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 MARCH 31, 1998 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 May 8, 1998, there were 2,014,848 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 --March 31, 1998 and December 31, 1997 Statements of Income -- Three months ended March 31, 1998 and 1997 Statements of Cash Flows -- Three months ended March 31, 1998 and 1997 and the twelve months ended December 31, 1997 Notes to Financial Statements - March 31, 1998 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 INFORMATION CONSOLIDATED BALANCE SHEETS SHORE BANCSHARES, INC. March 31, December 31, Dollars in thousands 1998 1997 (Unaudited) ----------- ----------- ASSETS Cash and due from banks $ 5,538 $ 5,092 Federal funds sold 12,155 3,504 Securities (Note 2) Held to Maturity 33,017 39,298 Available for Sale 9,351 9,444 Loans, less allowance for credit losses (Note 3 and 4) 105,165 107,764 Premises and fixed assets 3,277 3,259 Investments in unconsolidated subsidiaries 1,188 1,187 Accrued interest receivable 776 1,476 Goodwill 2,051 2,088 Net deferred taxes and other assets 2,492 2,003 ---------- ---------- TOTAL ASSETS $ 175,010 $ 175,115 ========== ========== LIABILITIES Deposits Non-interest bearing demand $ 15,854 $ 17,727 Interest bearing transaction 18,186 19,176 Savings and money market 38,341 37,575 Time, $100,000 or more 13,845 13,474 Other time 59,097 57,861 ---------- ---------- Total deposits 145,323 145,813 ---------- ---------- Long term debt (Note 5) 5,000 5,000 Accrued interest payable 197 189 Other liabilities 751 598 ---------- ---------- 5,948 5,787 ---------- ---------- Total liabilities 151,271 151,600 ---------- ---------- COMMITMENTS EQUITY CAPITAL Common stock, par value $.01; authorized 10,000,000 shares, issued and outstanding 2,014,848 shares 20 10 Surplus 10,064 10,064 Retained earnings 13,690 13,480 Accumulated other comprehensive income (35) (39) ---------- ---------- Total stockholders' equity 23,739 23,515 ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 175,010 $ 175,115 ========== ========== See Notes to Financial Statements
CONSOLIDATED STATEMENTS OF INCOME SHORE BANCSHARES, INC. (UNAUDITED) Quarter Quarter Dollars in thousands except per share data Ended Ended March 31, March 31, 1998 1997 --------------------------- INTEREST INCOME Interest and fee income on loans $ 2,438 $ 1,961 Interest and dividends on securities U.S. Treasury and U.S. Govt agencies 520 506 States and political subdivisions Taxable securities 10 10 Tax-exempt securities 122 107 Other securities (debt and equity) 32 11 Interest on federal funds sold 94 91 --------------------------- Total interest income 3,216 2,686 --------------------------- INTEREST EXPENSE Interest on certificates of deposit of $100,000 or more 185 210 Interest on other deposits 1,182 937 Interest on long term debt 71 - --------------------------- Total interest expense 1,438 1,147 --------------------------- NET INTEREST INCOME 1,778 1,539 Provision for credit losses - - --------------------------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 1,778 1,539 --------------------------- NONINTEREST INCOME Service charges on deposit accounts 159 161 Other noninterest income 49 28 Gains (losses) on securities - 4 --------------------------- Total noninterest income 208 193 --------------------------- NONINTEREST EXPENSE Salaries and employee benefits 592 512 Expenses of premises and fixed assets 172 151 Other noninterest expense 509 386 --------------------------- Total noninterest expense 1,273 1,049 --------------------------- INCOME BEFORE TAXES 713 683 Applicable income taxes 251 241 --------------------------- NET INCOME $ 462 $ 442 =========================== Net Income Per Share $ 0.23 $ 0.22 Number of Shares Outstanding 2,014,848 2,014,848 See Notes to the Financial Statements
<TABLE> <CAPTION> CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY SHORE BANCSHARES, INC. Accumulated (Unaudited) Other Common Retained Comprehensive Dollars in thousands Stock Surplus Earnings Income Total --------- -------- -------- ------------- ---------- <S><C> Balance at January 1, 1998 $10 $ 10,064 $13,480 ($39) $ 23,515 Comprehensive income: Net income 462 462 Other comprehensive income, net of tax: Unrealized gain on available-for-sale securities, net of reclassification adjustment 4 4 -------- Other comprehensive income 4 -------- Comprehensive income 466 Two-for-one stock split effected in the form of a 100% stock dividend 10 (10) 0 Cash dividends declared ($.12 per common share)* (242) (242) -------- --------- -------- -------------- ----------- Balance at March 31, 1998 20 10,064 13,690 (35) 23,739 ======== ========= ======== ============== =========== </TABLE> *Restated for two-for-one stock split effected in the form of a 100% stock dividend
CONSOLIDATED STATEMENTS OF CASH FLOW SHORE BANCSHARES, INC. (UNAUDITED) <TABLE> <CAPTION> Three Months Year Three Months Ended Ended Ended March 31, December 31, March 31, 1998 1997 1997 ------------------------------------------ <S><C> CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 462 $ 2,370 $ 442 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 60 424 50 Equity in net earnings of unconsolidated subsidiaries - (73) - Provision for credit losses, net (13) (115) (10) Deferred income tax benefits 58 265 - Net (gains) losses on disposal of assets - 40 (4) Changes in assets and liabilities: (Increase) decrease in accrued interest receivable 700 10 142 (Increase) decrease in other assets (576) (1,346) (624) Increase (decrease) in interest payable 8 (118) (1) Increase (decrease) in other liabilities 153 (89) 203 ----------------------------------------- Net cash provided by operating activities 852 1,368 198 ----------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from maturities of held-to-maturity securities 12,405 16,221 3,054 Proceeds from maturities of available-for-sale securities 42 1,081 1,500 Proceeds from sale of available-for-sale securities - 3,373 - Purchases of held-to-maturity securities (5,981) (22,899) (2,000) Purchases of available-for-securities - (1,693) (5,601) Net (increase) decrease in loans 2,612 46 549 Purchase of premises and equipment (101) (1,276) (193) Proceeds from sale of premises and equipment - - - Aquisition, net of cash aquired - (2,799) - ----------------------------------------- Net cash provided by (used in) investing activities 8,977 (7,946) (2,691) ----------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in demand, interest-bearing transaction, and savings deposits (2,097) 6,923 1,700 Increase (decrease) in time deposits 1,607 (6,034) (974) Proceeds from long-term debt - 5,000 Cash dividends paid (242) (977) (232) ----------------------------------------- Net cash provided by (used in) financing activities (732) 4,912 494 ----------------------------------------- Net increase (decrease) in cash and cash equivalents 9,097 (1,667) (1,999) Cash and cash equivalents, beginning 8,596 10,263 10,263 ----------------------------------------- Cash and cash equivalents, ending $ 17,693 $ 8,596 $ 8,264 ========================================= Supplementary cash flow information: Interest paid $ 1,360 $ 5,417 $ 1,148 Income taxes paid $ 369 $ 1,120 $ 15 All dollar amounts in thousands
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 three month period ended March 31, 1997 are not necessarily indicative of the results that may be expected for the year ended December 31, 1998. For further information, refer to the audited consolidated financial statements and footnotes included in the 1997 Annual Report to Shareholders and Form 10. New Accounting Standard During the first quarter 1998, Shore Bancshares, Inc. adopted FASB Statement no. 130 REPORTING COMPREHENSIVE INCOME. Statement no. 130 requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income discloses certain financial information that historically has not been recognized in the calculation of net income. The Company holds securities classified as available-for-sale, which have unrealized gain of $6 thousand before tax during the first quarter of 1998. The after tax gain of $4 thousand is reflected in the CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - SECURITIES (UNAUDITED) </TABLE> <TABLE> <CAPTION> March 31, 1998 December 31, 1997 -------------------------------------------- -------------------------------------------- Held-to-Maturity Available-for-Sale Held-to-Maturity Available-for-Sale Amortized Fair Amortized Fair Amortized Fair Amortized Fair Cost Value Cost Value Cost Value Cost Value ------------------------------------------ ---------------------------------------------- <S><C> U.S. Treasury securities $ 6,971 $ 7,019 $ 6,966 $ 7,014 U.S. Government agency and corporation obligations issued by U.S. Government sponsored $ 22,153 $ 22,148 $ 29,064 $ 29,086 100 100 agencies Securities issued by states and political subdivisions in the U.S. a.General obligations 9,494 9,633 9,221 9,378 b.Revenue obligations 1,348 1,361 989 1,007 Mortgage-backed securities 22 25 323 333 24 27 365 374 Equity Securities a. Investments in Mutual Funds 1,048 931 1,010 888 b. Other equity securites with readily determinable fair values c. All other equity securities 1,068 1,068 1,068 1,068 ------------------------------------------ ---------------------------------------------- TOTAL SECURITIES $ 33,017 $ 33,167 $ 9,410 $ 9,351 $ 39,298 $ 39,498 $ 9,509 $ 9,444 ========================================== ============================================== PLEDGED SECURITIES $14,406 $17,338 ========= ========== </TABLE> All dollar amounts in thousands
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE - 3 LOANS AND LEASE FINANCING RECEIVABLES (UNAUDITED) March 31, December 31 1998 1997 ---------- ----------- Loans secured by real estate a. Construction and land development $ 3,284 $ 2,866 b. Secured by farmland (including farm residential and other improvements) 4,235 4,282 c. Secured by 1-4 family residential properties 1. Revolving, open end loans 2,028 1,703 2. All others (a) Secured by first liens 65,456 68,772 (b) Secured by junior liens 3,482 3,855 d. Secured by multi-family (5 or more) residential properties e. Secured by nonfarm nonresidential properties 13,650 12,871 Loans to finance agricultural production and other loans to farmers 1,816 1,322 Commercial and industrial loans 6,108 7,027 Loans to individuals for household, family, and other personal expenditures (includes purchased paper) a. Credit card and related plans 91 81 b. Other 6,498 6,500 Obligations (other than securities) of states and political subdivisions in the U. S. - 13 Other loans a. Loans for purchasing or carrying securities (secured and unsecured) b. All other loans 36 42 Less any unearned income on loans 128 166 --------- --------- Total loans and leases, net of unearned income 106,556 109,168 Less allowance for loan and lease losses 1,391 1,404 --------- --------- Total loans and leases, net of unearned income and allowance for loan and lease losses $ 105,165 $ 107,764 ========= ========= All dollar amounts in thousands
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE - 4 CHARGE OFFS AND RECOVERIES AND CHANGE IN ALLOWANCE FOR LOAN AND LEASE LOSSES (UNAUDITED) I. CHARGE-OFFS AND RECOVERIES ON LOANS AND LEASES March 31, 1998 December 31, 1997 Charge-offs Recoveries Charge-offs Recoveries ------------------------- ------------------------ 1. Real estate loans $ - $ - $ 22 $ - 2. Installment loans 35 8 99 40 3. Credit cards and related plans 4 4. Commercial (time and demand) and all other loans - 18 37 4 ------------------------- ------------------------- 6. Total $ 39 $ 26 $ 158 $ 44 ========================= ========================= II. CHANGES IN ALLOWANCE FOR LOAN AND LEASE LOSSES 1. Balance at end of previous period $ 1,404 $ 1,503 2. Recoveries 26 44 3. Charge-offs (39) (158) 4. Provision for loan and lease losses - - 5. Allowance aquired - 15 ---------- --------- 6. Balance at end of period $ 1,391 $ 1,404 ========== ========= 7. Net charge-offs $ 13 $ 114 8. Average daily loan balance 108,539 103,742 9. Ratio-net of charge offs to average loans outstanding 0.01% 0.11% All dollar amounts in thousands
Note 5 - 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.
AVERAGE BALANCES, YIELDS AND RATES <TABLE> <CAPTION> YTD 3/31/98 YTD 3/31/97 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate <S><C> ASSETS Interest Earning assets: Money market investments: Federal funds sold 6,575,826 93,652 5.78% 6,881,660 91,422 5.39% Investment Securities: U.S. Treasury securities and obligations of U.S. government agencies 32,437,402 520,199 6.50% 32,139,550 505,681 6.38% Obligations of States and political subdivisions 10,008,958 184,224 7.46% 8,525,608 162,145 7.71% Taxable Municipals 512,815 10,121 8.00% 512,815 10,121 8.00% All other investment securities 1,710,819 31,940 7.58% 1,487,504 10,632 2.90% Federal Reserve Bank stock 302,250 - 0.00% 302,250 - 0.00% ---------------------------------- ----------------------------------- Total investment securities 44,972,244 746,501 6.73% 42,967,727 688,579 6.50% Loans - net of unearned income Commercial loans 9,144,563 221,326 9.82% 8,910,484 214,045 9.74% Installment loans 5,508,107 137,993 10.16% 5,247,975 130,403 10.08% Mortgage loans 93,886,763 2,059,711 8.90% 74,413,812 1,597,419 8.71% ---------------------------------- ----------------------------------- Total loans 108,539,433 2,419,030 9.04% 88,572,271 1,941,867 8.89% ---------------------------------- ----------------------------------- TOTAL INTEREST EARNING ASSETS 160,087,503 3,259,166 8.26% 138,421,658 2,721,868 7.97% Cash and due from banks 4,341,238 3,678,594 Other assets 9,815,479 6,029,266 Allowance for loan and lease losses (1,403,934) (1,496,608) ---------------------------------- ----------------------------------- TOTAL ASSETS 172,840,286 146,632,910 ================================== =================================== LIABILITIES Interest-bearing liabilities Other Borrowed Funds 5,007,500 70,860 5.74% - - Super NOW accounts 17,003,245 118,271 2.82% 16,209,094 120,818 3.02% Money market deposit accounts 19,805,752 164,436 3.37% 20,240,182 166,261 3.33% Time, $100,000 or more 12,109,406 160,870 5.39% 14,828,444 193,549 5.29% Other time deposits 44,839,794 594,067 5.37% 30,764,822 393,478 5.19% IRA deposits 15,705,086 197,106 5.09% 14,273,369 177,979 5.06% Savings deposits 17,449,893 133,211 3.10% 12,147,103 94,684 3.16% ---------------------------------- ----------------------------------- TOTAL INTEREST-BEARING LIABILITIES 131,920,676 1,438,821 4.42% 108,463,014 1,146,769 4.29% Demand deposits 16,210,359 15,127,398 Other liabilities 1,164,231 740,277 ---------------------------------- ----------------------------------- Total liabilities 149,295,265 124,330,689 Stockholders' equity 23,545,020 22,302,221 ---------------------------------- ----------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY 172,840,286 146,632,910 ================================== =================================== Net interest income & interest rate spread 1,820,345 3.83% 1,575,099 3.69% Net interest income as a % of earning assets 4.45% 4.45% ================================== =================================== </TABLE> 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.
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, 1997 audited consolidated financial statements and notes. 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. All data for the periods on and after July 1996 is presented in this analysis in consolidated form and is compared to like data for the Bank for prior years, restated to reflect the exchange of shares of Bank common stock for Company shares. Effective April 1, 1997, The Centreville National Bank of Maryland completed its merger with Kent Savings and Loan Association, F.A. (Kent Savings) of Chestertown, Maryland. The transaction was accounted for purchase and, therefore, results of operations for Kent Savings subsequent to March 31, 1997 are included in the consolidated statements of income and cash flows from date of acquisition. RESULTS OF OPERATIONS OVERVIEW The Company reported $462 thousand in net income for the three months ended March 31, 1997 or $.23 per share compared to the three months ended March 31, 1997 with net income of $442 thousand or $.22 per share. Net income in 1998 increased $20 thousand or 4.5% over the same period in 1997. The improvement was attributable to the $ 239 thousand or 15.5% growth in net interest income, the Company's major income component. March 31, 1998 net income includes net interest earnings on assets acquired in the Kent Savings merger. The March 31, 1997 net interest income does not reflect the April 1, 1997 merger. Year to date net income absorbed on going non-interest expense associated with the merger of Kent Savings including goodwill amortization as well as increased depreciation expense for the renovation of the Centreville office. Despite an increase in net interest spread, net interest income as a percent of earning assets of 4.45% remained unchanged as of March 31, 1998 compared to the same period in 1997, which reflects a growth in assets at the same rate as growth in earnings. 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. The quarter ended March 31, 1998 has been characterized by Page 1
relatively stable interest rates at the Bank level subsequent to decreases in loan and deposit rates recognized early in the quarter. As a result of balance sheet growth resulting from the Kent purchase, the Bank's net interest income, on a fully tax-equivalent basis, increased in the first three months of 1998 compared to the same period in 1997. Net interest income (on a tax equivalent basis) for March 31, 1998 increased by $245 thousand or 15.6% compared to the three months ended March 31, 1997. 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 three months ended March 31, 1998 and 1997 was 3.83%, and 3.69%, respectively. Interest rate spread in 1998 improved in the first quarter compared to the same period in 1997 resulting from an increased yield on average earning assets of .29% and an increase in yield of average interest bearing liabilities at a slower rate by .13%. A change in the mix of the balance sheet accounted for the increase in interest rate spread when comparing the first quarters of 1998 and 1997. A review of average earning assets shows 2.4% increase in earnings on federal funds because of yield increase but essentially no difference in average balance. The average balance in municipal bonds increased $1,483 thousand which provide a higher tax equivalent yield than U.S. Treasuries and government agency bonds which grew only $298 thousand. Despite loan rate decreases early in 1998 loan yield has grown in comparison to March 31, 1997. Average balances in each loan category have also increased adding to total interest income. Deposits have seen a change in mix as well. Other Time and IRA deposits average balances have increased. These are more "costly" deposits and account for the increased deposit interest expense. Despite lowering deposit rates early in 1998 the change in deposit mix provided higher yields on deposits as of March 31, 1998 than they were the previous year. Interest rate spread has essentially remained the same comparing March 31, 1998 to a spread of 3.82% at December 31, 1997. Yield on average earning assets have increased .09% primarily as a result of improved yield on investments and fed funds. Deposit yields have also increased primarily as a result in increased cost of funds for time deposits. The increased yield on interest bearing liabilities was assisted by additional cost of borrowed funds at a higher rate than other interest bearing liabilities. No change in net interest margin was reflected comparing March 31, 1998 to March 31, 1997. 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. As of March 31, 1998 and 1997 the net interest margin was 4.45% reflecting a growth in earning assets at the same rate as the growth in earnings. See the table 1 titled "Average Balances, Yields and Rates" for additional information. 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. PROVISION and ALLOWANCE FOR CREDIT LOSSES For the quarter ended March 31, 1998 and 1997, the Company recorded net charge offs of $13 thousand and $11 thousand, respectively compared to net charge offs of $114 thousand for Page 2
the year ended December 31, 1997. Internal loan review, in particular, has been 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 the first quarters of 1998 and for the year ended December 31, 1997. Gross charge offs as of March 31, 1998 amounted to $39 thousand, $23 thousand for the same period in 1997 and $158 thousand for the year ended 1997, the majority of which were installment loans. Efforts to collect charged off loans continue and are evidenced by recoveries totaling $26 thousand in the first quarter of 1998, $12 thousand for the same three months in 1997 and $44 thousand for the year ended December 31, 1997. The provision for credit losses has followed the same general trend as the amount of charge offs. No provision for credit losses was charged to expense in 1997 nor to date in 1998. 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, 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 $1.4 million as of March 31, 1998 and December 31, 1997 represents 1.30% and 1.29%, respectively of gross loans. As of March 31, 1997, the $1.5 million allowance for credit losses reflected 1.69% of gross loans. The decrease in percentage of allowance to outstanding loans, despite the increasing outstanding gross loans, is justified by lower levels of past due and classified loans. Analysis by loan review supports adequacy of the allowance. The reduction in percentage of allowance to outstanding loans reflects improvements in credit quality achieved through better credit underwriting and more aggressive collection efforts. In management's opinion, the allowance for credit losses is adequate as of March 31, 1998. See Notes 3 and 4 in the Notes to Financial Statements. NON-INTEREST INCOME AND EXPENSE As of March 31, 1998 non-interest income reflects $15 thousand increase compared to March 31, 1997 primarily resulting from a $6 thousand increase in check order commissions and $6 thousand in ATM surcharges implemented in February 1998. Non-interest expense as of March 31, 1998 increased $224 thousand or 21.3% compared to the same period last year. A portion of the increase reflects $80 thousand in salaries and benefits costs associated with the addition of 6 full time equivalent staff when comparing March 31, 1998 to March 31, 1997. Premise and fixed asset expenses increased $21 thousand as of March 31, 1998 compared to the same period in 1997 primarily as a result of overhead of the Kent Branch acquired in the purchase of Kent Savings and Loan Association as well as the increased cost of depreciation and facility costs for the renovated Commerce Street office. The $123 thousand increase in other non-interest expense in the first quarter of 1998 compared to the same period in 1997 includes the amortization of intangibles which increased as goodwill from the merger is amortized over 15 years. In the first Page 3
three months of 1998 costs have been added as the Company has invested in additional marketing programs and staff training programs. Data processing costs have also increased to as a result of the additional customers acquired in the Kent Savings merger. 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 $42.4 million and $48.7 million as of March 31 1998 and December 31, 1997, respectively. The net decreased level of investments in securities resulted primarily from securities called in the first quarter as a result of the bond market offering lower interest rates. The funds were primarily reinvested in federal funds and continue to be reinvested in federal funds and loans. 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. See Note 2 in the Notes to Financial Statements. 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. Lending authority is based on the level of risk, size of the loan and the experience of the lending officer. Total loans as of March 31, 1998 have decreased $2.6 million dollars since December 31, 1997. The decrease is attributed to loans refinancing to the secondary market at the lower rates offered by the market as well as pay downs of a number of lines of credit. Note 3 "Summary of Loan Portfolio" presents the composition of the Company's loan portfolio by significant concentration. The Company had no loan concentrations exceeding 10% of total loans which are not otherwise disclosed. Page 4
The Company's policy is to make the majority of its loan commitments in the market area it serves. This tends to reduce risk because management is familiar with the credit histories of loan applicants and has an in-depth knowledge of the risk to which a given credit is subject. The Company had no foreign loans in its portfolio as of March 31, 1998. 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 March 31, 1998 and December 31, 1997, $136 thousand and $199 thousand, respectively, of non-accrual loans were secured by collateral with an estimated value of $986 thousand as of March 31, 1998 and $1.1 million as of December 31, 1997. At March 31, 1998, the Bank had one troubled debt restructuring of $292 and $4.09 million in loans on the watch list for which payments were current, but the borrowers have the potential for experiencing financial difficulties. These loans are subject to on going management attention and their classifications are reviewed regularly. DEPOSITS Deposit liabilities reflected .03% decrease in the first three months of 1998 compared to December 31, 1997. Savings, money market and time account deposits were the main source of deposit growth and were offset by decreases in non-interest bearing demand deposits and interest bearing transaction accounts. The Company generally experiences deposit run off in the first quarter of the year, therefore, the decreases noted are not unusual. 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. OTHER BORROWED FUNDS Other borrowed funds consist 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 5 in the Notes to Financial Statements. 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. A substantial portion of the investment portfolio contains readily marketable securities that could be converted to cash immediately. Refer to Note 2 in the Consolidated Financial Page 5
Statements for a table reflecting the Bank's security portfolio's estimated fair value. On the liability side of the balance sheet, liquidity is affected by the timing of maturing liabilities 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. As discussed above, an additional source is the Federal Home Loan Bank from which a $5,000,000 advance was outstanding at March 31, 1998. During the first quarter of 1998 calls of investment securities, decreases in the loan portfolio and essentially no change in deposit liabilities have provided for the Company's higher liquidity position. 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 Company's subsidiary's, The Centreville National Bank of Maryland, risk 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 as 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 Board of Directors has adopted an Asset Liability Management Policy, which is administered by the Asset Liability Committee of the Board of Directors. 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 December 31, 1997 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 $142 thousand if rates were to increase by that amount and would increase $199 thousand if rates would decline a similar amount. CAPITAL RESOURCES AND ADEQUACY Total stockholders' equity increased $224 thousand or .9% in 1998 to $23.7 million at the end of the March 31, 1998 from $23.5 million at December 31, 1997. Earnings of $462 thousand were the primary contributor to this increase. The change in unrealized gain (loss) on Page 6
investments classified as available for sale accounted for a $4 thousand increase and dividends paid reduced stockholders' equity $242 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 March 31, 1998 was 12.70% and at December 31, 1997 was 12.23%. 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 March 31, 1998 was 23.28% and at December 31, 1997 was 23.61%. According to FDIC capital guidelines, the Company is considered to be "Well Capitalized." Building and technological improvements begun in 1997 were completed in 1997. Renovations at the Commerce street location are significantly complete. The remaining phase is the replacing the lighting and flooring will be completed in 1998. Cost estimates have not yet been finalized. On December 5, 1996 the Bank entered into an agreement to acquire Kent Savings and Loan Association, F.A.(Kent Savings) of Chestertown, Maryland. The merger transaction was accounted for as a purchase. Under the terms of the agreement, the Bank paid approximately $5,100,000 for all of the outstanding shares of Kent Savings resulting in $2.1 million in goodwill to be amortized over 15 years. The Kent Savings shareholders met on March 17, 1997 and approved the merger. The effective date of the merger was April 1, 1997. On March 3, 1998 the Board of Directors also approved a 2 for 1 stock split in the form of a 100% stock dividend to be distributed on March 31, 1998 to shareholders of record on March 10, 1998. Total capital did not change as a result of the transaction, nor were the Company's capital ratios impacted in a negative manner. Management knows of no other trend or event which will have a material impact on capital. FUTURE TRENDS The Year 2000 (Y2K) issue is a potential problem that is facing all users of automated information systems and equipment. The concern is that many computers and equipment are based on two digits for the year of the transaction (for example "97") rather than a full four digits. These systems may not operate effectively when the last two digits become "00", as occurs on January 1, 2000. This could result in a systems failure or miscalculations, causing disruptions in operations, the inability to process transactions or engage in similar normal business activity. This is not just a banking problem, as corporations and business around the world are similarly impacted. To mitigate the effects of the Y2K issue, the Company's subsidiary, The Centreville National Bank of Maryland, adopted a plan and formed an internal task force to identify and assess impact of the Year 2000 issues, test the systems, and determine and implement the needed changes. The Bank is coordinating its efforts with other entities with which it interacts including Page 7
suppliers, customers, creditors, borrowers and financial service organizations. The Bank's primary supplier of data processing services also has adopted a Year 2000 plan and timetable. Based on assessments made to date, the total cost of the project is estimated to be approximately $170 thousand and may be as low as $120 thousand, which is being funded through operating cash flows. The majority of the cost is attributable to the purchase of equipment and software to replace those systems which cannot be made Year 2000 compliant. The equipment and software will be capitalized. 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. 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 8
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 None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K EXHIBIT INDEX (2) Plan of Acquisition, Reorganization, Arrangement, Liquidation or Succession (2.1) Plan of Reorganization and Agreement to Merge dated March 15, 1996, 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. 0-22345). (2.2) Merger Agreement dated December 5, 1996 among Kent Savings and Loan Association, F.A., The Centreville National Bank of Maryland, and the Company 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. 0-22345). (3) Charter and Bylaws (3.1) Articles of Incorporation of the Company are 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. 0-22345). (3.2) Bylaws of the Company are 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. 0-22345) (13) 1997 Annual Report filed herewith. (16) Letter re: Change in Certifying Accountants 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. 0-22345) (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 is filed electronically herewith via EDGAR. (b) Reports on Form 8-K None (c) Exhibits to Item 601 to Regulation S-K See the Exhibits described in Item 14(a)(3) above.
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: March 12, 1998 SHORE BANCSHARES, INC. /S/ DANIEL T. CANNON ________________________________ DANIEL T. CANNON President /S/ CAROL I. BROWNAWELL ________________________________ CAROL I. BROWNAWELL Treasurer