Prosperity Bancshares - 10-Q quarterly report FY

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 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)

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 Act).  Yes  x    No  ¨

As of May 8, 2003, there were 18,944,027 shares of the registrant’s Common Stock, par value $1.00 per share, outstanding.

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PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

INDEX TO FORM 10-Q

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PART I – FINANCIAL INFORMATION

ITEM 1. INTERIM FINANCIAL STATEMENTS

PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

See notes to interim consolidated financial statements.

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PROSPERITY BANCSHARES, INC.^SM AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2003

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

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. On May 31, 2002, Prosperity completed a two-for-one stock split effected in the form of a 100 percent stock dividend. All prior period per share and share data have been restated to reflect this split. 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 three month period ended March 31, 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.

3. RECENT DEVELOPMENTS

On May 6, 2003, the Company completed the acquisition of Abrams Centre Bancshares, Dallas, Texas (“Abrams”). Abrams wholly owned subsidiary, Abrams Centre National Bank, became a subsidiary of the Company. Under the terms of the Agreement and Plan of Merger, the Company paid approximately $16.3 million in cash. Abrams operated two (2) banking offices in Dallas, Texas. As of March 31, 2003, Abrams Centre National Bank had total assets of $96.5 million, loans of $31.7 million, deposits of $70.8 million and shareholders’ equity of $14.0 million.

On March 4, 2003, the Company entered into a definitive agreement with Dallas Bancshares Corporation, Dallas, Texas. Pursuant to the agreement, Dallas Bancshares will merge into the Company and its wholly owned subsidiary, BankDallas will merge into the Bank. Under the terms of the agreement, the Company will pay approximately $7.0 million in cash. Dallas Bancshares is privately held and operates one (1) banking office in Dallas, Texas. As of March 31, 2003, BankDallas had total assets of $42.0 million, loans of $28.3 million, deposits of $37.6 million and shareholders’ equity of $4.3 million. The transaction is expected to close in the second quarter of 2003. The Company will not complete the acquisition

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PROSPERITY BANCSHARES, INC. ^SM AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(CONTINUED)

MARCH 31, 2003

(DOLLARS IN THOUSANDS)

(UNAUDITED)

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 Banking Department and the Federal Deposit Insurance Corporation.

4. 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 prices 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.

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 ended March 31, 2002, the Company’s net income and earnings per share would have been as follows:

5. 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.

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PROSPERITY BANCSHARES, INC. ^SM AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS—(CONTINUED)

MARCH 31, 2003

(DOLLARS IN THOUSANDS)

(UNAUDITED)

Changes in the carrying amount of the Company’s goodwill for three months ended March 31, 2003 were as follows:

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:

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A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. The Company believes it has chosen these assumptions or bases in good faith and that they are reasonable. However, the Company cautions you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material.

The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require the Company to do so.

RECENT DEVELOPMENTS

On May 6, 2003, the Company completed the acquisition of Abrams Centre Bancshares, Dallas, Texas (“Abrams”). Abrams wholly owned subsidiary, Abrams Centre National Bank, became a subsidiary of the Company. Under the terms of the Agreement and Plan of Merger, the Company paid approximately $16.3 million in cash. Abrams operated two (2) banking offices in Dallas, Texas. As of March 31, 2003, Abrams Centre National Bank had total assets of $96.5 million, loans of $31.7 million, deposits of $70.8 million and shareholders’ equity of $14.0 million.

On March 4, 2003, the Company entered into a definitive agreement with Dallas Bancshares Corporation, Dallas, Texas. Pursuant to the agreement, Dallas Bancshares will merge into the Company and its wholly owned subsidiary, BankDallas will merge into the Bank. Under the terms of the agreement, the Company will pay approximately $7.0 million in cash. Dallas Bancshares is privately held and operates one (1) banking office in Dallas, Texas. As of March 31, 2003, BankDallas had total assets of $42.0 million, loans of $28.3 million, deposits of $37.6 million and shareholders’ equity of $4.3 million. The transaction is expected to close in the second 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 Banking Department and the Federal Deposit Insurance Corporation.

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 Bank^SM (“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 (40) full-service banking locations in the Greater Houston CMSA and fifteen contiguous counties situated south and southwest of Houston and extending into South Texas and two (2) full service banking locations in Dallas, Texas. The Greater Houston CMSA includes Brazoria, Chambers, Fort Bend, Galveston, Harris, Liberty, and Montgomery counties.

Total assets were $1.88 billion at March 31, 2003 compared with $1.82 billion at December 31, 2002. Total loans decreased to $656.6 million at March 31, 2003 from $679.6 million at December 31, 2002, a decrease of $23.0 million, or

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3.4%. Total deposits were $1.63 billion at March 31, 2003 compared with $1.59 billion at December 31, 2002, an increase of $47.7 million, or 3.0%. Shareholders’ equity increased $5.5 million or 3.6%, to $160.3 million at March 31, 2003 compared with $154.7 million at December 31, 2002.

RESULTS OF OPERATIONS AS REPORTED

Net income available to common shareholders was $6.4 million ($0.33 per common share on a diluted basis) for the quarter ended March 31, 2003 compared with $4.5 million ($0.27 per common share on a diluted basis) for the quarter ended March 31, 2002, an increase of $1.9 million, or 42.3%. The Company posted returns on average common equity of 16.19% and 19.36%, returns on average assets of 1.40% and 1.40% and efficiency ratios of 51.24% and 52.34% for the quarters ended March 31, 2003 and 2002, respectively.

Net Interest Income

Net interest income was $16.1 million for the quarter ended March 31, 2003 compared with $12.0 million for the quarter ended March 31, 2002, an increase of $4.1 million, or 34.2%. Net interest income increased as a result of an increase in average interest-earning assets to $1.67 billion for the quarter ended March 31, 2003 from $1.20 billion for the quarter ended March 31, 2002, an increase of $460.6 million, or 38.1%. The net interest margin on a tax equivalent basis decreased to 4.00% from 4.15% for the same periods, principally due to a 77 basis point decrease in the rate paid on interest-bearing liabilities from 2.61% for the quarter ended March 31, 2002 to 1.84% for the quarter ended March 31, 2003 and a $349.0 million increase in total interest-bearing liabilities for the same periods, partially offset by a 77 basis point decrease in the yield on earning assets from 6.09% for the quarter ended March 31, 2002 to 5.32% for the quarter ended March 31, 2003 and a $460.6 million increase in total interest-earning assets for the same periods.

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.”

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The following table sets 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 quarters ended March 31, 2003 and 2002. The table also sets forth the average rate paid on total interest-bearing liabilities, and the net interest margin on average total interest-earning assets for the same periods. Except as indicated in the footnotes, no tax-equivalent adjustments were made and all average balances are daily average balances. Any nonaccruing loans have been included in the table as loans carrying a zero yield.

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The following table presents the dollar amount of changes in interest income and interest expense for the major components of interest-earning assets and interest-bearing liabilities and distinguishes between the increase (decrease) related to outstanding balances and the volatility of interest rates. For purposes of this table, changes attributable to both rate and volume which cannot be segregated have been allocated to rate.

Provision for Credit Losses

Management actively monitors the Company’s asset quality and provides specific loss provisions when necessary. Provisions for credit losses are charged to income to bring the total allowance for credit losses to a level deemed appropriate by management of the Company based on such factors as historical credit loss experience, industry diversification of the commercial loan portfolio, the amount of nonperforming loans and related collateral, the volume growth and composition of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay and the value of collateral, the evaluation of the loan portfolio through the internal loan review function and other relevant factors.

Loans are charged-off against the allowance for credit losses when appropriate. Although management believes it uses the best information available to make determinations with respect to the provision for credit losses, future adjustments may be necessary if economic conditions differ from the assumptions used in making the initial determinations.

The Company made a $120,000 provision for credit losses for the quarter ended March 31, 2003 and for the quarter ended March 31, 2002. For the quarter ended March 31, 2003, net charge-offs were $383,000 compared with net recoveries of $21,000 for the quarter ended March 31, 2002.

Noninterest Income

The Company’s primary sources of noninterest income are service charges on deposit accounts and other banking service related fees. Noninterest income totaled $3.8 million for the three months ended March 31, 2003 compared with $2.2 million for the same period in 2002, an increase of $1.7 million, or 76.8%.

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The following table presents, for the periods indicated, the major categories of noninterest income:

Noninterest Expense

Noninterest expense totaled $10.5 million for the quarter ended March 31, 2003 compared with $7.7 million for the quarter ended March 31, 2002, an increase of $2.8 million, or 37.0%. This increase is principally due to increases in salaries and employee benefits and increases in core deposit intangibles amortization. The following table presents, for the periods indicated, the major categories of noninterest expense:

Salaries and employee benefit expenses were $5.4 million for the quarter ended March 31, 2003 compared with $3.9 million for the quarter ended March 31, 2002, an increase of $1.5 million, or 38.3%. The change was principally due to additional staff associated with the Texas Guaranty, First State, Paradigm and Southwest Acquisitions.

Non-staff expenses increased $1.3 million, or 35.7%, to $5.1 million for the quarter ended March 31, 2003 compared with the same period in 2002. The increase was principally due to additional expenses associated with the Texas Guaranty, First State, Paradigm and Southwest Acquisitions.

Income Taxes

Income tax expense increased $1.0 million to $2.9 million for the quarter ended March 31, 2003 from $1.9 million for the same period in 2002. The increase was primarily attributable to higher pretax net earnings for the quarter ended March 31, 2003 when compared to the same period in 2002.

FINANCIAL CONDITION

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Loan Portfolio

Total loans were $656.6 million at March 31, 2003, a decrease of $23.0 million, or 3.4% from $679.6 million at December 31, 2002. Period end loans comprised 39.4% of average earning assets at March 31, 2003 compared with 49.8% at December 31, 2002.

The following table summarizes the loan portfolio of the Company by type of loan as of March 31, 2003 and December 31, 2002:

Nonperforming Assets

The Company had $3.5 million in nonperforming assets at March 31, 2003 and $2.6 million in nonperforming assets at December 31, 2002.

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.

The following table presents information regarding nonperforming assets as of the dates indicated.

Allowance for Credit Losses

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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 March 31, 2003, the allowance for credit losses amounted to $9.3 million, or 1.42% of total loans compared with $9.6 million, or 1.41% of total loans at December 31, 2002.

Set forth below is an analysis of the allowance for credit losses for the three months ended March 31, 2003 and the year ended December 31, 2002:

Securities

Securities totaled $1.06 billion at March 31, 2003 compared with $950.3 million at December 31 2002, an increase of $106.0 million, or 11.2%. The increase was principally due to increased growth in deposits and a decrease in total loans. At March 31, 2003, securities represented 56.2% of total assets compared with 52.2% of total assets at December 31, 2002.

Premises and Equipment

Premises and equipment, net of accumulated depreciation, totaled $27.5 million and $27.0 million at March 31, 2003 and December 31, 2002, respectively.

Deposits

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Total deposits were $1.63 billion at March 31, 2003 compared with $1.59 billion at December 31, 2002, an increase of $47.7 million or 3.0%. At March 31, 2003, non-interest bearing deposits accounted for approximately 19.1% of total deposits compared with 20.7% of total deposits at December 31, 2002. Interest-bearing demand deposits totaled $1.32 billion, or 80.9%, of total deposits at March 31, 2003 compared with $1.26 billion, or 79.3%, of total deposits at December 31, 2002.

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 March 31, 2003, the Company had $40.0 million in FHLB borrowings, of which $12.5 million consisted of FHLB notes payable and $27.5 million consisted of FHLB advances. The FHLB advances are secured by a blanket lien on the Bank’s first mortgage loans against one-to-four family residential properties. 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.

At March 31, 2003 and December 31, 2002, the Company had no outstanding borrowings under a revolving line of credit extended by a commercial bank.

Trust Preferred Securities

At March 31, 2003 and December 31, 2002, the Company’s subsidiary trusts had outstanding $33.0 in million trust preferred securities.

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 March 31, 2003, the Company had cash and cash equivalents of $55.6 million, down 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 March 31, 2003 are summarized below:

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Off Balance Sheet Items

The Company’s commitments associated with outstanding letters of credit and commitments to extend credit as of March 31, 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:

Capital Resources

Total shareholders’ equity was $160.3 million at March 31, 2003 compared with $154.7 million at December 31, 2002, an increase of $5.5 million, or 3.6%. The increase was due primarily to net earnings of $6.4 million partially offset by dividends paid of $1.2 million for the three months ended March 31, 2003.

Both the Board of Governors of the Federal Reserve System, with respect to the Company, and the Federal Deposit Insurance Corporation (“FDIC”), with respect to the Bank, have established certain minimum risk-based capital standards that apply to bank holding companies and federally insured banks. As of March 31, 2003, the Company’s Tier 1 risk-based capital, total risk-based capital and leverage capital ratios were 14.93%, 16.10% and 6.73%, respectively. As of March 31, 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 risk-based capital, total risk-based capital and leverage capital ratios of 14.84%, 16.02% and 6.69%, 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. Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of it’s management, including it’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of it’s disclosure controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) 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 controls. Subsequent to the date of their evaluation, there were no significant changes in the Company’s internal controls or in other factors that could significantly affect the Company’s disclosure controls and procedures, and there were no corrective actions with regard to significant deficiencies and material weaknesses based on such evaluation.

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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

Not applicable

ITEM 5. OTHER INFORMATION

Not applicable

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

b. Reports on Form 8-K

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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.