Fulton Financial - 10-Q quarterly report FY

 

(Mark One)

(Exact name of registrant as specified in its charter)

(717) 291-2411

(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 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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

The accompanying unaudited consolidated financial statements of Fulton Financial Corporation (the Corporation) 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 and six-month periods ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

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:

Total comprehensive income was $57.1 million and $73.1 million for the three and six months ended June 30, 2005, respectively. Total comprehensive loss was $4.3 million for the quarter ended June 30, 2004 and total comprehensive income was $35.7 million for the six months ended June 30, 2004.

The Corporation declared a 5-for-4 stock split on April 13, 2005, which was paid in the form of a 25% stock dividend on June 8, 2005 to shareholders of record on May 17, 2005. All share and per-share information has been restated to reflect the impact of this stock split.

The Corporation does not have any operating segments, which require disclosure of additional information. While the Corporation owned thirteen separate banks as of June 30, 2005, each engaged in similar activities and provided similar products and services. The Corporation’s non-banking activities are immaterial and, therefore, separate information has not been disclosed.

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” (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 (SEC) 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. On July 1, 2005 the Corporation granted 1.1 million stock options under its Stock Option and Compensation Plan.

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 three and six-month periods ended June 30:

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 three or six-month periods ended June 30, 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 released Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (EITF 03-1), which provides guidance for evaluating whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments.

In June 2005, the FASB voted to nullify certain provisions of EITF 03-1 which addressed the evaluation of an impairment to determine whether it was other-than-temporary. In general, these provisions required companies to declare their ability and intent to hold other-than-temporarily impaired investments until they recovered their losses. If a company was unable to make this declaration, write-downs of investment securities through losses charged to the income statement would be required. The effective date of these provisions was

originally delayed in September 2004, due to industry concerns about the potential impact of this proposed accounting.

Adoption of the surviving provisions of EITF 03-1 did not have a material impact on the Corporation’s financial condition or results of operations. The Corporation continues to apply the provisions of existing authoritative literature in evaluating its investments for other-than-temporary impairment.

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 (FWSB), 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 stock options assumed and $610,000 in First Washington stock purchased for cash and other direct acquisition costs. The Corporation issued 1.69 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.

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. 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 total purchase price was $195.7 million, including $185.9 million in stock issued and stock options assumed and $9.8 million in Resource stock purchased for cash and other direct acquisition costs. The Corporation issued 1.925 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.

The following table summarizes unaudited pro-forma information assuming the acquisitions of Resource and First Washington 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):

Acquisition of SVB Financial Services, Inc.: On July 1, 2005, the Corporation completed its acquisition of SVB Financial Services, Inc. (SVB). SVB was a $530 million bank holding company whose primary subsidiary was Somerset Valley Bank (Somerset Valley), which operates 11 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 was acquired by the Corporation based on a “cash election merger” structure. Each SVB shareholder elected to receive 100% of the merger consideration in stock, 100% in cash, or a combination of stock and cash.

As a result of the SVB shareholder elections, approximately 3.1 million of the SVB shares outstanding on the acquisition date were converted into shares of Corporation common stock, based on a fixed exchange ratio of 1.1899 shares of Corporation stock for each share of SVB stock. The remaining 984,000 shares of SVB stock were purchased for $21.00 per share, or a total of $20.7 million cash. In addition, each of the options to acquire SVB’s stock were converted into options to purchase the Corporation’s stock or were settled in cash, based on the election of each option holder and the terms of the merger agreement.

As a result of the acquisition, SVB was merged into the Corporation and Somerset Valley became a wholly owned subsidiary. The acquisition is being accounted for using purchase accounting, which 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 purchase price being recorded as goodwill. Resulting goodwill balances are then subject to an impairment test on at least an annual basis. The results of Somerset Valley’s operations will be included in the Corporation’s financial statements prospectively from the July 1, 2005 acquisition date.

The total purchase price of approximately $90 million includes the value of the Corporation’s stock issued ($65.7 million), cash paid ($20.7 million), SVB options converted or settled in cash ($2.5 million), and certain acquisition related costs ($1.0 million). The carrying value of the net assets of Somerset Valley as of July 1, 2005 was approximately $31.5 million and, therefore, the purchase price exceeded the carrying value of the net assets by approximately $58.5 million. The total purchase price will be allocated to the net assets acquired, based on acquisition date fair values. The Corporation expects to record a core deposit intangible asset and goodwill as a result of the acquisition accounting. The Corporation is in the process of completing its fair value analysis and will determine the allocation of the purchase price to the fair value of net assets acquired and goodwill during the third quarter of 2005.

Pending Acquisition – Columbia Bancorp: On July 26, 2005, the Corporation entered into a merger agreement to acquire Columbia Bancorp (Columbia), of Columbia, Maryland. Columbia is a $1.3 billion bank holding company whose primary subsidiary is Columbia Bank, which operates 19 full-service community banking offices and five retirement community offices in Howard, Montgomery, Prince George’s and Baltimore Counties and Baltimore City.

Under the terms of the merger agreement, each of the approximately 6.9 million shares of Columbia’s common stock will be acquired based on a “cash election merger” structure. Each Columbia shareholder will have the ability to elect to receive 100% of the merger consideration in stock, 100% in cash, or a combination of stock and cash. Their elections will be subject to prorating to achieve a result where a minimum of 20% and a maximum of 50% of Columbia’s outstanding shares will receive cash consideration. Those shares that will be converted into Corporation common stock would be exchanged based on a fixed exchange ratio of 2.325 shares of Corporation stock for each share of Columbia stock. Those shares of Columbia stock that will be converted into cash will be converted into a per-share amount of cash based on a fixed price of $42.48 per

share of Columbia stock. In addition, each of the options to acquire Columbia’s stock will be converted to options to purchase the Corporation’s stock.

The acquisition is subject to approval by both the Columbia shareholders and applicable bank regulatory authorities. The acquisition is expected to be completed during the first quarter of 2006. As a result of the acquisition, Columbia will be merged into the Corporation and Columbia Bank will become a wholly-owned subsidiary.

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 Columbia’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 $313 million, which includes cash expected to be paid, the value of the Corporation’s stock expected to be issued, the value of Columbia’s options to be converted and certain acquisition related costs. The net assets of Columbia as of June 30, 2005 were $91.3 million and, therefore, the estimated purchase price exceeded the carrying value of the net assets by $221.7 million. 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.

As of June 30, 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 (loss) 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 97.7% effective as of June 30, 2005. As a result, a $109,000 and $46,000 credit to income for the three and six-month periods ended June 30, 2005, respectively, was recognized. During the six months ended June 30, 2005, the Corporation also recorded a $1.0 million other comprehensive loss (net of $540,000 tax effect) to recognize the fair value changes of derivatives resulting from the rising interest rate environment.

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.

The outstanding amounts of commitments to extend credit and letters of credit were as follows:

On May 4, 2005, the Corporation purchased 4.3 million shares of its common stock from an investment bank at a total cost of $73.6 million, or $17.06 per share, under an “Accelerated Share Repurchase” program (ASR), which allowed the shares to be purchased 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 will settle its position with the investment bank at the completion 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. Through June 30, 2005, the investment bank had repurchased 193,000 shares at an average weighted cost of $17.73 per share. The Corporation expects the ASR to be completed in 2006.

On March 28, 2005 the Corporation issued $100.0 million of ten-year subordinated notes, which mature April 1, 2015 and carry a fixed rate of 5.35%. Interest is paid semi-annually, commencing in October 2005. These notes were registered with the SEC on Form S-4, filed August 4, 2005.

Certain amounts in the 2004 consolidated financial statements and notes have been reclassified to conform to the 2005 presentation.

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.

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.

As a financial institution with a focus on traditional banking activities, the 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, investments, or properties. Offsetting these revenue sources are provisions for credit losses on loans, other operating expenses and income taxes.

The Corporation’s net income for the second quarter of 2005 increased $3.7 million, or 9.8%, from $37.9 million in 2004 to $41.6 million in 2005. Diluted net income per share increased $0.02, or 8.0%, from $0.25 in 2004 to $0.27 in 2005. The percentage increase in net income per share was slightly 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 1.46% and average equity of 13.95% during the second 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 20.64% for the quarter.

The increase in net income compared to the second quarter of 2004 resulted from an $11.2 million increase in net interest income and a $5.6 million increase in other income (excluding security gains), offset by a $3.9 million

decrease in security gains, a $7.6 million increase in other expenses and a $1.7 million increase in income taxes. Net interest income growth resulted from increases in average earning assets, due to the acquisition of First Washington FinancialCorp (First Washington) in December 2004 (see “Acquisitions” below) and internal growth. The net interest margin increased 5.1% compared to the second 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 second quarter 2005 results.

Interest Rates – Changes in the interest rate environment can have an effect on both the Corporation’s net interest income and its non-interest income. The interest rate environment is commonly evaluated based on the shape of the U. S. Treasury yield curve (Yield Curve), which plots the yields on treasury issues over various maturity periods. During the past year, the Yield Curve has flattened, with short-term rates increasing and longer-term rates decreasing.

Floating rate loans, short-term borrowings and savings and time deposit rates are generally influenced by short-term rates. The FRB raised the Federal funds rate nine times since June 2004, for a total increase of 225 basis points (from 1.00% to 3.25%). The Corporation’s prime lending rate had a corresponding increase, from 4.00% to 6.25%. The increase in short-term rates initially benefited the Corporation as floating rate loans quickly adjusted to higher rates, while increases in deposit rates – which are more discretionary – were less pronounced. As a result, the Corporation realized an increase in net interest margin in the third and fourth quarters of 2004 and the first quarter of 2005.

During the second quarter of 2005, competitive pressures resulted in increases in deposit rates. In addition, the Corporation issued $100 million of subordinated debt at 5.35% at the end of March 2005. As a result, the net interest margin decreased three basis points compared to the first quarter of 2005.

With respect to longer-term rates, the 10-year treasury yield, which is a common benchmark for evaluating residential mortgage rates, decreased to 3.94% at June 30, 2005 as compared to 4.58% at June 30, 2004. Mortgage rates have been generally low over the past several years, generating strong refinance activity and significant gains for the Corporation as fixed rate residential mortgages are generally sold in the secondary market. With the decrease in long-term rates from the prior year, origination volume and the resulting gains on sales of these loans have remained strong, contributing to the Corporation’s non-interest income.

The Corporation manages its risk associated with changes in interest rates through the techniques documented in the “Market Risk” section of Management’s Discussion. As of June 30, 2005, the Corporation projects improvements in net interest income in a rising rate environment. 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 from 2004 to 2005 as a result of the First Washington acquisition and strong internal loan growth. This growth also contributed to the increase in net interest income. With improving regional economic conditions the Corporation is optimistic that internal loan growth in the short-term will continue to be strong.

From 2004 to 2005, the Corporation experienced a shift in its composition of interest-earning assets from investments (23.3% of total average interest-earning assets in 2005, compared to 27.7% in 2004) to loans (74.8% in 2005 compared to 71.1% in 2004). This change resulted from strong loan demand being funded with the proceeds from maturing investment securities, primarily mortgage-backed securities. 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 second quarter of 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 second quarters of 2005 and 2004, with total gains of $1.4 million and $5.3 million, respectively. Declines in bank stock portfolio values could have a detrimental impact on the Corporation’s ability to recognize gains from these sales.

Acquisitions — In April 2004, the Corporation acquired Resource Bankshares Corporation (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 (FWSB). Results for 2005 in comparison to 2004 were impacted by these acquisitions, as documented in the appropriate sections of Management’s Discussion.

In July 2005, the Corporation acquired SVB Financial Services, Inc. (SVB) of Somerville, New Jersey. SVB was a $530 million bank holding company whose primary subsidiary was Somerset Valley Bank, which operates 11 community-banking offices in Somerset, Hunterdon and Middlesex counties in New Jersey. The acquisition was completed on July 1, 2005. For additional information on the terms of this acquisition, see Note I, “Subsequent Events”, in the Notes to Consolidated Financial Statements.

Acquisitions have long been a supplement to the Corporation’s internal growth. These recent 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.

Merger and acquisition activity also impacted the Corporation’s capital and liquidity. In order to complete acquisitions, the Corporation must have strategies in place to maintain appropriate levels of capital and to provide necessary cash resources. In March 2005, the Corporation issued $100 million of subordinated debt, in part to support

treasury stock repurchases related to acquisitions. This financing instrument also qualifies as a component of total regulatory capital. See additional information in the “liquidity” section of Management’s Discussion.

Results for the second quarter of 2005 compared to the results of the second quarter of 2004 were impacted by the December 2004 acquisition of FWSB, whose results are included in 2005 amounts, but not in 2004.

Net interest income increased $11.2 million, or 12.6% ($7.0 million, or 7.9%, excluding FWSB), to $99.9 million in 2005 from $88.7 million in 2004. The increase was due to both average balance growth, with total earning assets increasing 7.0%, and an improving net interest margin. The average taxable equivalent yield on earning assets increased 69 basis points (a 13.5% increase) over 2004 while the cost of interest-bearing liabilities increased 62 basis points (a 37.1% increase). This resulted in a 19 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.

The following table provides a comparative average balance sheet and net interest income analysis for the second quarter of 2005 as compared to the same period in 2004. Interest income and yields are presented on a tax-equivalent basis, using a 35% Federal tax rate. The discussion following this table is based on these tax-equivalent amounts. All dollar amounts are in thousands.

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 $26.6 million, or 21.4%, mainly as a result of both the increased yield on interest earning assets and growth in average balances. Interest income increased $14.6 million as a result of the 69 basis point increase in rates. An additional $12.0 million increase was realized from the 7.0% increase in average balances.

Average loans increased $877.1 million, or 12.6%. The following presents the growth in average loans by category:

FWSB contributed $251.6 million to the increase in average loans, presented by type in the following table:

The following table presents the growth in average loans, by type, excluding the average balances contributed by FWSB:

Excluding the impact of FWSB, loan growth continued to be particularly strong in the commercial and commercial mortgage categories, which together increased $334.0 million, or 8.4%. Commercial agricultural loans decreased $11.7 million, or 3.5% due to agricultural customers using excess funds to pay down loans, instead of expanding their facilities. Residential mortgage and residential construction increased $142.8 million, or 18.8%, mainly due to an increase in residential construction lending at Resource Bank. Home equity loans increased $133.1 million, or 13.9%, 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.

The average yield on loans during the second quarter of 2005 was 6.36%, a 71 basis point, or 12.6%, increase over 2004. This reflects the impact of a significant portfolio of floating rate loans, which reprice to higher rates when interest rates rise.

Average investment securities decreased $273.5 million, or 10.1%. Excluding the impact of FWSB, this decrease was $506.7 million, or 18.7%. During the past twelve months, maturities of investment securities exceeded purchases of new investments, with the resulting net inflow of funds used to support loan growth.

The average yield on investment securities increased 29 basis points, from 3.62% in 2004 to 3.91% in 2005.

Interest expense increased $15.4 million, or 46.1%, to $48.7 million in the second quarter of 2005, from $33.3 million in the second quarter of 2004. Interest expense increased $11.9 million as a result of the 62 basis point increase in the cost of total interest-bearing liabilities, with the remaining $3.4 million increase due to an increase in average balances, The cost of interest-bearing deposits increased 44 basis points, or 29.7%, from 1.48% in 2004 to 1.92% 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 presents average deposits by category: