SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 ------------------------------ FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED JUNE 30, 1999 COMMISSION FILE NUMBER 0-22345 ------------------------------ SHORE BANCSHARES, INC. 109 North Commerce Street Post Office Box 400 Centreville, Maryland 21617-0400 Telephone: (410) 758-1600 IRS Employer Identification Number: 52-1974638 Securities registered under Section 12(b) of the Act: None Securities registered under Section 12(g) of the Act: Common Stock, Par Value $0.01 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 the number of shares of outstanding of each of the issuer's classes of common stock as of the latest practicable date. As of August 3, 1999, there were 1,913,882 shares of Common Stock $0.01 Par Value outstanding. This is the only class of outstanding shares.
SHORE BANCSHARES, INC. FORM 10-Q INDEX PART I FINANCIAL INFORMATION - ------ --------------------- Item 1. Financial Statements (Unaudited) Balance Sheets -June 30, 1999 and December 31, 1998 Statements of Income -- Three months ended June 30, 1999 and 1998 and the six months ended June 30, 1999 and 1998. Statements of Cash Flows -- Six months ended June 30, 1999 and 1998 and the twelve months ended December 31, 1998. Notes to Financial Statements - June 30, 1999 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk PART II OTHER INFORMATION - ------- ----------------- Item 1. Legal Proceedings Item 2. Changes in Securities and Use of Proceeds Item 3. Defaults upon Senior Securities Item 4. Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K SIGNATURES - ----------
PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS SHORE BANCSHARES, INC. <TABLE> <CAPTION> June 30, December 31, Dollars in thousands 1999 1998 (Unaudited) ----------- ------------ ASSETS <S> <C> <C> Cash and due from banks $ 4,077 $ 4,536 Federal funds sold 8,878 9,752 Securities Held to Maturity at amortized cost 18,625 23,916 (fair value of $18,512 and $24,253 respectively) Available for Sale 32,778 23,203 Loans, less allowance for credit losses 114,610 109,848 ($1,236 and $1,349 respectively) Premises and fixed assets 3,297 3,369 Investments in unconsolidated subsidiaries 1,170 1,167 Accrued interest receivable 1,540 1,355 Goodwill 1,843 1,917 Other assets 2,497 1,991 ----------- ----------- TOTAL ASSETS $ 189,315 $ 181,054 =========== =========== LIABILITIES Deposits Non-interest bearing demand $ 18,951 $ 19,774 Interest bearing transaction 19,738 20,467 Savings and money market 39,328 35,322 Time, $100,000 or more 15,534 15,357 Other time 66,346 62,388 ----------- ----------- Total deposits 159,897 153,308 ----------- ----------- Securities sold under agreements to repurchase 1,391 -- Long term debt 5,000 5,000 Accrued interest payable 202 208 Other liabilities 712 634 ----------- ----------- 7,305 5,842 ----------- ----------- Total liabilities 167,202 159,150 ----------- ----------- COMMITMENTS EQUITY CAPITAL Common stock, par value $.01; authorized 10,000,000 shares, issued and outstanding: 6/30/99 1,913,786 12/30/98 1,913,516 19 19 Surplus 10,071 10,064 Retained earnings 12,435 11,866 Accumulated other comprehensive income (412) (45) ----------- ----------- Total stockholders' equity 22,113 21,904 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 189,315 $ 181,054 =========== =========== </TABLE> See Notes to Consolidated Financial Statements -2-
CONSOLIDATED STATEMENTS OF INCOME SHORE BANCSHARES, INC. (UNAUDITED) <TABLE> <CAPTION> Quarter Six Months Quarter Six Months Dollars in thousands except per share data Ended Ended Ended Ended June 30, June 30, June 30, June 30, 1999 1999 1998 1998 -------------------------------------------------- INTEREST INCOME <S> <C> <C> <C> <C> Interest and fee income on loans $2,401 $4,724 $2,382 $4,820 Interest and dividends on securities Taxable securities 577 1,130 526 1,056 Tax-exempt securities 113 224 119 241 Other securities (debt and equity) 33 67 39 71 Interest on federal funds sold 98 212 129 223 --------------------------------------------- Total interest income 3,222 6,357 3,195 6,411 --------------------------------------------- INTEREST EXPENSE Interest on certificates of deposit of $100,000 or more 204 415 190 375 Interest on other deposits 1,252 2,471 1,190 2,372 Interest on securities sold under agreements to repurchase 1 1 -- -- Interest on long term debt 71 142 71 142 --------------------------------------------- Total interest expense 1,528 3,029 1,451 2,889 --------------------------------------------- NET INTEREST INCOME 1,694 3,328 1,744 3,522 Provision for credit losses -- -- -- -- --------------------------------------------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 1,694 3,328 1,744 3,522 --------------------------------------------- NONINTEREST INCOME Service charges on deposit accounts 210 400 176 335 Other noninterest income 78 144 58 107 Gains (losses) on securities -- 42 -- -- --------------------------------------------- Total noninterest income 288 586 234 442 --------------------------------------------- NONINTEREST EXPENSE Salaries and employee benefits 547 1,203 526 1,118 Expenses of premises and fixed assets 145 284 144 316 Other noninterest expense 336 834 457 966 --------------------------------------------- Total noninterest expense 1,028 2,321 1,127 2,400 --------------------------------------------- INCOME BEFORE TAXES 954 1,593 851 1,564 Applicable income taxes 302 526 291 542 --------------------------------------------- NET INCOME $ 652 $1,067 $ 560 $1,022 ============================================= Basic Earnings Per Common Share $ 0.34 $ 0.58 $ 0.28 $ 0.51 Diluted Earnings Per Common Share 0.34 0.56 0.28 0.51 Dividends Declared Per Common Share 0.13 0.26 0.12 0.24 </TABLE> See Notes to the Consolidated Financial Statements -3-
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY SHORE BANCSHARES, INC. (Unaudited) <TABLE> <CAPTION> Accumulated Other Common Retained Comprehensive Dollars in thousands Stock Surplus Earnings Income Total ------ ------- -------- -------------- ------- <S> <C> <C> <C> <C> <C> Balance at December 31, 1998 $ 19 $ 10,064 $ 11,866 $ (45) $ 21,904 Comprehensive income: Net income 1,067 1,067 Other comprehensive income, net of tax: Unrealized loss on available-for-sale securities, net of reclassification adjustment (367) (367) -------- Total comprehensive income 700 -------- Issuance of common stock upon exercise of stock options 7 7 Cash dividends declared ($.26 per common share) (498) (498) -------- -------- -------- -------- -------- Balance at June 30, 1999 $ 19 $ 10,071 $ 12,435 $ (412) $ 22,113 ======== ======== ======== ======== ======== Accumulated Other Common Retained Comprehensive Stock Surplus Earnings Income Total ------ ------- -------- -------------- ------- Balance at December 31, 1997 $ 10 $ 10,064 $ 13,480 $ (39) $ 23,515 Comprehensive income: Net income 1,022 1,022 Other comprehensive income, net of tax: Unrealized loss on available-for-sale securities, net of reclassification adjustment 4 4 -------- Total comprehensive income 1,026 -------- Two-for-one stock split effected in the form of a 100% stock dividend 10 (10) 0 Cash dividends declared ($.24 per common share) (483) (483) -------- -------- -------- -------- -------- Balance at June 30, 1998 $ 20 $ 10,064 $ 14,009 $ (35) $ 24,058 ======== ======== ======== ======== ======== </TABLE> See Notes to Financial Statements -4-
CONSOLIDATED STATEMENTS OF CASH FLOW SHORE BANCSHARES, INC. (UNAUDITED) <TABLE> <CAPTION> Six Months Year Six Months Ended Ended Ended June 30, December 31, June 30, 1999 1998 1998 ------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES <S> <C> <C> <C> Net income $ 1,067 $ 2,219 $ 1,022 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 217 457 151 Equity in net earnings of unconsolidated subsidiaries -- 20 -- Provision for credit losses, net (113) (55) (18) Deferred income taxes 7 (31) (7) Net (gains) losses on sale of assets (42) (5) -- Changes in assets and liabilities: (Increase) decrease in accrued interest receivable (185) 121 91 (Increase) decrease in other assets (225) 47 (35) Increase (decrease) in accrued interest payable (6) 19 1 Increase (decrease) in other liabilities 78 36 (30) -------- -------- -------- Net cash provided by operating activities 798 2,828 1,175 -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from maturities of investment securities held to maturity 6,856 34,268 15,944 Proceeds from maturities of investment securities available-for-sale 3,550 2,651 99 Proceeds from sale of investment securities available-for-sale 2,085 -- -- Purchases of held-to-maturity securities (1,565) (18,767) (15,269) Purchases of available-for-sale securities (15,743) (16,499) -- Net (increase) decrease in loans (4,649) (2,029) 2,544 Purchase of premises and equipment (154) (429) (262) -------- -------- -------- Net cash provided by (used in) investing activities (9,620) (805) 3,056 -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in demand, interest-bearing transaction, and savings deposits 2,454 1,084 1,412 Increase (decrease) in time deposits 4,135 6,410 1,610 Increase (decrease) in securities repurchased 1,391 -- -- Common stock repurchased and retired -- (1,012) -- Proceeds from issuance of common stock 7 -- -- Cash dividends paid (498) (2,812) (483) -------- -------- -------- Net cash provided by (used in) financing activities 7,489 3,670 2,539 -------- -------- -------- Net increase (decrease) in cash and cash equivalents (1,333) 5,693 6,770 Cash and cash equivalents, beginning 14,288 8,596 8,596 -------- -------- -------- Cash and cash equivalents, ending $ 12,955 $ 14,289 $ 15,366 ======== ======== ======== Supplementary cash flow information: Interest paid $ 2,892 $ 5,617 $ 2,745 Income taxes paid $ 422 $ 1,240 $ 592 All dollar amounts in thousands </TABLE> -5-
Note 1 - Financial Information The unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10Q. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. Operating results for the six month period ended June 30, 1999 are not necessarily indicative of the results that may be expected for the year ended December 31, 1999. For further information, refer to the audited consolidated financial statements and footnotes included in the 1998 Annual Report to Shareholders and Form 10. Consolidation has resulted in the elimination of all significant intercompany accounts and transactions. -6-
NOTE -2 Analysis of the Allowance for Credit Losses (In Thousands) <TABLE> <CAPTION> June 30, December 31, 1999 1998 --------- ------------ <S> <C> <C> BALANCE AT BEGINNING OF PERIOD $ 1,349 $ 1,404 CHARGE-OFFS: Real Estate: Construction and land development 0 0 Commercial 0 0 Residential 0 14 Commercial 61 0 Consumer installment 61 90 -------- -------- 122 104 -------- -------- RECOVERIES: Real Estate: Construction and land development 0 0 Commercial 0 0 Residential 0 0 Commercial 2 26 Consumer installment 7 23 -------- -------- 9 49 -------- -------- NET CHARGE-OFFS (RECOVERIES) 113 55 PROVISION FOR CREDIT LOSSES 0 0 ALLOWANCE ACQUIRED 0 0 -------- -------- BALANCE AT END OF PERIOD $ 1,236 $ 1,349 ======== ======== Average daily balance of loans $113,215 $108,180 Ratio of net charge-offs to average loans outstanding 0.10% 0.05% </TABLE> -7-
Note 3 - Other Borrowed Funds As of September 30, 1997, the Bank had received a convertible advance from the Federal Home Loan Bank in the amount of $5,000,000 at an interest rate of 5.66% which is due September 24, 2002. The Bank has pledged mortgage loans as collateral on this advance. Note 4 - Computation of Earnings Per Share In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, Earnings Per Share, which became effective for the Company for reporting periods ending after December 31, 1998. Under the provisions of SFAS No. 128, primary and fully-diluted earnings per share were replaced with basic diluted earnings per share in an effort to simplify the computation of these measures and align them more closely with the methodology used internationally. Basic earnings per share is arrived at by dividing net income available to common stockholders by the weighted-average number of common shares outstanding and does not include the impact of any potentially dilutive common stock equivalents. The diluted earnings per share calculation method is arrived at by dividing net income by the weighted-average number of shares outstanding, adjusted for the dilutive effect of outstanding stock options and warrants. For purposes of comparability, the prior-period earnings per share data has been restated <TABLE> <CAPTION> Quarter Ending Six Months Ending 06/30/99 06/30/99 -------------- ----------------- Basic: <S> <C> <C> Net Income (applicable to common stock) $ 652,000 $1,067,000 Average common shares outstanding 1,913,703 1,913,610 Basic net income per share $ .34 $ .58 Diluted Net income (applicable to common stock) $ 652,000 $1,067,000 Average common shares outstanding 1,913,703 1,913,610 Dilutive effect of stock options 127 123 ---------- ---------- Average common shares outstanding 1,913,830 1,913,733 Diluted net income per share $ .34 $ .56 </TABLE> -8-
<TABLE> <CAPTION> Quarter Ending Six Months Ending 06/30/98 06/30/98 --------------- ----------------- Basic: <S> <C> <C> Net Income (applicable to common stock) $ 560,000 $1,022,000 Average common shares outstanding 2,014,848 2,014,848 Basic net income per share $ .28 $ .51 Diluted Net income (applicable to common stock) $ 560,000 $1,022,000 Average common shares outstanding 2,014,848 2,014,848 Dilutive effect of stock options 0 0 ---------- ---------- Average common shares outstanding 2,014,848 2,014,848 Diluted net income per share $ .28 $ .51 </TABLE> -9-
AVERAGE BALANCES, YIELDS AND RATES <TABLE> <CAPTION> YTD 6/30/99 YTD 6/30/98 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate <S> <C> <C> <C> <C> <C> <C> ASSETS Interest Earning assets: Money market investments: Federal funds sold 9,002,283 212,007 4.75% 7,846,609 222,600 5.72% Investment Securities: U.S. Treasury securities and obligations of U.S. government agencies 38,037,573 1,129,954 5.99% 33,023,916 1,036,243 6.33% Obligations of States and political subdivisions 9,793,041 339,027 6.98% 10,476,219 365,159 7.03% Taxable Municipals -- -- 0.00% 512,815 20,242 7.96% All other investment securities 1,654,386 57,855 7.05% 1,703,870 62,273 7.37% Federal Reserve Bank stock 302,250 9,067 6.05% 302,250 9,068 6.05% ============ =========== ====== =========== =========== ====== Total investment securities 49,787,250 1,535,903 6.22% 46,019,070 1,492,985 6.54% Loans - net of unearned income Commercial loans 10,464,963 480,003 9.25% 9,279,504 448,802 9.75% Installment loans 6,227,092 292,235 9.46% 5,546,947 277,798 10.10% Mortgage loans 96,522,721 3,896,270 8.14% 92,684,611 4,057,410 8.83% ============ =========== ====== =========== =========== ====== Total loans 113,214,776 4,668,508 8.32% 107,511,062 4,784,010 8.97% ============ =========== ====== =========== =========== ====== TOTAL INTEREST EARNING ASSETS 172,004,309 6,416,418 7.52% 161,376,741 6,499,595 8.12% Cash and due from banks 3,858,332 4,175,857 Other assets 9,697,312 9,661,600 Allowance for loan and lease losses (1,274,372) (1,392,369) ============ =========== ====== =========== =========== ====== TOTAL ASSETS 184,285,581 173,821,829 ============ =========== ====== =========== =========== ====== LIABILITIES Interest-bearing liabilities Other Borrowed Funds 5,000,000 142,286 5.74% 5,003,729 142,396 5.74% Repurchase agreements 88,686 1,074 2.44% -- -- 0.00% Super NOW accounts 19,500,775 253,954 2.63% 17,216,218 238,767 2.80% Money market deposit accounts 19,303,640 305,631 3.19% 19,225,171 320,652 3.36% Time, $100,000 or more 13,670,474 366,194 5.40% 12,157,097 325,789 5.40% Other time deposits 50,805,223 1,329,340 5.28% 45,186,175 1,200,360 5.36% IRA deposits 15,377,732 365,650 4.79% 15,567,253 391,076 5.07% Savings deposits 17,908,362 264,821 2.98% 17,752,436 269,824 3.07% ============ =========== ====== =========== =========== ====== TOTAL INTEREST BEARING LIABILITIES 141,654,892 3,028,950 4.31% 132,108,079 2,888,864 4.41% Demand deposits 19,677,497 16,994,953 Other liabilities 977,873 994,495 ============ =========== ====== =========== =========== ====== Total liabilities 162,310,262 150,097,527 Stockholders' equity 21,975,319 23,724,302 ============ =========== ====== =========== =========== ====== TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 184,285,581 173,821,829 ============ =========== ====== =========== =========== ====== Net interest income & interest rate spread 3,387,468 3.21% 3,610,731 3.71% Net interest income as a % of earning assets 3.84% 4.36% ============ =========== ====== =========== =========== ====== <FN> 1. All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34%, exclusive of the alternative minimum tax rate and non deductible interest expense. 2. Loan fee income is included in interest income for each loan catagory and yields are stated to include all. 3. Balances of nonaccrual loans and related income have been included for computational purposes. </FN> </TABLE> -10-
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion is designed to provide a better understanding of the financial position of Shore Bancshares, Inc., and should be read in conjunction with the December 31, 1998 audited consolidated financial statements and notes. Portions of this Quarterly Report on Form 10Q contain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) with respect to the adequacy of the allowance for loan losses, interest rate risk, realization of deferred taxes, liquidity levels, and the Year 2000 issue, which, by their nature, are subject to significant uncertainties which are described in further detail in Item 1 of the Company's 1998 Form 10-K, under the heading "Risk Factors." The Company believes that the expectations reflected in such forward-looking statements are reasonable. However, because these uncertainties and the assumptions on which statements in this report are based, the actual future results may differ materially from those indicated in this report. ORGANIZATIONAL BACKGROUND On July 1, 1996, Shore Bancshares, Inc. (the Company) commenced operations as the parent company of its sole subsidiary, The Centreville National Bank of Maryland (the Bank) which has conducted the business of banking since 1876. Since the Bank is the primary possession of the Company, the assets and liabilities of the Company are made up almost entirely of the assets and liabilities of the Bank. The same is true for the income and expense of the Company. RESULTS OF OPERATIONS OVERVIEW The Company reported $ 1,067 thousand in net income for the six months ended June 30, 1999 or $.56 diluted earnings per share compared to the six months ended June 30, 1998 with net income of $1,022 thousand or $.51 diluted earnings per share. As a result of $144 thousand increase in noninterest income, net income through the second quarter 1999 reflects an increase despite the declining interest rate environment. Rate decreases resulted in the refinancing of many loans as well as calls of investment securities in 1998. Loan refinancings continued into early 1999. The effects of those declines continue to impact net income. The Company experienced growth in total assets of 4.56% and in total deposits of 4.30% in the first six months of 1999. Average earning assets continue to grow and reflect an increase of 6.58% as of June 30, 1999 compared to the prior year. Despite the growth in earning assets, net interest income declined $194 thousand or 5.51%. Earnings reflect a shrinking net interest margin compared to the prior year, however, the decline is stablizing as noted by a margin which has not changed from March 31, 1999. Page 1
NET INTEREST INCOME and NET INTEREST MARGIN Net interest income is the principal source of earnings for a banking company. It represents the difference between interest and fees earned on the loan and investment portfolios and the interest paid on deposits and borrowings. Despite balance sheet growth resulting primarily from loan and deposit growth, the Bank's net interest income, on a fully tax-equivalent basis, decreased in the first six months of 1999 compared to the same period in 1998. Net interest income (on a tax equivalent basis) for June 30, 1999 decreased $223 thousand or 6.59% compared to the six months ended June 30, 1998. The table titled "Average Balances, Yields and Rates" sets forth the major components of net interest income, on a tax equivalent basis, for June 30, 1999 and 1998. Interest rate spread is the difference between the average yield on interest earning assets and the average rate paid on interest bearing liabilities (deposits). Interest rate spread for the six months ended June 30, 1999 and 1998 was 3.21%, and 3.71%, respectively. Interest rate spread decreased through the end of the second quarter compared to the same period in 1998 resulting from a decreased yield on average earning assets of 60 basis points and a decrease in yield of average interest bearing liabilities by only 10 basis points. This is also a decrease from the December 31, 1998 interest rate spread of 3.65% . The balance sheet mix has not changed significantly since year end, however, the yields on earning assets decreased at a faster rate than the decrease in yields on deposits. As a result of a lower interest rate environment, the Company experienced a large number of calls of investment securities in 1998. These securities were replaced with lower yielding investments and the full effects of this are evident in the 32 basis point reduction in investment yield comparing June 30, 1999 to the same period in 1998. Despite some loan rate increases during 1998 and the first quarter of 1999, overall loan yield decreased 65 basis points in the second quarter compared to June 30, 1998. Fourth quarter 1998 loan rate decreases and more significantly, loans refinanced with the Company and new loans at lower rates are reflected in decreased loan yield as of June 30, 1999. However, the average balances in each loan category have increased and total average loans outstanding have increased $5.7 million since June 30, 1998. The volume has not improved enough to increase interest income when comparing the first quarters of 1999 and 1998. Interest bearing liabilities have grown most notably in Time and Super NOW deposit average balances. These are more costly deposits which account for increased deposit interest expense despite a reduced yield on interest bearing deposits. The effects of lowering deposit rates during 1998 and in the first half of 1999 reflect a slightly lower yield on deposits of 4.31% as of June 30, 1999 compared to 4.41% for the same period in the prior year. Net interest margin decreased comparing June 30, 1998 to June 30, 1999 from 4.36% to 3.84%. Net interest margin is calculated as tax equivalent net interest income divided by average earning assets and represents the net yield on its earning assets. The second quarter 1999 net interest margin decrease is the result of repricing as previously discussed. Management and the Board of Directors monitor interest rates on a regular basis to assess the Company's competitive position and to maintain a reasonable and profitable interest rate spread. The Company also considers the maturity distribution of loans, investments, and deposits and its effect on net interest income as interest rates rise and fall over time. Page 2
PROVISION and ALLOWANCE FOR CREDIT LOSSES For the quarter ended June 30, 1999 and 1998, the Company recorded net charge offs of $113 thousand and $18 thousand, respectively compared to net charge offs of $55 thousand for the year ended December 31, 1998. Internal loan review, in particular, is effective in identifying problem credits and in achieving timely recognition of potential and actual losses within the loan portfolio. Improved overall credit quality and increased collection efforts have also contributed to the immaterial amount of net charge offs in 1999 and for the year ended December 31,1998. Gross charge offs as of June 30, 1999 amounted to $122 thousand, $50 thousand for the same period in 1998 and $104 thousand for the year ended 1998. One half of the charge off dollars recorded resulted from two commercial loans and the remaining $61 thousand were consumer installment loans. Efforts to collect charged off loans continue and of the $61 thousand charged off for commercial loans, $38 thousand is expected to be recovered. Recoveries totaled $9 thousand in the first six months of 1999, $32 thousand for the same six months in 1998 and $49 thousand for the year ended December 31, 1998. No provision for credit losses was charged to expense in 1998 nor to date in 1999. The allowance for credit losses is maintained at a level believed adequate by management to absorb estimated probable credit losses. Management's quarterly evaluation of the adequacy of the allowance is based on analysis of the loan portfolio and its known and inherent risks, assessment of current economic conditions, the Year 2000 issue, diversification and size of the portfolio, adequacy of the collateral, past and anticipated loss experience and the amount of non-performing loans. The allowance for credit losses has remained relatively unchanged despite the increase in outstanding loan balances. The allowance for credit losses of $1.2 million as of June 30, 1999 and $1.3 million as of December 31, 1998 represents 1.07% and 1.22%, respectively, of gross loans. The decrease in percentage of allowance to outstanding, despite the increasing outstanding gross loans, is justified by lower levels of classified loans. Past due loan levels have decreased from year end and they consist primarily of loans secured by real estate. Analysis by loan review supports adequacy of the allowance. In management's opinion, the allowance for credit losses is adequate as of June 30, 1999. See Note 2 in the Notes to Financial Statements. NONINTEREST INCOME AND EXPENSE As of June 30, 1999 noninterest income reflects $144 thousand increase compared to June 30, 1998 partially from a $42 thousand gain on the sale of available for sale investment securities. The rise in service fees reflects higher return check charges and volume. Other noninterest income increased compared to June 30, 1998 and includes 6 months of ATM surcharges in 1999 compared 5 months in 1998. ATM surcharges were implemented in February 1998. In addition, the surcharge fee increased in 1999. Page 3
Noninterest expense as of June 30, 1999 decreased $79 thousand or 3.3% compared to the same period last year. The decrease is the result of rescheduling certain expense payments from the beginning of the year to distribute the expense over the entire year. Salaries and benefits increased as a result of an additional pay period in the first quarter of 1999. A new biweekly pay schedule was implemented in April 1998. Also increased pay rates and insurance premiums are reflected when comparing June 30, 1999 to June 30, 1998. Premise and fixed asset expenses decreased $32 thousand as of June 30, 1999 compared to the same period in 1998 primarily as a result of a change in accounting estimates. Also 1998 reflects increased expensed equipment costs for the renovated Commerce Street office. INVESTMENT SECURITIES Investment securities classified as available-for-sale are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions as part of the asset/liability management strategy. Available-for-sale securities are carried at market value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity net of income taxes. Investment securities classified as held-to-maturity are those that management has both the positive intent and ability to hold to maturity, and are reported at amortized cost. The Company does not currently follow a strategy of making securities purchases with a view to near-term sales, and, therefore, does not own trading securities, nor are derivatives used as investments. The Company manages the investment portfolios within policies which seek to achieve desired levels of liquidity, manage interest rate sensitivity risk, meet earnings objectives, and provide required collateral support for deposit activities. Total investment securities amounted to $51.4 million and $47.1 million as of June 30, 1999 and December 31, 1998, respectively. The net increased level of investments in securities resulted primarily from the investment of funds from deposit growth and the use of federal funds. Funds were invested primarily in U.S. Government sponsored agency securities. Excluding the U.S. Government and U.S. Government sponsored agencies, the Company had no concentrations of investment securities from any single issuers that exceeded 10% of stockholders' equity. LOAN PORTFOLIO The Bank is actively engaged in originating loans to customers in Queen Anne's, Caroline, Kent and Talbot Counties. The Company has policies and procedures designed to mitigate credit risk and to maintain the quality of the loan portfolio. These policies include underwriting standards for new credits as well as the continuous monitoring and reporting of asset quality and the adequacy of the allowance for credit losses. These policies, coupled with continuous training efforts, have provided effective checks and balances for the risk associated with the lending process. Total gross loans as of June 30, 1999 have grown approximately $4.6 million since December 31, 1998. Mortgage loans, primarily consumer mortgages, accounted for $2.8 million of the increase. Loan growth is attributed to new product development and the reduction in loan rates. In addition, an active officer calling program supported by increased marketing efforts were implemented and are showing signs of success. The Company had no loan concentrations exceeding 10% of total loans which are not otherwise disclosed. Page 4
The Company policy is to make the majority of its loan commitments in the market area it serves. The Company attempts to reduce risk through its management's familiarity with the credit histories of loan applicants and in-depth knowledge of the risk to which a given credit is subject. Lending in a limited market area does subject the Company to economic conditions of that market area. The Company had no foreign loans in its portfolio as of June 30, 1999. It is the policy of the Bank to place a loan in non-accrual status whenever there is substantial doubt about the ability of a borrower to pay principal or interest on any outstanding credit. Management considers such factors as payment history, the nature of the collateral securing the loan and the overall economic situation of the borrower when making a non-accrual decision. Non-accrual loans are closely monitored by management . A non-accruing loan is restored to current status when the prospects of future contractual payments are no longer in doubt. At June 30, 1999 and December 31, 1998, $3 thousand and $55 thousand, respectively, of non-accrual loans were secured by collateral with an estimated value of $20 thousand as of June 30, 1999 and $343 thousand as of December 31, 1998. At June 30, 1999, the Bank had $274 thousand in loans 90 days or more past due and still accruing interest, troubled debt restructurings of $869 thousand and $2.5 million in loans on the watch list for which payments were current, but the borrowers have the potential for experiencing financial difficulties. Expressed as a percentage of total assets , nonperforming assets were .61% at June 30, 1999. These loans are subject to on going management attention and their classifications are reviewed regularly. The Company had no "other real estate owned" at June 30, 1999. DEPOSITS Deposit liabilities reflected 4.3% increase in the first six months of 1999 compared to December 31, 1998. Interest bearing transaction (Super NOW) and time account deposits were the main sources of deposit growth. Competitive time deposit rates, NOW account product features, and marketing efforts have contributed to the growth in these products. In addition, the Company's new Silver CD product, with limited withdrawal penalties, for consumers over age 62 continues to be a popular product. The Company continues to experience strong competition from other commercial banks, credit unions, the stock market and mutual funds. The Company has no foreign banking offices. LONG TERM DEBT Long term debt consists of an advance from the Federal Home Loan Bank of $5,000,000 at the end of the third quarter of 1997. These funds were utilized for securities purchases. See Note 3 in the Notes to Financial Statements. Page 5
LIQUIDITY MANAGEMENT Liquidity describes the ability of Shore Bancshares, Inc. and its subsidiary, The Centreville National Bank of Maryland to meet financial obligations that arise out of the ordinary course of business. Liquidity is primarily needed to meet borrowing and deposit withdrawal requirements of the customers of the Bank and to fund current and planned expenditures. The Company maintains its asset liquidity position internally through short term investments, the maturity distribution of the investment portfolio, loan repayments and income from earning assets. As indicated by the Consolidated Statement of Cash Flows, the primary sources of cash flow in the second quarter of 1999 was the maturity of investment securities and deposit growth. A substantial portion of the investment portfolio contains readily marketable securities that could be converted to cash immediately. On the liability side of the balance sheet, liquidity is affected by the timing of maturing deposits and the ability to generate new deposits or borrowings as needed. Other sources, not currently in use, are available through borrowings from the Federal Reserve Bank and from lines of credit approved at correspondent banks. Management knows of no trend or event which will have a material impact on the Bank's ability to maintain liquidity at satisfactory levels. MARKET RISK MANAGEMENT Market risk is the risk of loss that arises from changes in interest rates, foreign currency exchange prices, commodity prices, equity prices, and other market changes that affect market sensitive financial instruments. The market risk for the Company is composed primarily of interest rate risk, which is the exposure of the Bank's earnings and capital arising from future interest rate changes. This risk is a normal part of the banking business because assets and liabilities do not reprice at the same rate, nor do they move to the same degree when interest rates change. In addition, the maturity distribution of the Bank's assets and liabilities do not match for given periods of time. The Bank's interest rate sensitivity position is managed to maintain an appropriate balance between the maturity and repricing characteristics of assets and liabilities that is consistent with the Bank's liquidity, growth, earnings and capital adequacy goals. The Board of Directors has adopted an Asset / Liability Management Policy, which is administered by the Asset / Liability Committee. The Committee is responsible for monitoring the Bank's interest rate sensitivity position and recommending policies to the Board of Directors to limit exposure to interest rate risk while maximizing net interest income. The Bank uses earnings simulation modeling to measure the effect specific rate changes would have on one year of net interest income. Key assumptions include calls and maturities of investment securities, depositors' rate sensitivity, maturity dates of fixed rate loans and investment securities and repricing date of variable rate loans. As with any method of gauging risk, there are inherent shortcomings and actual results may deviate significantly from assumptions used in the model. Actual results will differ from simulated results due to timing, magnitude and frequency of interest-rate changes as well as changes in market conditions and management strategies. At June 30, 1999 the Bank's estimated earnings sensitivity profile reflected a modest sensitivity to interest rate changes. Based on an assumed 100 basis point immediate change in interest rates the Bank's net interest income would decrease by $230 thousand if rates were to increase by that amount and net interest income would increase $138 thousand if rates would decline a similar amount. Page 6
CAPITAL RESOURCES AND ADEQUACY Total stockholders' equity increased $209 thousand to $22.1 in 1999 compared to $21.9 million as of June 30,1999. Earnings of $1,067 thousand added to shareholders' equity. Capital also increased $7 thousand as a result of 270 shares of common stock issued under the Employee Stock Purchase Plan. Dividends paid reduced stockholders' equity $498 thousand as did the increase in unrealized loss in available for sale securities of $367 thousand. One measure of capital adequacy is the leverage capital ratio which is calculated by dividing average total assets for the most recent quarter into Tier 1 capital. The regulatory minimum for this ratio is 4%. The leverage capital ratio at the Company level at June 30, 1999 was 11.15% and at December 31, 1998 was 11.08%. Another measure of capital adequacy is the risk based capital ratio or the ratio of total capital to risk adjusted assets. Total capital is composed of both core capital (Tier 1) and supplemental capital (Tier 2) including adjustments for off balance sheet items such as letters of credit and taking into account the different degrees of risk among various assets. Regulators require a minimum total risk based capital ratio of 8%. The Company's ratio at June 30, 1999 was 20.48% and at December 31, 1998 was 21.05%. According to FDIC capital guidelines, the Company is considered to be "Well Capitalized." In the first quarter of 1999 the Office of the Comptroller of the Currency approved two new branches for The Centreville National Bank of Maryland. A branch site at the corner of Sharp Road and Route 404 in Denton, Maryland, Caroline County has been approved and completion is anticipated late in the first quarter of 2000. The property on the corner of Route 18/Piney Creek Road and Castle Marina Road in Chester, Maryland is an addional Queen Anne County site. This branch location is anticipated to be completed in the second or third quarters of 2000. The total anticipated cost of the land and buildings for both projects is approximately $2 million dollars. Subsequent to completion of the branches the opportunity cost of the funds invested in the branches, operating costs and depreciation expense could have an impact on earnings in the short term until the long term growth of the branch improves profitability. Management knows of no other trend or event, which will have a material impact on capital. FUTURE TRENDS This is a Year 2000 Readiness Disclosure under the Year 2000 Information and Readiness Disclosure Act of 1998. The "Year 2000 Issue", which is common to most corporations, including banks, is a general term used to describe the problems that may result from the improper processing of dates and date-sensitive calculations as the Year 2000 approaches. This issue is caused by the fact that many of the world's existing computer programs use only two digits to identify the year in the date field of a program. These programs could experience serious malfunctions when the last two digits of the year change to "00" as a result of identifying a year designated "00" as the year 1900 rather than the Year 2000. Page 7
The Company formed a Year 2000 Committee, which is comprised of a cross-section of the Company's employees, in the fourth quarter of 1997. This Committee is leading the Company's Year 2000 efforts to ensure that the Company is properly prepared for the Year 2000. The Company's Board of Directors has approved a plan submitted by the Year 2000 Committee that was developed in accordance with guidelines set forth by the Federal Financial Institutions Examination Council. This plan has five primary phases related to internal Year 2000 compliance: 1. Awareness - this phase is ongoing and is designed to inform the Company's Board of Directors (the "Board") and Executive management ("Management"), employees, customers and vendors of the impact of the Year 2000 Issue. Since January 1998, the Board has been apprised of the Company's efforts at their regular meetings. In addition, customers and the community continue to be updated with respect to the Company's Year 2000 efforts through mailings, published articles, lobby brochures and a Year 2000 Readiness Disclosure posted in the branch lobbies. A public seminar was presented in April 1998. The Company's ongoing outreach efforts include Year 2000 presentations to business organizations and community groups. 2. Assessment - during this phase an inventory was conducted of all known Company processes that could reasonably be expected to be impacted by the Year 2000 Issue and their related vendors, if applicable. The identification process included information technology and communication systems such as personal computers, local area networks and servers, ATM modems, printers, copy machines, facsimile machines, telephones and the operating systems and software for these systems. It also included non-information technology systems, such as heating, air conditioning and vault controls, alarm systems, surveillance systems, and postage meters. The Company inventoried all the systems listed above in the second and third quarters of 1998 and performed an initial assessment of potential risks from either under or nonperformance arising from incorrect processing and usage of dates after December 31, 1999. All outside servicers and major vendors were contacted to ascertain their individual levels of Year 2000 compliance. From vendor responses and/or certifications of Year 2000 compliance the Company determined that all vendors and service providers who provide mission critical and significant systems to the Company are addressing Year 2000 compliance for the products and services they provide to the Company and the Company expects all of the mission critical and significant vendors to be Year 2000 compliant by December 31, 1999. The assessment phase is complete, although it is updated periodically as necessary. 3. Renovation and/or replacement - this phase includes programming code enhancements, hardware and software upgrades, system replacements, vendor certification and any other changes necessary to make any hardware, software and other equipment Year 2000 compliant. The Company does not perform in-house programming, and thus is dependent on external vendors to ensure and modify, if needed, the hardware, software or other services they provide to the Company for Year 2000 compliance. The Company's primary service provider has a comprehensive Year 2000 Plan in place and has successfully completed Year 2000 testing of their mission critical systems. Page 8
4. Testing - The next phase for the Company under the plan is to complete a comprehensive testing of all known processes. As noted in the renovation and/or replacement phase above, the Company's primary service provider has already successfully tested their system for Year 2000 compliance. The next step, which was completed in the second quarters of fiscal 1999, is the testing of the Company's network mission critical software applications and hardware. The Company has performed Year 2000 testing of all employee computer work stations, and has updated or replaced work stations which are not Year 2000 compliant. The testing of the remainder of the Company's processes was substantially complete by June 1999. 5. Implementation - this phase will occur when Year 2000 processing commences. On some applications the Company is already entering dates greater than December 31, 1999 into their systems. In these situations no adverse events have been noted. The significant part of the implementation phase will occur after December 31,1999. The Company has developed contingency plans for processes that do not process information reliably and accurately after December 31, 1999. The contingency plans for all systems were substantially complete by the end of the second calendar quarter of fiscal 1999. Senior management completed a contingency plan to provide operating alternatives for continuation of services to the Company's customers in the event of systems or communication failures at the beginning of the Year 2000. Contingency plans will be updated as necessary. Based on preliminary planning during development of the contingency plan, management expects that the Company will be able to continue to operate in the Year 2000 even if some systems fail. At the end of December 1999, the Company will generate paper and systems backup of all customer and general ledger accounts. Due to the size of the Company, the Company expects that it will be able to operate with all transactions processed manually until normal operations can be restored. This procedure could require changing of schedules and hiring of temporary staff, which would increase cost of operations. If this procedure were to continue for any extended period of time, or if the Company ultimately had to change data service providers, the cost could be material. The Company is in the process of assessing the Year 2000 readiness of significant borrowers and depositors. The Company has completed its initial review of these significant relationships and assessed the risks these relationships may pose to the Company. The Company will continue to monitor the risk and expects any potential losses to the Company caused by Year 2000 problems of significant borrowers and depositors not to be material. This step is not expected to require a significant amount of time or resources. As of June 30, 1999 the following chart shows the current and projected status of the Company's Year 2000 compliance efforts: PHASE 9/30/98 12/31/98 3/31/99 6/30/99 - ----- ------- -------- ------- ------- Awareness 100% 100% 100% 100% Assessment 98 98 100 100 Renovation 89 96 100 100 Validation 58 78 85 90 Implementation 54 67 80 85 Page 9
The Company expensed approximately $16 thousand on Year 2000 costs in the second quarter of 1999. Based on an analysis of projected expenses performed during the first quarter of 1998 and subsequent updates, the total cost of the Year 2000 project is currently estimated at $110 thousand. These costs do not include the opportunity costs of the additional cash that will be held in our vaults to meet anticipated customer demand at year end. Funding of the Year 2000 project costs has come and is expected to come from normal operating cash flow. Additional costs including staff time will be expensed in the normal course of business and will not have a material impact on the Company's results of operations, liquidity, capital resources or financial condition. However, the expenses associated with the Year 2000 issue will directly reduce otherwise reported net income for the Company. Should the Company have to resort to alternative operating procedures due to major systems or communications failures at the beginning of the Year 2000, the extra cost could be material. Management of the Company believes that the potential effects on the Company's internal operations of the Year 2000 Issue can and will be addressed prior to the Year 2000. However, if required modifications or conversions are not made or are not completed on a timely basis prior to the Year 2000, the Year 2000 Issue could disrupt normal business operations. The most reasonably likely worst case Year 2000 scenarios foreseeable at this time would include the Company temporarily not being able to process, in some combination, various types of customer transactions. This could affect the ability of the Company to, among other things, originate new loans, post loan payments, accept deposits or allow immediate withdrawals, and, depending on the amount of time such a scenario lasted, could have a material adverse effect on the Company. Because of the serious implications of these scenarios, the primary emphasis of the Company's Year 2000 efforts is to correct, with complete replacement if necessary, any systems or processes whose Year 2000 test results are not satisfactory prior to the Year 2000. Nevertheless, should one of the most reasonably likely worst case scenarios occur in the Year 2000, the Company, as noted above, is in the process of formalizing a contingency plan that would allow for limited transactions until the Year 2000 problems are fixed. The costs of the Year 2000 project and the date on which the Company plans to complete Year 2000 compliance are based on management's best estimates, which were derived using numerous assumptions of future events such as the availability of certain resources (including internal and external resources), third party vendor plans and other factors. However, there can be no guarantee that these estimates will be achieved at the cost disclosed or within the timeframe indicated, and actual results could differ materially from these plans. Factors that might affect the timely and efficient completion of the Company's Year 2000 project include, but are not limited to, vendor's ability to adequately correct or convert software and the effect on the Company's ability to test its systems, the availability and cost of personnel trained in the Year 2000 area, the ability to identify and correct all relevant computer programs and similar uncertainties. Bank regulatory agencies have recently issued additional guidance under which they are assessing Year 2000 readiness. The failure of a financial institution to take appropriate action to address deficiencies in the Year 2000 project management process may result in enforcement actions which could have a material adverse effect on such institution, result in the imposition of civil money penalties or result in the delay (or receipt of an unfavorable or critical evaluation of management of a financial institution in connection with regulatory review) of applications seeking to acquire other entities or otherwise expand the institution's activities. Page 10
Ultimately, the success of the Company's efforts to address the Year 2000 issue depends to a large extent not only on the corrective measures that the Company undertakes, but also on the efforts undertaken by businesses and other independent entities who provide data to, or receive data from, the Company such as borrowers, vendors or customers. In particular, the Company's credit risk associated with its borrowers may increase as a result of problems such borrowers may have resolving their own Year 2000 issues. Although it is not possible to evaluate the magnitude of any potential increased credit risk at this time, the impact of the Year 2000 issue on borrowers could result in increases in problem loans and credit losses in future years. From now until 2000, the Company will endeavor to monitor the Year 2000 efforts of its borrowers and will implement a course of action and procedures designed to reduce any increased potential risk as a result of Year 2000 issues. ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For information regarding the market risk of the Company's financial instruments, see "Management Discussion and Analysis of Results of Operation and Financial Condition - Market Risk Management." The Company's principal market risk exposure is to interest rates. Page 11
PART II OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders The following matters were subimitted to and approved by stockholders, through the solicitation of proxies or otherwise, at the Annual Meeting of Stockholders held on April 20, 1999: (a) The following persons were elected as Class I Directors of the Company until the 2000 Annual Meeting. The results were as follows: AFFIRMATIVE NEGATIVE VOTES VOTES VOTES ABSTAINING ----------- -------- ---------- Thomas K. Helfenbein 1,432,493 6,202 0 Susanne K. Nuttle 1,432,493 6,202 0 Wm Maurice Sanger 1,429,037 9,658 0 Walter E. Schmidt 1,432,493 6,202 0 (b) The following person were elected as Class II Directors of the Company until the 2001 Annual Meeting. The results were as follows: AFFIRMATIVE NEGATIVE VOTES VOTES VOTES ABSTAINING ----------- -------- ---------- J. Robert Barton 1,437,895 0 0 Paul M. Bowman 1,437,895 0 0 Daniel T. Cannon 1,432,565 5,330 0 Mark M. Freestate 1,428,289 9,606 0 (c) The following person were elected as Class III Directors of the Company until the 2002 Annual Meeting. The results were as follows: AFFIRMATIVE NEGATIVE VOTES VOTES VOTES ABSTAINING ----------- -------- ---------- David C. Bryan 1,433,365 5,330 0 B. Vance Carmean, Jr 1,438,695 0 0 Neil R. LeCompte 1,433,365 5,330 0 Jerry F. Pierson 1,433,365 5,330 0 (d) Stegman and Company, P.A. were appointed to serve as the Company's independent auditors for the fiscal year ending December 31, 1999. Affirmative Votes Cast: 1,415,591 Negative Votes Cast: 5,330 Abstained: 19,174
Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K A. Exhibits Required by Item 601 of Regulation S-K are set forth below: (3) Charter and Bylaws (3.1) Articles of Amendment and Restatement of the Company are incorporated by reference from the Company's June 30, 1998 Form 10-Q, filed with the Commission on August 13, 1998. (3.2) Bylaws of the Company as amended and restated are filed electronically here within via Edgar. (10.1) 1998 Employee Stock Purchase Plan is incorporated by reference from the Company's Registration Statement on Form S-8 filed with the Commission on September 25, 1998 (Registration No. 333-64317). (10.2) 1998 Stock Option Plan is incorporated by reference from the Company's Registration Statement on Form S-8 filed with the Commission on September 25, 1998 (Registration No. 333-64319). (13) 1998 Annual Report filed with the Commission on March 31, 1999 (Registration No.0- 22345). (21) List of Subsidiaries is incorporated by reference from the Company's Form 10, filed with the Commission on April 3, 1997, and Form 10/A, filed with the Commission on May 30, 1997 (Registration No. 0-22523) (27) Financial Data Schedule for June 30, 1999 is filed electronically here within via EDGAR. B Reports on Form 8-K None
SIGNATURES Pursuant to the requirements of Section 13 of the Securities and Exchange Act of 1934, the Bank has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: August 9, 1999 SHORE BANCSHARES, INC. /S/ DANIEL T. CANNON -------------------- DANIEL T. CANNON President /S/ CAROL I. BROWNAWELL ----------------------- CAROL I. BROWNAWELL Treasurer