UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003
OR
For the transition period from to
Commission File Number: 000-25051
PROSPERITY BANCSHARES, INC.SM
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
As of November 5, 2003, there were 20,464,374 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.
PROSPERITY BANCSHARES, INC.SM AND SUBSIDIARIES
INDEX TO FORM 10-Q
PART I - FINANCIAL INFORMATION
Item 1.
Interim Financial Statements
Consolidated Balance Sheets as of September 30, 2003 (unaudited) and December 31, 2002
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2003 and 2002 (unaudited)
Consolidated Statements of Shareholders’ Equity for the Year Ended December 31, 2002 and for the Nine Months Ended September 30, 2003 (unaudited)
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002 (unaudited)
Notes to Interim Consolidated Financial Statements
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
Legal Proceedings
Changes in Securities and Use of Proceeds
Defaults upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5.
Other Information
Item 6.
Exhibits and Reports on Form 8-K
Signatures
2
PART I – FINANCIAL INFORMATION
ITEM 1. INTERIM FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
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 $228,413 (unaudited) and $305,158, respectively)
Held to maturity securities, at cost (fair value of $926,115 (unaudited) and $660,261, respectively)
Loans
Less allowance for credit losses
Loans, net
Accrued interest receivable
Goodwill
Core Deposit Intangibles (net of accumulated amortization of $782,000 (unaudited) and $192,000, respectively)
Bank premises and equipment, net
Other real estate owned
Other assets
TOTAL ASSETS
LIABILITIES:
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Other borrowings
Accrued interest payable
Other liabilities
Total liabilities
COMPANY-OBLIGATED MANDATORILY REDEEMABLE TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUSTS
SHAREHOLDERS’ EQUITY:
Common stock, $1.00 par value; 50,000,000 shares authorized; 19,001,343 (unaudited) and 18,903,028, shares issued at September 30, 2003 and December 31, 2002, respectively; 18,964,265 (unaudited) and 18,895,876 shares outstanding at September 30, 2003 and December 31, 2002, respectively
Capital surplus
Retained earnings
Accumulated other comprehensive income— net unrealized gain on available for sale securities, net of tax of $739 (unaudited) and $1,424 respectively
Less treasury stock, at cost, 37,088 shares at September 30, 2003 (unaudited) and 7,152 shares at December 31, 2002
Total shareholders’ equity
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See notes to interim consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three Months
Ended
September 30,
Nine Months
INTEREST INCOME:
Loans, including fees
Securities:
Taxable
Nontaxable
70% nontaxable preferred dividends
Deposits in financial institutions
Total interest income
INTEREST EXPENSE:
Deposits
Note payable and federal funds sold
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
Data processing
Core deposit intangible amortization
Depreciation expense
Minority interest trust preferred securities
Total noninterest expense
INCOME BEFORE INCOME TAXES
PROVISION FOR INCOME TAXES
NET INCOME
EARNINGS PER SHARE
Basic
Diluted
4
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
TotalShareholders’
Equity
BALANCE AT JANUARY 1, 2002
Net income
Net change in unrealized gain on available for sale securities
Total comprehensive income
Common Stock issued in connection with the exercise of stock options
Common Stock issued in connection with Paradigm Acquisition
Cash paid in lieu of fractional shares in connection with the Paradigm Acquisition
Cash dividends declared, $0.22 per share
BALANCE AT DECEMBER 31, 2002
Net income (unaudited)
Net change in unrealized gain on available for sale securities (unaudited)
Total comprehensive income (unaudited)
Stock option compensation (unaudited)
Trust preferred issuance cost (unaudited)
Common Stock issued in connection with the exercise of stock options (unaudited)
Treasury shares received in distribution from Paradigm holdback escrow (unaudited)
Cash dividends declared, $0.19 per share (unaudited)
BALANCE AT SEPTMEBER 30, 2003 (unaudited)
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Provision for credit losses
(Gain) loss on sale of premises and equipment
Gain on sale of other real estate
Net amortization of premium on investments
Decrease (increase) in accrued interest receivable and other assets
Decrease in accrued interest payable and other liabilities
Total adjustments
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
Net decrease in loans
Purchase of bank premises and equipment
Proceeds from sale of bank premises and equipment and other real estate acquired by foreclosure
Net decrease in interest-bearing deposits in financial institutions
Premium paid for the purchase of Dallas Bancshares
Net liabilities acquired in the purchase of Dallas Bancshares (net of cash of $10,517)
Premium paid for the purchase of Abrams Centre Bancshares
Net liabilities acquired in the purchase of Abrams Centre Bancshares (net of cash of $38,458)
Premium paid for the purchase of Texas Guaranty Bank N.A.
Net liabilities acquired in the purchase of Texas Guaranty Bank, N.A. (net of cash of $12,723)
Premium paid for the purchase of The First State Bank of Needville
Net liabilities acquired in the purchase of The First State Bank of Needville (net of cash of $4,938)
Premium paid for the purchase of Paradigm Bancorporation
Net liabilities acquired in the purchase of Paradigm Bancorporation (net of cash of $14,447)
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in noninterest-bearing deposits
Net increase in interest-bearing deposits
(Repayments) proceeds of other borrowings
Proceeds from the issuance of trust preferred securities
Cash paid in lieu of fractional shares for the Paradigm acquisition
(Table continued on following page)
6
Stock issuance costs
Payments of cash dividends
Sale of common stock
Net cash provided by financing activities
NET INCREASE OF CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
CASH AND CASH EQUIVALENTS, END OF PERIOD
7
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2003
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1. BASIS OF PRESENTATION
The interim consolidated financial statements include the accounts of Prosperity Bancshares, Inc.SM (the “Company”) and its wholly-owned subsidiaries, Prosperity Bank SM (the “Bank”) and Prosperity Holdings, Inc. 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, 2002. Operating results for the nine month period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.
2. INCOME PER COMMON SHARE
The following table illustrates the computation of basic and diluted earnings per share (in thousands, except per share data):
Net income available to common shareholders
Weighted average common shares outstanding
Potential dilutive common shares
Weighted average common shares and equivalents outstanding
Basic earnings per common share
Diluted earnings per common share
8
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
(DOLLARS IN THOUSANDS)
3. NEW ACCOUNTING STANDARDS
FIN No. 46 “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulleting No. 51.” FIN 46 establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIE’s were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangements entered into after January 31, 2003, and are otherwise effective at the beginning of the first interim period beginning after December 15, 2003.
The Company adopted FIN 46 on July 1, 2003. In its current form, FIN 46 may require the Company to de-consolidate its investments in Prosperity Capital Trust I, Prosperity Statutory Trust II, Paradigm Capital Trust I and Prosperity Statutory Trust III in future financial statements. The potential de-consolidation of subsidiary trusts of bank holding companies formed in connection with the issuance of trust preferred securities appears to be an unintended consequence of FIN 46. It is currently unknown if, or when, the Financial Accounting Standards Board will address this issue. In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier 1 capital for regulatory purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. As of September 30, 2003, assuming the Company was not allowed to include the $45.50 million in trust preferred securities issued by Prosperity Capital Trust I, Prosperity Statutory Trust II, Paradigm Capital Trust I and Prosperity Statutory Trust III, the Company would still exceed the regulatory required minimums for capital adequacy purposes.
SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” The amendments (i) reflect decisions of the Derivatives Implementation Group (DIG); (ii) reflect decisions made by the Financial Accounting Standards Board in conjunction with other projects dealing with financial instruments; and (iii) address implementation issues related to the application of the definition of a derivative. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, with all provisions applied prospectively. Adoption of SFAS 149 on July 1, 2003 did not have a significant impact on the Company’s financial statements.
SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in most circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments. The Company expects that SFAS 150 as written will cause the mandatorily redeemable trust preferred securities of subsidiary trust to be reclassified from a mezzanine equity item to a liability and the interest paid with respect to the trust preferred securities will be reclassified from noninterest expense to interest expense. On October 29, 2003, the FASB deferred the effective date for certain provisions of SFAS No. 150.
At the time the Company issued its earnings release on October 15, 2003, the effective date for SFAS 150 had not been deferred. In compliance with SFAS 150 as in effect as of October 15, 2003, the trust preferred securities balance of $45.5 million was reclassified to a liability from a mezzanine equity item. In addition, the dividend payments on the trust preferred securities were changed from being reported as a component of noninterest expense to being included as interest expense. As a result of these reclassifications at the time of the earnings release, the Company reported additional interest expense of $657,000 for a total interest expense of $6.4 million, total noninterest expense of $9.7 million and a net interest margin of 3.39% for the three months ended September 30, 2003 and interest expense of $18.5 million, total noninterest expense of $30.7 million and a net interest margin of 3.71% for the nine months ended September 30, 2003. With the effective date of SFAS 150 delayed, for the three months ended September 30, 2003, the Company’s interest expense is $5.7 million, noninterest expense is $10.4 million and the net interest margin is 3.54% and for the nine months ended September 30, 2003, the Company’s interest expense is $17.9 million, noninterest expense is $31.4 million and the net interest margin is 3.76%.
9
4. RECENT MERGER ACTIVITY
On October 3, 2003, the Company entered into a definitive agreement with First State Bank of North Texas, Dallas, Texas (“First State”) pursuant to which First State will be merged with and into the Bank. Under the terms of the agreement, the Company will pay approximately $12.6 million in cash and issue approximately 393,075 shares of its common stock, subject to adjustment, for all outstanding shares of First State. First State is privately held and operates four (4) banking offices in Dallas, Texas. As of September 30, 2003, First State had total assets of $100.70 million, loans of $20.1 million, deposits of $91.4 million and shareholders’ equity of $8.8 million. The transaction is expected to close during the fourth quarter of 2003. The Company will not complete the acquisition unless customary closing conditions are satisfied or waived, including receipt of the necessary shareholder and regulatory approvals and consents from applicable regulatory agencies including the Federal Reserve Board, the Texas Department of Banking and the Federal Deposit Insurance Corporation.
On November 1, 2003, the Company completed the merger of MainBancorp, Inc., Dallas Texas (“MainBancorp”) with and into the Company. In connection with the transaction, MainBancorp’s wholly owned subsidiary, mainbank, n.a., was merged with and into the Bank. Under the terms of the Agreement and Plan of Merger, as amended, the Company issued 1,500,000 shares of its Common Stock and paid approximately $9,149,421 in cash for all outstanding shares of MainBancorp stock. In addition, the Company assumed options to acquire 100,851 shares of its Common Stock. MainBancorp was privately held and operated four (4) banking offices in Dallas, Texas. As of September 30, 2003, mainbank, n.a. had total assets of $177.1 million, loans of $90.8 million, deposits of $153.7 million and shareholders’ equity of $22.6 million.
5. STOCK INCENTIVE PROGRAM
The Company has two stock-based employee compensation plans. 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. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the FASB issued Statement No. 148 (SFAS 148). Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment to FASB Statement 123. SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 is effective for financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2003, the Company adopted the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, as provided by SFAS No. 148 for stock-based employee compensation.
10
If compensation expense had been recorded based on the fair value at the grant date for awards consistent with SFAS No. 123 for the quarter and nine months ended September 30, 2002, the Company’s net income and earnings per share would have been as follows:
Net Income as reported
Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects
Proforma net income
Earnings per share:
Basic-as reported
Basic-proforma
Diluted-as reported
Diluted-proforma
6. GOODWILL AMORTIZATION
In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121 and subsequently, SFAS No. 144 after its adoption.
The Company adopted the provisions of SFAS No. 142 as of January 1, 2002. Goodwill and intangible assets determined to have an indefinite useful life acquired in a purchase business combination completed after June 30, 2001 are no longer amortized.
11
Changes in the carrying amount of the Company’s goodwill and core deposit intangibles for nine months ended September 30, 2003 were as follows:
Balance as of December 31, 2002
Less:
Amortization
Add:
Acquisition of Paradigm Bancorporation
Additional core deposit intangibles identified related to the acquisition of First National Bank of Bay City
Acquisition of Southwest Bank Holding Company
Acquisition of Abrams Centre Bancshares
Acquisition of Dallas Bancshares
Balance as of September 30, 2003
12
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.
13
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.
RECENT DEVELOPMENTS
OVERVIEW
Prosperity Bancshares, Inc.SM (the “Company”) was formed in 1983 as a vehicle to acquire the former Allied Bank in Edna, Texas which was chartered in 1949. 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 BankSM (“Prosperity Bank” or the “Bank”). The Bank provides a broad line of financial products and services to small and medium-sized businesses and consumers. The Bank operates forty-five (45) full-service banking locations; with forty (40) in the Greater Houston CMSA and fifteen contiguous counties situated south and southwest of Houston and extending into South Texas and five (5) in Dallas, Texas. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, and Montgomery counties.
Total assets were $2.08 billion at September 30, 2003 compared with $1.82 billion at December 31, 2002. Total loans increased to $700.2 million at September 30, 2003 from $679.6 million at December 31, 2002, an increase of $20.7 million, or 3.0%. Loans from the Abrams Centre Bancshares acquisition which was completed on May 6, 2003 (“Abrams”) totaled $27.8 million and loans from the Dallas Bancshares acquisition which was completed on June 1, 2003 (“Dallas Bancshares”) totaled $26.9 million. Total deposits were $1.83 billion at September 30, 2003 compared with $1.59 billion at December 31, 2002, an increase of $240.7 million, or 15.2%. Trust preferred securities increased from $33.0 million at December 31, 2002 to $45.5 million at September 30, 2003, an increase of $12.5 million or 37.9%. Shareholders’ equity increased $14.2 million or 9.2%, to $169.0 million at September 30, 2003 compared with $154.7 million at December 31, 2002.
RESULTS OF OPERATIONS
Net income available to common shareholders was $6.5 million ($0.34 per common share on a diluted basis) for the quarter ended September 30, 2003 compared with $5.7 million ($0.32 per common share on a diluted basis) for the quarter ended September 30, 2002, an increase of $817,000, or 14.5%. The Company posted returns on average common equity of 15.45% and 19.43%, returns on average assets of 1.29% and 1.54% and efficiency ratios of 50.25% and 48.90% for the quarters ended September 30, 2003 and 2002, respectively.
14
For the nine months ended September 30, 2003, net income available to common shareholders was $19.4 million ($1.01 per common share on a diluted basis) compared with $14.9 million ($0.89 per common share on a diluted basis) for the same period in 2002, an increase of $4.4 million or 29.6%. The Company posted returns on average common equity of 15.83% and 19.64%, returns on average assets of 1.34% and 1.46% and efficiency ratios of 50.74% and 50.99% for the nine months ended September 30, 2003 and 2002, respectively.
Net Interest Income
Net interest income was $15.7 million for the quarter ended September 30, 2003 compared with $14.0 million for the quarter ended September 30, 2002, an increase of $1.7 million, or 12.3%. Net interest income increased primarily as a result of an increase in average interest-earning assets to $1.83 billion for the quarter ended September 30, 2003 from $1.36 billion for the quarter ended September 30, 2002, an increase of $468.3 million, or 34.4%. Additionally, the increase in net interest income was partially offset by a decrease in the net interest margin from 4.10% for the three months ended September 30, 2002 to 3.42% for the three months ended September 30, 2003.
The decrease of the net interest margin was principally due to a 133 basis point decrease in the yield on earning assets from 6.00% for the quarter ended September 30, 2002 to 4.67% for the quarter ended September 30, 2003 partially offset by a 80 basis point decrease in the rate paid on interest-bearing liabilities from 2.40% for the quarter ended September 30, 2002 compared with 1.60% for the quarter ended September 30, 2003.
Net interest income increased $9.1 million, or 23.5%, to $47.9 million for the nine months ended September 30, 2003 from $38.8 million for the same period in 2002. This increase is mainly attributable to an increase in average interest-earning assets to $1.75 billion for the nine months ended September 30, 2003 from $1.28 billion for the nine months ended September 30, 2002, an increase of $476.9 million, or 37.3%. Additionally, the increase net interest income was partially offset by a decrease in the net interest margin from 4.05% for the nine months ended September 30, 2002 to 3.64% for the nine months ended September 30, 2003.
The decrease of the net interest margin was primarily due to a 104 basis point decrease in the yield on earning assets from 6.04% for the nine months ended September 30, 2002 to 5.00% for the nine months ended September 30, 2003 partially offset by a 76 basis point decrease in the rate paid on interest-bearing liabilities from 2.49% for the nine months ended September 30, 2002 to 1.73% for the nine months ended September 30, 2003.
15
The following tables set forth, for each 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 quarter ended September 30, 2003 and 2002 and for the nine months ended September 30, 2003 and 2002, respectively. The tables also set forth 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:
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
Company-obligated mandatorily redeemable trust preferred securities of subsidiary trusts
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)
16
17
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.”
The following tables present the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguish between the increase (decrease) related to outstanding balances and the volatility of interest rates for the periods indicated. For purposes of these tables, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.
Three Months Ended
2003 vs. 2002
Increase
(Decrease)
Due to
Total
Securities
Total increase (decrease) in interest income
Total increase (decrease) 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,
18
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.
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 loan 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.
The provision for credit losses for the quarter ended September 30, 2003 and 2002 was $120,000. The provision for credit losses for the nine months ended September 30, 2003 and 2002 was $360,000.
Noninterest Income
The Company’s primary sources of noninterest income are service charges on deposit accounts and other banking service related fees. The following table presents, for the periods indicated, the major categories of noninterest income:
Three MonthsEnded
Service charges on deposit accounts
Other noninterest income
Net gain on sale of assets
Noninterest income totaled $4.3 million for the three months ended September 30, 2003 compared with $2.9 million for the same period in 2002, an increase of $1.4 million, or 48.9%. Noninterest income increased $4.7 million, or 64.2%, to $12.1 million for the nine months ended September 30, 2003 from $7.4 million for the same period in 2002. The increases are primarily attributable to the First National Bank of Bay City (“FNB”), Paradigm Bancorporation (“Paradigm”), Southwest Bank Holding Company (“Southwest”), Abrams and Dallas Bancshares acquisitions. The increases are also partially attributable to increases in net gain on sale of assets of $193,000 for the three months ended September 30, 2003 compared with the same period in 2002 and $199,000 for the nine months ended September 30, 2003 compared with the same period in 2002. The net gains on the sale of assets are non-recurring in nature.
Noninterest Expense
Noninterest expense totaled $10.4 million for the quarter ended September 30, 2003 compared with $8.5 million for the quarter ended September 30, 2002, an increase of $1.9 million, or 21.8%. This increase is principally due to increases in salaries and employee benefits, increases in occupancy expense and increases in core deposit intangibles amortization expense related to the Paradigm, FNB, Southwest, Abrams and Dallas Bancshares acquisitions.
19
Noninterest expense totaled $31.4 million for the nine months ended September 30, 2003, an increase of $7.1 million, or 29.1%, from $24.3 million for the same period in 2002. This increase is principally due to increases in salaries and employee benefits, increases in occupancy expense and increases in core deposit intangibles amortization expense related to the Paradigm, FNB, Southwest, Abrams and Dallas Bancshares acquisitions.
The following table presents, for the periods indicated, the major categories of noninterest expense:
Non-staff expenses:
Depreciation
Communications expense (telephone, data circuits and courier)
Professional fees
Regulatory assessments and FDIC insurance
Ad valorem and franchise taxes.
Core deposit intangibles and goodwill amortization
Minority interest expense trust preferred securities
Total non-staff expenses
Salaries and employee benefit expenses were $5.3 million for the quarter ended September 30, 2003 compared with $4.0 million for the quarter ended September 30, 2002, an increase of $1.3 million, or 33.0%. For the nine months ended September 30, 2003, salaries and employee benefits increased $4.7 million or 41.5% compared with the same period in 2002. Both increases were principally due to additional staff associated with the acquisition of Paradigm, FNB, Southwest, Abrams and Dallas Bancshares acquisitions.
Non-staff expenses increased $553,000, or 1.2%, to $5.1 million for the quarter ended September 30, 2003 compared with the same period in 2002. For the nine month period ended September 30, 2003, non-staff expenses increased $2.4 million, or 18.3%, to $15.4 million from $13.0 million for the same period in 2002. The increase during nine months ended September 30, 2003 was principally due to acquisition expenses related to the addition of thirteen banking centers since September 30, 2002.
Income Taxes
Income tax expense increased $450,000, or 17.5%, to $3.0 million for the three months ended September 30, 2003 from $2.6 million for the same period in 2002. For the nine month period ended September 30, 2003, income tax expense increased $2.4 million, or 36.4%, to $9.0 million from $6.6 million for the same period in 2002. The increase was primarily attributable to higher pretax net earnings.
FINANCIAL CONDITION
Loan Portfolio
Total loans were $700.2 million at September 30, 2003, an increase of $20.7 million, or 3.0% from $679.6 million at December 31, 2002. Loans acquired as a part of the Abrams acquisition totaled $27.8 million and loans from the Dallas Bancshares acquisition totaled $26.9 million. Loans from acquisitions completed during 2002 declined during the first nine months of 2003 primarily from management’s desire to improve the credit quality of its
20
acquired loans. Period end loans comprised 39.9% of average earning assets at September 30, 2003 compared with 49.8% at December 31, 2002. Loan growth occurred primarily in commercial mortgage loans.
The following table summarizes the loan portfolio of the Company by type of loan as of September 30, 2003 and December 31, 2002:
2003
December 31,
2002
Commercial and industrial
Real estate:
Construction and land development
1-4 family residential
Home equity
Commercial mortgages
Farmland
Multifamily residential
Agriculture
Consumer
Total loans
Nonperforming Assets
The Company had $1.4 million in nonperforming assets at September 30, 2003 and $2.6 million in nonperforming assets at December 31, 2002, a decrease of $1.2 million or 82.0%. 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. Other real estate, which consists of one commercial property, totaled $765,000 at September 30, 2003.
The following table presents information regarding nonperforming assets as of the dates indicated:
Nonaccrual loans
Other non-performing loans
Accruing loans 90 or more days past due
Total nonperforming loans
Repossessed assets
Other real estate
Total nonperforming assets
Allowance for Credit Losses
Management actively monitors the Company’s asset quality and provides specific loss allowances when necessary. 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 September 30, 2003, the allowance for credit losses amounted to $9.1 million, or 1.29% of total loans compared with $6.0 million, or 1.41% of total loans at December 31, 2002.
21
Set forth below is an analysis of the allowance for credit losses for the periods indicated:
Nine MonthsEnded
September 30,2003
Year
December 31,2002
Average loans outstanding
Gross loans outstanding at end of period
Allowance for credit losses at beginning of period
Balance acquired with the Abrams and Dallas Bancshares acquisitions
Balance acquired with the Texas Guaranty, First State, Paradigm, FNB and Southwest acquisitions
Charge-offs:
Real estate and agriculture
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 $1.15 billion at September 30, 2003 compared with $950.3 million at December 31, 2002, an increase of $200.6 million, or 21.1%. At September 30, 2003, securities represented 55.4% of total assets compared with 52.2% of total assets at December 31, 2002. The growth in securities was primarily due to the Paradigm, FNB, Southwest, Abrams and Dallas Bancshares acquisitions.
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
Equity securities
Collateralized mortgage obligations
Mortgage-backed securities
22
Premises and Equipment
Premises and equipment, net of accumulated depreciation, totaled $28.3 million at September 30, 2003 and $27.0 million at December 31, 2002.
Total deposits were $1.83 billion at September 30, 2003 compared with $1.59 billion at December 31, 2002, an increase of $240.7 million or 15.2%. Total deposits acquired in the Abrams acquisition were $66.7 million and total deposits acquired in the Dallas Bancshares acquisition were $33.9 million. At September 30, 2003, noninterest-bearing deposits accounted for 20.5% of total deposits compared with 20.7% of total deposits at December 31, 2002. Interest-bearing deposits totaled $1.45 billion, or 79.5%, of total deposits at September 30, 2003 compared with $1.26 billion, or 79.3%, of total deposits at December 31, 2002.
The following table summarizes the daily average balances and weighted average rates paid on deposits for the dates presented below:
Interest-bearing checking
Regular savings
Money market savings
Time deposits
Total interest-bearing deposits
Noninterest-bearing deposits
Other Borrowings
Deposits are the primary source of funds for the Company’s lending and investment activities. Occasionally, the Company obtains additional funds from the Federal Home Loan Bank (“FHLB”) and correspondent banks. At September 30, 2003, the Company had $12.1 million in FHLB borrowings, all of which consisted of FHLB notes payable. The FHLB notes payable were obtained through various bank acquisitions. The maturity dates on the FHLB notes payable range from the years 2004 to 2018 and have interest rates ranging from 5.95% to 6.48%. At December 31, 2002, the Company had $37.9 million in FHLB borrowings of which $12.6 million consisted of FHLB notes payable and $25.3 million consisted of FHLB advances. Any FHLB advances are secured by a blanket lien on the Bank’s first mortgage loans against one-to-four family residential properties.
At September 30, 2003, the Company had $19.0 million in securities sold under repurchase agreements.
Trust Preferred Securities
At September 30, 2003, the Company’s subsidiary trusts had outstanding $45.5 million in trust preferred securities compared with $33.0 million at December 31, 2002, an increase of $12.5 million or 37.9%. The increase is due to the issuance of $12.5 million in fixed/floating rate trust preferred securities on August 15, 2003 by Prosperity Statutory Trust III (“Trust III”). Trust III used all of the proceeds from the sale of the trust preferred securities and the common securities of Trust III to purchase Fixed/Floating Rate Junior Subordinated Deferrable Interest Debentures of the Company (the “Debentures”). The Debentures bear interest at a fixed rate per annum of 6.50%, payable quarterly, through September 17, 2008. Thereafter, the Debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 3.00%, reset quarterly. The dividends paid by Trust III on the trust preferred securities are equal to the interest paid by the Company on the Debentures.
23
The Debentures mature on September 17, 2033. The Debentures may be redeemed by the Company, in whole or in part, on or after September 17, 2008 if certain conditions are met (including the Company having received the prior approval of the Federal Reserve and any other required regulatory approvals). The Debentures may also be redeemed in whole at any time upon the occurrence and continuation of certain events including a change in the tax status or regulatory capital treatment of the trust preferred securities or Trust III being considered an investment company. The trust preferred securities will be subject to mandatory redemption in a like amount contemporaneously with the optional prepayment of the Debentures by the Company.
Liquidity
Effective management of balance sheet liquidity is necessary to fund growth in earning assets and to pay liability maturities, depository customers’ withdrawal requirements and shareholders’ dividends. The Company has numerous sources of liquidity including a significant portfolio of shorter-term assets, marketable investment securities (excluding those presently classified as “held-to-maturity”), increases in customers’ deposits, and access to borrowing arrangements. Available borrowing arrangements maintained by the Company include federal funds lines with other commercial banks and an advancement arrangement with the FHLB.
Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. As of September 30, 2003, the Company had cash and cash equivalents of $103.9 million, up from $80.8 million at December 31, 2002.
The Company’s future cash payments associated with its contractual obligations pursuant to its long-term debt and operating leases as of September 30, 2003 are summarized below:
Fiscal
2004-2005
2006-2007
Long-term debt
Operating leases
Off Balance Sheet Items
The Company’s commitments associated with outstanding letters of credit and commitments to extend credit as of September 30, 2003 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 $169.0 million at September 30, 2003 compared with $154.7 million at December 31, 2002, an increase of $14.2 million, or 9.2%. The increase was primarily due to net earnings of $19.4 million partially offset by a net change in unrealized gain on available for sale securities of $1.3 million and cash dividends paid of $3.6 million.
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 September 30, 2003, the
24
Company’s Tier 1 capital, total risk-based capital and leverage capital ratios were 16.09%, 17.20% and 6.85%, respectively. As of September 30, 2003, 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 capital, total risk-based capital and leverage capital ratios of 14.67%, 15.78% and 6.25%, respectively.
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. It considers macroeconomic variables, Company strategy, liquidity and other factors as it quantifies market risk. See Form 10-K, Item 7 “Management’s Discussion and Analysis and Results of Operations-Interest Rate Sensitivity and Liquidity” which was filed on March 7, 2003 for further discussion.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. The Company carried out an evaluation, under the supervision and with the participation of it’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. 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. There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II – OTHER INFORMATION
Not Applicable
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
25
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
The following exhibits are filed with this Quarterly Report on Form 10-Q:
26
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.
/s/ David Zalman
/s/ David Hollaway
27
Exhibit Index