recorded as other assets or other liabilities. Changes in the fair values during the period are recorded in other comprehensive income to the extent the hedge is effective. Ineffectiveness resulting from differences between the changes in fair value or cash flows of the certificate of deposits and the interest rate swaps must be recorded in current period earnings.
The Corporation’s analysis of the effectiveness of the hedges indicated they were 98.2% effective as of March 31, 2005. As a result, a $63,000 charge to income for the three-month period ended March 31, 2005 was recognized. During the first quarter of 2005, the Corporation recorded a $3.2 million other comprehensive loss to recognize the effective fair value changes of derivatives resulting from the rising interest rate environment.
NOTE J – Financial Instruments With Off-Balance Sheet Risk
The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and letters of credit, which involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Corporation’s Consolidated Balance Sheets. Exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the outstanding amount of those instruments.
12
The outstanding amounts of commitments to extend credit and letters of credit were as follows:
NOTE K – Subordinated Debt
On March 28, 2005 the Corporation issued $100.0 million of ten-year subordinated notes at a fixed rate of 5.35%, with semi annual interest payments commencing in October 2005. The notes mature on April 1, 2015.
NOTE L – Reclassifications
Certain amounts in the 2004 consolidated financial statements and notes have been reclassified to conform to the 2005 presentation.
13
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion) concerns Fulton Financial Corporation (the Corporation), a financial holding company incorporated under the laws of the Commonwealth of Pennsylvania in 1982, and its wholly owned subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and notes presented in this report.
FORWARD-LOOKING STATEMENTS
The Corporation has made, and may continue to make, certain forward-looking statements with respect to its acquisition and growth strategies, management of net interest income and margin, the ability to realize gains on equity investments, allowance and provision for loan losses, expected levels of certain non-interest expenses and the liquidity position of the Corporation and Parent Company. The Corporation cautions that these forward-looking statements are subject to various assumptions, risks and uncertainties. Because of the possibility of changes in these assumptions, risks and uncertainties, actual results could differ materially from forward-looking statements.
In addition to the factors identified herein, the following could cause actual results to differ materially from such forward-looking statements: pricing pressures on loan and deposit products, actions of bank and non-bank competitors, changes in local and national economic conditions, changes in regulatory requirements, actions of the Federal Reserve Board (FRB), creditworthiness of current borrowers, customers’ acceptance of the Corporation’s products and services and acquisition pricing and the ability of the Corporation to continue making acquisitions.
The Corporation’s forward-looking statements are relevant only as of the date on which such statements are made. By making any forward-looking statements, the Corporation assumes no duty to update them to reflect new, changing or unanticipated events or circumstances.
RESULTS OF OPERATIONS
Overview
As a financial institution with a focus on traditional banking activities, Fulton Financial Corporation generates the majority of its revenue through net interest income, or the difference between interest income earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon balance sheet growth and maintaining or increasing the net interest margin, which is net interest income as a percentage of average interest-earning assets. The Corporation also generates revenue through fees earned on the various services and products offered to its customers and through sales of assets, such as loans or investments. Offsetting these revenue sources are provisions for credit losses on loans, other operating expenses and income taxes.
The Corporation’s net income for the first quarter of 2005 increased $5.7 million, or 15.9%, from $35.8 million in 2004 to $41.5 million in 2005. Diluted net income per share increased $0.02, or 6.5%, from $0.31 in 2004 to $0.33 in 2005. The percentage increase in net income per share was lower than the net income increase as the average number of shares outstanding increased as a result of shares issued for acquisitions. The Corporation realized annualized returns on average assets of 1.50% and average equity of 13.48% during the first quarter of 2005. The annualized return on average tangible equity, which is net income divided by average shareholders’ equity, excluding goodwill and intangible assets, was 19.56% for the quarter.
The increase in net income compared to the first quarter of 2004 resulted from an $15.3 million increase in net interest income, a $6.3 million increase in other income (excluding security gains) and a $940,000 decrease in the
14
provision for loan losses, offset by a $2.5 million decrease in security gains, an $11.5 million increase in other expenses and a $2.9 million increase in income taxes. Net interest income growth resulted from increases in average earning assets, due to the acquisitions of Resource Bancshares Corporation (Resource) in April 2004 and First Washington FinancialCorp (First Washington) in December 2004 (see “Acquisitions” below). The net interest margin increased 4.2% compared to the first quarter of 2004, compounding the impact of the earning asset growth.
The following summarizes some of the more significant factors that influenced the Corporation’s first quarter 2005 results.
Interest Rates — The FRB raised short-term interest rates seven times since March, 2004, resulting in a 175 basis point increase in both the Federal funds rate (from 1.00% to 2.75%) and the prime lending rate, (from 4.00% to 5.75%). These increases have had a positive impact on the Corporation’s net interest margin and earnings as floating rate assets immediately adjusted to higher rates. The offsetting increase in rates on deposits and borrowings has not been as pronounced, however competitive pressure to reprice deposits has recently increased.
Longer-term rates also increased over the past twelve months. The national monthly average of 30-year mortgage rates increased 42 basis points from 5.59% in 2004 to 6.01% in 2005. In a rising rate environment, the Corporation expects improvements in net interest income, as discussed in the “Market Risk” section of Management’s Discussion. Continued increases in long-term rates, however, may have a detrimental impact on mortgage loan origination volumes and related gains on sales of mortgage loans.
Earning Assets — The Corporation’s interest-earning assets increased significantly, as a result of acquisitions and strong internal loan growth. This growth also contributed to the increase in net interest income. With improving regional economic conditions and with the slowdown of mortgage loan refinances, the Corporation is optimistic that internal loan growth in the short-term will continue to be positive.
From 2004 to 2005, the Corporation experienced a shift in its composition of interest-earning assets from investments (23.8% of total average interest-earning assets in 2005, compared to 31.2% in 2004) to loans (74.8% in 2005 compared to 68.6% in 2004). This change resulted as funds from investment maturities, primarily mortgage-backed securities were reinvested in loans. The movement to higher-yielding loans has had a positive effect on the Corporation’s net interest income and net interest margin.
Asset Quality — Asset quality refers to the underlying credit characteristics of borrowers and the likelihood that defaults on contractual payments will result in charge-offs of account balances. Asset quality is generally a function of economic conditions, but can be managed through conservative underwriting and sound collection policies and procedures.
The Corporation continued to maintain excellent asset quality, attributable to its credit culture and underwriting policies. Asset quality measures such as non-performing assets to total assets and net charge-offs to average loans improved in comparison to 2004, resulting in a lower provision for loan losses in the first quarter 2005. While overall asset quality has remained strong, deterioration in quality of one or several significant accounts could have a detrimental impact and result in losses that may not be foreseeable based on current information. In addition, rising interest rates could increase the total payments of borrowers and could have a negative impact on the ability of some to pay according to the terms of their loans.
Equity Markets — As noted in the “Market Risk” section of Management’s Discussion, equity valuations can have an impact on the Corporation’s financial performance. In particular, bank stocks account for a significant portion of the Corporation’s equity investment portfolio. Gains on sales of these equities have been a recurring component of the Corporation’s earnings for many years, including the first quarters of 2005 and 2004 with total
15
gains of $2.5 million and $4.8 million, respectively. If this portfolio declines in value, this component of earnings could contract.
Acquisitions — In April 2004, the Corporation acquired Resource, an $890 million financial holding company located in Virginia Beach, Virginia whose primary subsidiary was Resource Bank. This was the Corporation’s first acquisition in Virginia, allowing it to enter a new geographic market. In December 2004, the Corporation acquired First Washington, a $490 million bank holding company located in Windsor, New Jersey whose primary subsidiary was First Washington State Bank. Results for 2005 in comparison to 2004 were impacted by these acquisitions (referred to collectively as the “Acquisitions”).
On January 11, 2005, the Corporation entered into a merger agreement to acquire SVB Financial Services, Inc. (SVB) of Somerville, New Jersey. SVB is a $475 million bank holding company whose primary subsidiary is Somerset Valley Bank, which operates eleven community-banking offices in Somerset, Hunterdon and Middlesex counties in New Jersey. The acquisition is expected to be completed in the third quarter of 2005. For additional information on the terms of this pending acquisition, see Note H, “Acquisitions”, in the Notes to Consolidated Financial Statements.
Acquisitions have long been a supplement to the Corporation’s internal growth. These recent and pending acquisitions provide the opportunity for additional growth as they will allow the Corporation’s existing products and services to be sold in new markets. The Corporation’s acquisition strategy focuses on high growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance and good asset quality, among other factors. Under its “super-community” banking philosophy, acquired organizations generally retain their status as separate legal entities, unless consolidation with an existing affiliate bank is practical. Back office functions are generally consolidated to maximize efficiencies.
Merger and acquisition activity in the financial services industry has been very competitive in recent years, as evidenced by the prices paid for certain acquisitions. While the Corporation has been an active acquirer, management is committed to basing its pricing on rational economic models. Management will continue to focus on generating growth in the most cost-effective manner.
Quarter ended March 31, 2005 versus quarter ended March 31, 2004
Net Interest Income
Net interest income increased $15.3 million, to $98.2 million in 2005 from $83.0 million in 2004. This increase was due to both average balance growth, with total earning assets increasing 15.8%, and an improving net interest margin. The average yield on earning assets increased 49 basis points (a 9.7% increase) over 2004 while the cost of interest-bearing liabilities increased 38 basis points (a 22.5% increase). This resulted in a 16 basis point increase in net interest margin compared to the same period in 2004. The Corporation continues to manage its asset/liability position and interest rate risk through the methods discussed in the “Market Risk” section of Management’s Discussion.
16
The following table provides a comparative average balance sheet and net interest income analysis for the first quarter of 2005 as compared to the same period in 2004 (dollars in thousands):
17
The following table summarizes the changes in interest income and expense due to changes in average balances (volume) and changes in rates:
Interest income increased $26.9 million, or 23.6%, mainly as a result of the growth in average balances. Total interest-earning assets increased 13.8%, resulting in a $19.8 million increase in interest income. An additional $7.0 million increase was realized from the 49 basis point increase in rates.
Average loans and leases increased $1.5 billion, or 24.0%. The following summarizes the growth in average loans by category:
18
The Acquisitions contributed approximately $1.0 billion to the increase in average balances. The following table presents the average balance impact of the Acquisitions, by type:
The following table presents the growth in average loans, by type, excluding the average balances contributed by the Acquisitions:
Excluding the impact of the acquisitions, loan growth continued to be particularly strong in the commercial and commercial mortgage categories, which together increased $319.4 million, or 7.6%. Residential mortgage and residential construction increased $41.9 million, or 8.6%. Home equity loans increased $158.2 million, or 17.6%, due to promotional efforts and customers using home equity loans as a cost-effective refinance alternative. Consumer loans decreased slightly, reflecting repayment of these loans with tax-advantaged residential mortgage or home equity loans. Leasing and other loans decreased $14.2 million, or 20.7%.
The average yield on loans during the first quarter of 2005 was 6.16%, a 41 basis point, or 7.1%, increase over 2004. This reflects the impact of a significant portfolio of floating rate loans, which immediately reprice to higher rates when interest rates rise, as they have over the past twelve months.
Average investment securities decreased $367.1 million, or 13.1%. Excluding the impact of the Acquisitions, this decrease was $697.7 million, or 24.8%. During the past twelve months, the Corporation did not reinvest a significant portion of investment maturities in order to minimize interest rate risk in expectation of rising rates
19
and to help fund loan growth. The average yield on investment securities increased 7 basis points from 3.61% in 2004 to 3.68% in 2005.
Interest expense increased $11.6 million, or 37.4%, to $42.6 million in the first quarter of 2005 from $31.0 million in the first quarter of 2004. Interest expense increased $5.2 million due to an increase in average balances, with the remaining $6.4 million increase resulting from the 38 basis point increase in the cost of total interest-bearing liabilities. The cost of interest-bearing deposits increased 26 basis points, or 17.3%, from 1.50% in 2004 to 1.76% in 2005. This increase was due to rising rates in general as a result of the FRB’s rate increases over the past twelve months.
The following table summarizes the growth in average deposits by category:
The Acquisitions accounted for approximately $1.1 billion of the increase in average balances. The following table presents the average balance impact of the Acquisitions, by type:
The following table presents the growth in average deposits, by type, excluding the contribution of the Acquisitions:
20
Average borrowings increased slightly from the first quarter of 2004. The Acquisitions added $227.1 million to short-term borrowings and $115.5 million to long-term debt. Excluding the Acquisitions, average short-term borrowings decreased $332.9 million, or 24.7%, to $1.0 billion in 2005, while average long-term debt decreased $4.1 million or 0.7%, to $565.9 million. The decrease in short-term borrowings was mainly due to a decrease in Federal funds purchased which were reduced with funds from maturing securities.
Provision and Allowance for Loan Losses
The following table summarizes loans outstanding (net of unearned income) as of the dates shown:
21
The following table summarizes the activity in the Corporation’s allowance for loan losses:
The following table summarizes the Corporation’s non-performing assets as of the indicated dates:
The provision for loan losses for the first quarter of 2005 totaled $800,000, a decrease of $940,000, or 54.0%, from the same period in 2004. Net charge-offs totaled $300,000, or 0.02% of average loans on an annualized
22
basis, during the first quarter of 2005, an $869,000 improvement over the $1.2 million, or 0.08%, in net charge-offs for the first quarter of 2004. Non-performing assets decreased to $29.0 million, or 0.25% of total assets, at March 31, 2005, from $30.7 million, or 0.32% of total assets, at March 31, 2004.
Management believes that the allowance balance of $90.1 million at March 31, 2005 is sufficient to cover losses inherent in the loan portfolio on that date and is appropriate based on applicable accounting standards.
Other Income
The following table details the components of other income:
Total other income for the quarter ended March 31, 2005 was $35.9 million, an increase of $3.8 million, or 11.9%, over the comparable period in 2004. Excluding investment securities gains, which decreased from $5.8 million in 2004 to $3.3 million in 2005, other income increased $6.3 million, or 24.1%. The Acquisitions contributed $4.9 million to total other income in the first quarter of 2005.
Gains on sale of mortgage loans increased $4.3 million with Resource Bank contributing $3.7 million of the increase. Service charges on deposit accounts decreased $173,000, or 1.8%, (excluding the Acquisitions, service charges on deposit accounts decreased $456,000). The decrease was mainly due to increases in existing customers’ balances resulting in lower service charges for those accounts. Other income increased $1.3 million or 95.6%. The Acquisitions contributed $673,000 of the increase in other income with the remaining increase due to the change in the fair values of certain derivatives related to forward commitments for loan sales.
Investment securities gains decreased $2.5 million, or 43.1%. Investment securities gains during the first quarter of 2005 consisted of net realized gains of $2.5 million on the sale of equity securities and $790,000 on the sale of available for sale debt securities. Investment securities gains during the first quarter of 2004 consisted of net realized gains of $4.8 million on the sale of equity securities and $1.0 million on the sale of available for sale debt securities.
23
Other Expenses
The following table details the components of other expenses:
Total other expenses increased $11.5 million, or 18.4%, in 2005, including $10.8 million due to the Acquisitions, detailed as follows:
The following table presents the components of other expenses, excluding the amounts contributed by the Acquisitions, for the quarter ended March 31, 2005:
24
The discussion that follows addresses changes in other expenses, excluding the Acquisitions.
Salaries and employee benefits increased $1.6 million, or 4.2%, in comparison to the first quarter of 2004. The salary expense component increased $1.0 million, or 3.4%, driven by salary increases for existing employees, as total average full-time equivalent employees remained relatively consistent at approximately 2,900. Employee benefits increased $533,000, or 7.8%, in comparison to the first quarter of 2004 driven mainly by continued increases in healthcare costs.
Net occupancy expense increased $847,000, or 15.3%, to $6.4 million in 2005. The increase resulted from the expansion of the branch network and the addition of new office space for existing affiliates. Equipment expense decreased $127,000 or 4.8%, due to lower depreciation expense as certain equipment became fully depreciated.
Data processing expense decreased $153,000, or 5.4%, mainly as a result of renegotiations of key processing contracts with certain vendors. Advertising expense increased $225,000, or 14.7%, due to normal retail promotional campaigns. Intangible amortization decreased $72,000, or 7.3%, in the first quarter of 2005. Intangible amortization consists of the amortization of unidentifiable intangible assets related to branch and loan acquisitions, core deposit intangible assets, and other identified intangible assets. Since many of these intangibles are amortized using accelerated methods, amortization expense of existing intangibles decreases over time. Other expense decreased $1.6 million, or 13.4%, mainly as a result of several non-recurring items, including a reduction of the reserve for legal contingencies and an adjustment in deferred origination costs.
Income Taxes
Income tax expense for the first quarter of 2005 was $18.0 million, a $2.9 million, or 19.1%, increase from $15.1 million in 2004. The Corporation’s effective tax rate was approximately 30.3% in 2005 as compared to 29.7% in 2004. The effective rate is lower than the federal statutory rate of 35% due mainly to investments in tax-free municipal securities and federal tax credits from investments in low and moderate income housing partnerships.
FINANCIAL CONDITION
Total assets of the Corporation increased $260.0 million, or 2.3%, to $11.4 billion at March 31, 2005, compared to $11.2 billion at December 31, 2004. Investment securities decreased $64.5 million, or 2.6%, as a result of investment maturities exceeding investment purchases, and a $25.1 million increase in unrealized losses due to rising interest rates. Loans outstanding, net of unearned income, increased $162.8 million, or 2.1%, during the period. Commercial loans, commercial mortgages, residential mortgages and home equity loans each increased slightly, offset by declines in consumer and leasing and other loans.
Cash and due from banks increased $58.0 million, or 20.9%, to $336.0 million at March 31, 2005. Due to the nature of these accounts, daily balances can fluctuate up or down in the normal course of business.
Other short-term investments, Federal funds sold and mortgage loans held for sale increased $51.6 million, or 26.4%, mainly due to a $43.0 million increase in Federal funds sold which was offset by an increase in federal funds purchased. Other assets increased $49.5 million, or 30.4%, primarily due to an increase in receivables related to unsettled investment security sales.
Deposits increased $85.6 million, or 1.1%, from December 31, 2004. Noninterest-bearing deposits increased $71.6 million, or 4.7%, while interest-bearing demand deposits decreased $22.4 million, or 1.5%, and savings deposits were unchanged. Time deposits increased $36.6 million reflecting a slight shift by customers to longer term investments as rates on time deposits have increased due to competitive pressures resulting from the FRB’s two short-term interest rate increases during the first quarter of 2005.
25
Short-term borrowings, which consist mainly of Federal funds purchased and customer cash management accounts, increased $70.8 million, or 5.9%, during the first quarter of 2005. This was mainly due to an increase in Federal funds purchased. Long-term debt increased $88.9 million, or 13.0%, mainly due to $100.0 million of subordinated debt issued in March 2005. See the “Liquidity” section of Management’s Discussion for a summary of the terms of this debt.
Other liabilities increased $19.1 million, or 16.7%, due to a $6.7 million increase in accrued Federal income taxes and a $9.5 million increase in payables related to unsettled investment security purchases.
Capital Resources
Total shareholders’ equity decreased $6.8 million, or 0.5%, during the first three months of 2005. Increases due to net income of $41.5 million and $5.0 million in stock issuances were offset by $22.3 million in unrealized losses on securities, $20.8 million in cash dividends to shareholders, $6.9 million in stock repurchases and $3.2 million in unrealized losses on derivative financial instruments.
The Corporation periodically implements stock repurchase plans for various corporate purposes. In addition to evaluating the financial benefits of implementing repurchase plans, management also considers liquidity needs, the current market price per share and regulatory limitations. In 2002, the Board of Directors approved a stock repurchase plan, which was extended in both 2003 and 2004. On December 21, 2004 the Board of Directors approved an additional extension of the plan from December 31, 2004 to June 30, 2005 and increased the total number of shares that could be repurchased to 4.0 million. The plan originally permitted the Corporation to purchase 4.0 million shares. Prior to the date of the extension, there were only 1.5 million of the original 4.0 million shares still available to be repurchased. During the first quarter of 2005, 319,800 shares were purchased under this plan. As of March 31, 2005, there were approximately 3.7 million shares remaining that may be repurchased.
The Corporation and its subsidiary banks are subject to various regulatory capital requirements administered by banking regulators. Failure to meet minimum capital requirements can initiate certain actions by regulators that could have a material effect on the Corporation’s financial statements. The regulations require that banks maintain minimum amounts and ratios of total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined), and Tier I capital to average assets (as defined). As of March 31, 2005, the Corporation and each of its bank subsidiaries met the minimum requirements. In addition, the Corporation and each of its bank subsidiaries’ capital ratios exceeded the amounts required to be considered “well-capitalized” as defined in the regulations. The following table summarizes the Corporation’s capital ratios in comparison to regulatory requirements as of March 31:
Liquidity
The Corporation must maintain a sufficient level of liquid assets to meet the cash needs of its customers, who, as depositors, may want to withdraw funds or who, as borrowers, need credit availability. Liquidity is provided on a continuous basis through scheduled and unscheduled principal and interest payments on outstanding loans and investments and through the availability of deposits and borrowings. In addition,
26
the Corporation can borrow on a secured basis from the Federal Home Loan Bank to meet short-term liquidity needs.
The Corporation’s sources and uses of cash were discussed in general terms in the net interest income section of Management’s Discussion. The Consolidated Statements of Cash Flows provide additional information. The Corporation generated $39.8 million in cash from operating activities during the first quarter of 2005, mainly due to net income. Investing activities resulted in a net cash outflow of $205.5 million, as purchases of investment securities and loan originations exceeded sales and maturities of investment securities. Finally, financing activities resulted in a net inflow of $223.6 million due to increases in both deposits and borrowings.
Liquidity must also be managed at the Fulton Financial Corporation Parent Company level. For safety and soundness reasons, banking regulations limit the amount of cash that can be transferred from subsidiary banks to the Parent Company in the form of loans and dividends. Generally, these limitations are based on the subsidiary banks’ regulatory capital levels and their net income. Until 2004, the Parent Company had been able to meet its cash needs through normal, allowable dividends and loans. However, as a result of increased acquisition activity and stock repurchase plans, the Parent Company’s cash needs have increased, requiring additional sources of funds.
In July 2004, the Parent Company entered into a revolving line of credit agreement with an unaffiliated bank. Under the terms of the agreement, the Parent Company can borrow up to $50.0 million (may be increased to $100.0 million upon request) with interest calculated at the one-month London Interbank Offering Rate (LIBOR) plus 0.625%. The credit agreement requires the Corporation to maintain certain financial ratios related to capital strength and earnings. The Corporation was in compliance with all required covenants under the credit agreement as of March 31, 2005. As of March 31, 2005, there were no borrowings against this line.
On March 28, 2005 the Corporation issued $100 million of ten-year subordinated notes at a fixed rate of 5.35%. See also Note K “Subordinated Debt “ in the Notes to Consolidated Financial Statements.
These borrowing arrangements supplement the liquidity available from subsidiaries through dividends and borrowings and provide some flexibility in Parent Company cash management. Management continues to monitor the liquidity and capital needs of the Parent Company and will implement appropriate strategies, as necessary, to remain well capitalized and to meet its cash needs.
In addition to its normal recurring and operating cash needs, the Parent Company will also pay cash for a portion of the SVB acquisition, which is expected to be completed in the third quarter of 2005. Based on the terms of the merger agreement, the Parent Company will pay a minimum of approximately $17.0 million and a maximum of approximately $34.0 million to consummate the acquisition. See Note H, “ Acquisitions” in the Notes to Consolidated Financial Statements for a summary of the terms of this transaction.
27
Market risk is the exposure to economic loss that arises from changes in the values of certain financial instruments. The types of market risk exposures generally faced by financial institutions include interest rate risk, equity market price risk, foreign currency risk and commodity price risk. Due to the nature of its operations, only equity market price risk and interest rate risk are significant to the Corporation.
Equity Market Price Risk
Equity market price risk is the risk that changes in the values of equity investments could have a material impact on the financial position or results of operations of the Corporation. The Corporation’s equity investments consist primarily of common stocks of publicly traded financial institutions (cost basis of approximately $58.3 million and fair value of $58.7 million at March 31, 2005). The Corporation’s financial institutions stock portfolio had gross unrealized gains of approximately $2.7 million at March 31, 2005.
Although the carrying value of equity investments accounted for less than 1.0% of the Corporation’s total assets, the unrealized gains on the portfolio represent a potential source of revenue. The Corporation has a history of periodically realizing gains from this portfolio and, if values were to decline significantly, this revenue source could be lost.
Management continuously monitors the fair value of its equity investments and evaluates current market conditions and operating results of the companies. Periodic sale and purchase decisions are made based on this monitoring process. None of the Corporation’s equity securities are classified as trading. Future cash flows from these investments are not provided in the table on page 29 as such investments do not have maturity dates.
The Corporation has evaluated, based on existing accounting guidance, whether any unrealized losses on individual equity investments constituted “other than temporary” impairment, which would require a write-down through a charge to earnings. Based on the results of such evaluations, the Corporation recorded write-downs of $137,000 in 2004 and $3.3 million in 2003 for specific equity securities which were deemed to exhibit other than temporary impairment in value. Through March 31, 2005, gains of approximately $2.5 million had been realized on the sale of investments previously written down. Additional impairment charges may be necessary depending upon the performance of the equity markets in general and the performance of the individual investments held by the Corporation
In addition to its equity portfolio, the Corporation’s investment management and trust services revenue could be impacted by fluctuations in the securities markets. A portion of the Corporation’s trust revenue is based on the value of the underlying investment portfolios. If securities markets contract, the Corporation’s revenue could be negatively impacted. In addition, the ability of the Corporation to sell its equities brokerage services is dependent, in part, upon consumers’ level of confidence in the outlook for rising securities prices.
Interest Rate Risk
Interest rate risk creates exposure in two primary areas. First, changes in rates have an impact on the Corporation’s liquidity position and could affect its ability to meet obligations and continue to grow. Second, movements in interest rates can create fluctuations in the Corporation’s net income and changes in the economic value of its equity.
The Corporation employs various management techniques to minimize its exposure to interest rate risk. An Asset/Liability Management Committee (ALCO), consisting of key financial and senior management
28
personnel, meets on a weekly basis. The ALCO is responsible for reviewing the interest rate sensitivity position of the Corporation, approving asset and liability management policies, and overseeing the formulation and implementation of strategies regarding balance sheet positions and earnings. The primary goal of asset/liability management is to address the liquidity and net income risks noted above.
The following table provides information about the Corporation’s interest rate sensitive financial instruments. The table provides expected cash flows and weighted average rates for each significant interest rate sensitive financial instrument, by expected maturity period. None of the Corporation’s financial instruments are classified as trading.
29
The preceding table and discussion addressed the liquidity implications of interest rate risk and focused on expected contractual cash flows from financial instruments. Expected maturities, however, do not necessarily estimate the net interest income impact of interest rate changes. Certain financial instruments, such as adjustable rate loans, have repricing periods that differ from expected cash flows.
The Corporation uses three complementary methods to measure and manage interest rate risk. They are static gap analysis, simulation of earnings, and estimates of economic value of equity. Using these measurements in tandem provides a reasonably comprehensive summary of the magnitude of interest rate risk in the Corporation, level of risk as time evolves, and exposure to changes in interest rate relationships.
Static gap provides a measurement of repricing risk in the Corporation’s balance sheet as of a point in time. This measurement is accomplished through stratification of the Corporation’s assets and liabilities into predetermined repricing periods. The assets and liabilities in each of these periods are summed and compared for mismatches within that maturity segment. Core deposits having noncontractual maturities are placed into repricing periods based upon historical balance performance. Repricing for mortgage loans held and for mortgage-backed securities includes the effect of expected cash flows. Estimated prepayment effects are applied to these balances based upon industry projections for prepayment speeds. The Corporation’s policy limits the cumulative 6-month gap to plus or minus 15% of total earning assets. The cumulative 6-month gap as of March 31, 2005 was 0.98.
Simulation of net interest income and of net income is performed for the next twelve-month period. A variety of interest rate scenarios are used to measure the effects of sudden and gradual movements upward and downward in the yield curve. These results are compared to the results obtained in a flat or unchanged interest rate scenario. Simulation of earnings is used primarily to measure the Corporation’s short-term earnings exposure to rate movements. The Corporation’s policy limits the potential exposure of net interest income to 10% of the base case net interest income for every 100 basis point “shock” in interest rates. A “shock’ is an immediate upward or downward movement of interest rates across the yield curve based upon changes in the prime rate. The following table summarizes the expected impact of interest rate shocks on net interest income:
Economic value of equity estimates the discounted present value of asset cash flows and liability cash flows. Discount rates are based upon market prices for like assets and liabilities. Upward and downward shocks of interest rates are used to determine the comparative effect of such interest rate movements relative to the unchanged environment. This measurement tool is used primarily to evaluate the longer-term re-pricing risks and options in the Corporation’s balance sheet. A policy limit of 10% of economic equity may be at risk for every 100 basis point “shock” movement in interest rates. The following table summarizes the expected impact of interest rate shocks on economic value of equity.
30
31
The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this quarterly report, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in Corporation reports filed or submitted 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.
There have been no changes in our internal control over financial reporting during the fiscal quarter covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
32
PART II — OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On December 21, 2004 the Board of Directors approved an extension of its stock repurchase plan from December 31, 2004 to June 30, 2005 and increased the total number of shares that could be repurchased to 4.0 million. The plan originally permitted the Corporation to purchase 4.0 million shares. Prior to the date of the extension, there were only 1.5 million of the original 4.0 million shares still available to be repurchased.
During the first quarter of 2005, 319,800 shares were repurchased under this plan. No stock repurchases were made outside publicly announced plans and all were made under the guidelines of Rule 10b-18 and in compliance with Regulation M.
33
See Exhibit Index for a list of the exhibits required by Item 601 of Regulation S-K and filed as part of this report.
34
FULTON FINANCIAL CORPORATION AND SUBSIDIARIES
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.
35
EXHIBIT INDEX
Exhibits Required Pursuantto Item 601 of Regulation S-K
36