Shore Bancshares - 10-Q quarterly report FY

Unless the context clearly suggests otherwise, references to “the Company”, “we”, “our”, and “us” in this report are to Shore Bancshares, Inc. and its consolidated subsidiaries.

The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of Shore Bancshares, Inc. and its consolidated subsidiaries for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements and related notes presented in this report, as well as the audited consolidated financial statements and related notes included in the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2006.

Shore Bancshares, Inc. is the largest independent financial holding company located on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland (“Talbot Bank”), The Centreville National Bank of Maryland located in Centreville, Maryland (“Centreville National Bank”) and The Felton Bank, located in Felton, Delaware (“Felton Bank”) (collectively, the “Banks”). The Banks operate 17 full service branches in Kent, Queen Anne’s, Talbot, Caroline and Dorchester Counties in Maryland and Kent County, Delaware. The Company offers a full range of insurance products and services to its customers through The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC (collectively, the “Insurance Agency”) and investment advisory services through Wye Financial Services, LLC, all of which are wholly-owned subsidiaries of Shore Bancshares, Inc. On October 1, 2007, the Company acquired Tri-State General Insurance Agency, LTD, a wholesale insurance agency located in Salisbury, Maryland, and its subsidiaries, and Jack Martin & Associates, Inc., a marine insurance agency located in Annapolis, Maryland.

The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Market under the symbol “SHBI”.

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within the financial statements is, to a significant extent, financial information contained that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning of income, recognizing an expense, recovering an asset or relieving a liability.

We believe that our most critical accounting policy relates to the allowance for credit losses. The allowance for credit losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable, and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from Management’s estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change.

Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the borrower’s prospects of repayment, and in establishing allowance factors on the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on Management’s continuing assessment of the totality of all factors, including, but not limited to, as delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of Management, national and local economic trends, concentrations of credit, quality of loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio, and allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based upon the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in Management’s perception and assessment of these factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs.

Three basic components comprise our allowance for credit losses: (i) a specific allowance; (ii) a formula allowance; and (iii) a nonspecific allowance. Each component is determined based on estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance to loans identified as impaired. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. When a loan is identified as impaired, a specific allowance is established based on our assessment of the loss that may be associated with the individual loan. The formula allowance is used to estimate the loss on internally risk rated loans, exclusive of those identified as impaired. Loans identified as special mention, substandard, doubtful and loss, as well as impaired, are segregated from performing loans. Remaining loans are then grouped by type (commercial, commercial real estate, construction, home equity or consumer). Each loan type is assigned an allowance factor based on Management’s estimate of the risk, complexity and size of individual loans within a particular category. Classified loans are assigned higher allowance factors than non-rated loans due to Management’s concerns regarding collectibility or Management’s knowledge of particular elements regarding the borrower. Allowance factors grow with the worsening of the internal risk rating. The nonspecific formula is used to estimate the loss of non-classified loans stemming from more global factors such as delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of Management, national and local economic trends, concentrations of credit, quality of loan review system and the effect of external factors such as competition and regulatory requirements. The nonspecific allowance captures losses whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance.

Net income for the third quarter of 2007 was $3,351,000, or diluted earnings per share of $.40, compared to $3,199,000, or diluted earnings per share of $.38, for the third quarter of 2006. Annualized return on average assets was 1.42% for the third quarter of 2007, compared to 1.40% for the same period in 2006. Annualized return on average stockholders’ equity was 11.51% for the third quarter of 2007 compared to 11.84% for the same period in 2006.

Net income for the nine months ended September 30, 2007 was $10,110,000, or diluted earnings per share of $1.20, compared to $10,501,000, or diluted earnings per share of $1.25, for the nine months ended September 30, 2006. Annualized return on average assets was 1.43% for the nine months ended September 30, 2007, compared to 1.60% for the same period in 2006. Annualized return on average stockholder’s equity was 11.76% for the nine months ended September 30, 2007, compared to 13.22% for the same period in 2006.

Net interest income for the three- and nine-month periods ended September 30, 2007 was $10,463,000 and $30,610,000, respectively, an increase of $561,000 or 5.7% and $1,385,000 or 4.7%, respectively, when compared to the same periods last year. These increases are attributable to increases in earning assets, mostly loans, and increased yields on earning assets. Total interest income increased by $1,175,000 and $6,312,000 for the three- and nine-month periods ended September 30, 2007, respectively, when compared to the same periods last year.

Total interest expense increased $614,000 and $4,927,000 for the three- and nine-month periods ended September 30, 2007 when compared to the same periods last year. The increase is attributable to both an increase in the volume of interest bearing deposits as well as an increase in the overall rate paid for both interest bearing deposits and borrowings. The average balance of interest bearing deposits increased by $54,594,000 for the nine months ended September 30, 2007 when compared to the same period in 2006. The overall rate paid for interest bearing deposits increased 68 basis points to 3.27% as a result of higher rates paid for all deposits. For the nine months ended September 30, 2007, the average balance of certificates of deposits, including those $100,000 or more, increased by $58,722,000 when compared to the same period last year, and the average rate paid for those certificates of deposit declined during the third quarter resulting in an overall decrease for the nine months ended September 30, 2007 of 10 basis points to 4.18%. Other certificates of deposit increased $1,671,000 when compared to the same period last year, and the average rate paid for those deposits increased 130 basis points to 5.15%. Comparing the first nine months of 2007 to the same period in 2006, interest bearing demand deposits increased by approximately $6,961,000 and money management and savings deposits declined by $12,760,000.

Loans comprised 80.4% and 80.3% of total average earning assets at September 30, 2007 and 2006, respectively.

The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid through September 30, 2007 and 2006:

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate exclusive of the

alternative minimum tax rate of 35% and nondeductible interest expense.

(2) Average loan balances include nonaccrual loans.

(3) Interest income on loans includes amortized loan fees, net of costs, for each loan category and yield calculations are stated to include all.

The effective tax rate was 37% and 37.1%, respectively, for the three- and nine-month periods ended September 30, 2007 compared to 38.1% and 37.6%, respectively, for the same periods last year. Management believes that there have been no changes in tax laws or to our tax structure that are likely to have a material impact on our future effective tax rate.

Loans, net of unearned income, totaled $750,457,000 at September 30, 2007, an increase of $57,038,000 since December 31, 2006. Substantially all of the loan growth occurred during the second and third quarters of 2007. Average loans, net of unearned income, increased by $59,753,000 or 9.1% for the nine months ended September 30, 2007 when compared to the same period last of year.

We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts. The allowance is decreased by current period charge-off of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based upon this analysis. The evaluation of the adequacy of the allowance for credit losses is based on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans based on factors such as past credit loss experience, local economic trends, nonperforming and problem loans, and other factors which may impact collectibility. A loan is placed on nonaccrual when it is specifically determined to be impaired and principal and interest is delinquent for 90 days or more. Please refer to the discussion above under the caption “Critical Accounting Policies” for an overview of the underlying methodology Management employs on a quarterly basis to maintain the allowance.

The provision for credit losses for the three- and nine-month periods ended September 30, 2007 was $604,000 and $1,259,000, respectively, compared to $416,000 and $967,000, respectively for the same periods in 2006. The increase in the provision during the third quarter of 2007 when compared to the same period last year is attributable to the growth in the loan portfolio and the identification of losses in loans put on nonaccrual status during the third quarter. The overall credit quality of the portfolio remains strong as evidenced by loan delinquency and charge-off data at September 30, 2007. Management believes that we continue to maintain strong underwriting guidelines. Management also believes that the local economy remains stable, despite a slowing in the real estate market, and that collateral values remain stable. Our historical charge-off ratios remain lower than those of similarly sized institutions according to the most recent Bank Holding Company Performance Report prepared by the Federal Reserve Board. Net charge-offs were $338,000 for the nine-month period ended September 30, 2007, compared to $360,000 for the same period last year. The allowance for credit losses as a percentage of average loans was 1.01% at September 30, 2007, compared to .89% at September 30, 2006. Loans past due 90 days and still accruing at September 30, 2007 increased slightly during the quarter, totaling $1,018,000, compared to $641,000 at December 31, 2006. Nonaccrual loans increased during the third quarter, totaling $3,706,000, compared to 1,944,000 at June 30, 2007, $3,974,000 at March 31, 2007, and $7,658,000 at December 31, 2006. One loan totaling $4,500,000, which was on nonaccrual at December 31, 2006, was paid in full during the first quarter of 2007. Based on Management’s quarterly evaluation of the adequacy of the allowance for credit losses, it believes that the allowance for credit losses and the related provision are adequate at September 30, 2007.

The following table presents a summary of the activity in the allowance for credit losses:

Because most of our loans are secured by real estate, weaknesses in the local real estate market may have a material adverse effect on the performance of our loan portfolio and the value of the collateral securing that portfolio. We have a concentration of commercial real estate loans. Commercial real estate loans, excluding construction and land development loans, at September 30, 2007 were approximately $215,395,000 or 28.7% of total loans, compared to $223,743,000 or 32.0% of total loans at December 31, 2006. Construction and land development loans at September 30, 2007 were $156,027,000 or 20.8% of total outstanding loans, compared to $153,715,000 or 22.2% of total loans at December 31, 2006. We do not engage in foreign lending activities or subprime lending.

The following table summarizes our past due and nonperforming assets (in thousands):

Investment securities totaled $122,773,000 at September 30, 2007, compared to $130,246,000 at December 31, 2006. Reinvestment rates on bonds purchased during the first nine months of 2007 were much higher that the yields on bonds that matured during this period. Despite the yield increase, the overall portfolio balance has declined as some of the maturities were used to fund loan growth during the first nine months of 2007, producing an even higher overall yield to the Company. The average balance of investment securities was $128,811,000 for the nine months ended September 30, 2007, compared to $122,546,000 for the same period in 2006. The tax equivalent yields on investment securities were 4.65% and 4.29% for the nine-month periods ended September 30, 2007 and 2006, respectively.

Total deposits at September 30, 2007 were $760,123,000, compared to $774,182,000 at December 31, 2006. Certificates of deposit of $100,000 or more increased by $6,468,000 during the first nine months of 2007, NOW and SuperNOW declined $7,913,000 and noninterest bearing demand remained relatively stable, increasing only $534,000 since December 31, 2006. Other time and savings deposits have declined by $13,148,000 during the nine months ended September 30, 2007. The decline in other time and savings is attributable to a shift in deposits to higher yielding certificates of deposit and a loss of those deposits due to the competitive rates being offered in the local markets in which the Company operates.

Short-term borrowings at September 30, 2007 and December 31, 2006 were $39,389,000 and $28,525,000, respectively. Short-term borrowings consisted of securities sold under agreements to repurchase, overnight borrowings from correspondent banks, and short-term advance from the Federal Home Loan Bank. Short-term advances are defined as those with original maturities of one year or less.

At September 30, 2007, we had long term advances from the Federal Home Loan Bank totaling $16,000,000. Maturities of the outstanding advances are as follows:

We derive liquidity through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets through arrangements with correspondent banks. Talbot Bank and Centreville National Bank are also members of the Federal Home Loan Bank of Atlanta and Felton Bank is a member of the Federal Home Loan Bank of Pittsburgh to which they have pledged collateral sufficient to permit additional borrowings of up to approximately $146 million in the aggregate at September 30, 2007. Management is not aware of any trends or demands, commitments, events or uncertainties that are likely to materially affect our future ability to maintain liquidity at satisfactory levels.

Total stockholders’ equity was $117.7 million at September 30, 2007, an increase of 5.8% since December 31, 2006. Accumulated other comprehensive loss, which consists solely of net unrealized losses on investment securities available for sale, decreased by $490,000 during the first nine months of 2007, resulting in accumulated other comprehensive loss of $233,000 at September 30, 2007.

Bank regulatory agencies have adopted various capital standards for financial institutions, including risk-based capital standards. The primary objectives of the risk-based capital framework are to provide a more consistent system for comparing capital positions of financial institutions and to take into account the different risks among financial institutions’ assets and off-balance sheet items.

Risk-based capital standards have been supplemented with requirements for a minimum Tier 1 capital to assets ratio (leverage ratio). In addition, regulatory agencies consider the published capital levels as minimum levels and may require a financial institution to maintain capital at higher levels.

A comparison of our capital ratios as of September 30, 2007 to the minimum regulatory requirements is presented below:

Our primary market risk is to interest rate fluctuation and Management has procedures in place to evaluate and mitigate this risk. This risk and these procedures are discussed in Item 7 of Part II of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2006 under the caption “Market Risk Management”. Management believes that there have been no material changes in our market risks, the procedures used to evaluate and mitigate these risks, or our actual and simulated sensitivity positions since December 31, 2006.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to Management, including the Chief Executive Officer (“CEO”) and the Principal Accounting Officer (“PAO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

An evaluation of the effectiveness of these disclosure controls as of September 30, 2007 was carried out under the supervision and with the participation of Management, including the CEO and the PAO. Based on that evaluation, the Company’s management, including the CEO and the PAO, has concluded that our disclosure controls and procedures are, in fact, effective at the reasonable assurance level.

During the third quarter of 2007, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2006. Management does not believe that any material changes in our risk factors have occurred since they were last disclosed.

The exhibits filed or furnished with this quarterly report are shown on the Exhibit List that follows the signatures to this report, which list is incorporated herein by reference.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.