Shore Bancshares - 10-Q quarterly report FY

For the Quarterly Period Ended March 31, 2008

For the transition period from ________ to ________

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Registrant’s Telephone Number, Including Area Code

Former name, former address and former fiscal year, if changed since last report.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 8,395,450 shares of common stock outstanding as of April 25, 2008.

 

 

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)

See accompanying notes to Consolidated Financial Statements.

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except per share amounts)

 

See accompanying notes to Consolidated Financial Statements.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Three-Month Periods Ended March 31, 2008 and 2007

(Dollars in thousands, except per share amounts)

 

 

See accompanying notes to Consolidated Financial Statements.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

 

 

See accompanying notes to Consolidated Financial Statements.

 

 

Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

For the Three Months Ended March 31, 2008 and 2007

(Unaudited)

There were no antidilutive stock-based awards excluded from the calculation of earnings per share for the three months ended

March 31, 2008 and 2007.

Under the provisions of Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, "Accounting by Creditors for Impairment of a Loan," a loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contracted terms. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan’s principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.

Information with respect to impaired loans and the related valuation allowance is shown below:

Gross interest income of $68 thousand for the first quarter of 2008, $404 thousand for fiscal year 2007 and $194 thousand for the first quarter of 2007 would have been recorded if nonaccrual loans had been current and performing in accordance with their original terms. Interest actually recorded on such loans was $1 thousand for the first quarter of 2008, $142 thousand for fiscal year 2007 and $133 thousand for the first quarter of 2007.

In the normal course of business, to meet the financial needs of its customers, the Company’s bank subsidiaries are parties to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At March 31, 2008, total commitments to extend credit were approximately $242.6 million. Outstanding letters of credit were approximately $18.4 million at March 31, 2008.

At March 31, 2008, the Company had three equity compensation plans: (i) the Shore Bancshares, Inc. 1998 Stock Option Plan; (ii) the Shore Bancshares, Inc. Employee Stock Purchase Plan (“ESPP”); and (iii) the Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity Plan”). The plans are described in detail in Note 13 to the audited financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. Stock-based awards granted to date are generally time-based, vesting on each anniversary of the grant date over a three to five year period of time and, in the case of stock options, expiring 10 years from the grant date. ESPP awards allow employees to purchase shares of common stock at 85% of the fair market value on the date of grant. ESPP grants are 100% vested at date of grant and have a 27-month term.

During the three-month periods ended March 31, 2008 and 2007, the Company recognized pre-tax stock-based compensation expense of $23 thousand and $12 thousand, respectively. Stock-based compensation expense is recognized ratably over the requisite service period for all awards and is based on the grant-date fair value. Unrecognized stock-based compensation expense related to nonvested share-based compensation arrangements was $368 thousand as of March 31, 2008. The weighted-average period over which this unrecognized expense was expected to be recognized was 4.2 years.

 

The Company estimates the fair value of stock options using the Black-Scholes valuation model with weighted average assumptions for dividend yield, expected volatility, risk-free interest rate and expected lives (in years). The expected dividend yield is calculated by dividing the total expected annual dividend payout by the average stock price. The expected volatility is based on historical volatility of the underlying securities. The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in effect at grant date. The expected life of the options represents the period of time that the Company expects the awards to be outstanding based on historical experience with similar awards. Stock-based compensation expense recognized in the consolidated statements of income in the first quarter of 2008 and 2007 reflects forfeitures as they occurred.

No options were granted during the quarters ended March 31, 2008 and 2007.

The following table summarizes stock option activity for the Company under all plans for the three months ended March 31, 2008:

The following summarizes information about options outstanding at March 31, 2008:

The total intrinsic value of stock options exercised during the three-month periods ended March 31, 2008 and 2007 was approximately $9 thousand and $15 thousand, respectively. Cash received upon exercise of options during the three-month periods ended March 31, 2008 and 2007 was approximately $16 thousand and $24 thousand, respectively.

The following table summarizes restricted stock award activity for the Company under the 2006 Equity Plan for the three months ended March 31, 2008:

The Company operates two primary business segments: Community Banking and Insurance Products and Services. Through the Community Banking business, the Company provides services to consumers and small businesses on the Eastern Shore of Maryland and Delaware through its 17-branch network. Community banking activities include small business services, retail brokerage, and consumer banking products and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable financing arrangements, and merchant card services.

Through the Insurance Products and Services business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s market areas. Products include property and casualty, life, marine, individual health and long-term care insurance. Pension and profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.

Selected financial information by line of business for the three months ended March 31, 2008 and 2007 is included in the following table:

Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Available-for-sale securities is the only balance sheet category that the Company is required by generally accepted accounting principles to account for at fair value. The following table presents information about the Company’s assets measured at fair value on a recurring basis as of March 31, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value.

 

The Emerging Issues Task Force (“EITF”) of the FASB issued EITF Issue 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements,” which was effective January 1, 2008. EITF 06-4 requires the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods as defined in SFAS No. 106, " Employers' Accounting for Postretirement Benefits Other Than Pensions." The EITF reached a consensus that Bank Owned Life Insurance policies purchased for this purpose do not effectively settle the entity's obligation to the employee in this regard and thus the entity must record compensation cost and a related liability. Entities should recognize the effects of applying this Issue through either, (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity or net assets in the balance sheet as of the beginning of the year of adoption, or (b) a change in accounting principle through retrospective application to all prior periods. This Issue is effective for fiscal years beginning after December 15, 2007. The effects of the guidance have been applied as a change in accounting principle through a cumulative-effect adjustment to retained earnings of $318,000.

 

 

EITF Issue 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF 06-11 requires that tax benefits generated by dividends paid during the vesting period on certain equity-classified share-based compensation awards be classified as additional paid-in capital and included in a pool of excess tax benefits available to absorb tax deficiencies from share-based payment awards. EITF 06-11 is effective for years beginning after December 15, 2007. The adoption of EITF 06-11 did not have a significant impact on the Company’s consolidated financial position or results of operations.

 

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 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, 2007.

 

 

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 engages in the insurance business through three insurance producer firms, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC and Jack Martin Associates, Inc.; a wholesale insurance company, TSGIA, Inc.; and two insurance premium finance companies, Mubell Finance, LLC and ESFS, Inc. (all of the foregoing are collectively referred to as the “Insurance Subsidiary”) and the mortgage broker business through Wye Mortgage Group, LLC, all of which are wholly-owned subsidiaries of Shore Bancshares, Inc.

The shares of common stock of Shore Bancshares, Inc. are listed on the Nasdaq Global Select 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 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, 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, the quality of the 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.

 

Net income for the first quarter of 2008 was $3.372 million, or diluted earnings per share of $0.40, compared to $3.403 million, or diluted earnings per share of $0.41, for the first quarter of 2007. For the fourth quarter of 2007, net income was $3.340 million or $0.40 per diluted share.

Annualized return on average assets was 1.38% for the three months ended March 31, 2008, compared to 1.43% for the same period in 2007. Annualized return on average stockholders’ equity was 10.96% for the three-month period ended March 31, 2008, compared to 12.09% for the same period in 2007. For the fourth quarter of 2007, return on average assets was 1.40% and return on average equity was 11.78%.

Net interest income for the three-month period ended March 31, 2008 was $10.0 million, representing an increase of 1.3% when compared to the same period last year. Increased loan volume was the reason for the increase. The net interest margin remained relatively flat at 4.42% for the first quarter of 2008 when compared to the first quarter of 2007. Net interest income decreased 3.8% from the fourth quarter of 2007 primarily due to decreased rates. The net interest margin decreased 28 basis points from 4.70% for the fourth quarter of 2007. The 200 basis-point reduction in interest rates by the Federal Reserve in the first quarter of 2008 had a significant and immediate impact on the overall yield on earning assets.

Interest income was $15.9 million for both the first quarters of 2008 and 2007. Average earning assets increased 3.1% during the first quarter of 2008 when compared to the same period in 2007, and yields earned decreased 15 basis points to 7.00%. Average loans increased 14.0% while the yield earned on loans decreased 44 basis points. Loans comprised 86.5% and 78.1% of total average earning assets for the quarters ended March 31, 2008 and 2007, respectively. Interest income decreased 3.2% when compared to the fourth quarter of 2007.

Interest expense decreased 1.5% for the three-month period ended March 31, 2008 when compared to the same period last year. Average interest bearing liabilities increased 3.0% while rates paid decreased 13 basis points to 3.17%. Declining average balances and lower rates paid on money market and savings deposits and long-term debt were the primary reasons for the decreased expense. Although lower rates were paid for certificates of deposit and short-term borrowings, interest expense increased for these two categories due to increased average balances. The average balance of interest bearing deposits increased by 2.6% for the three months ended March 31, 2008 when compared to the same period in 2007. The overall rate paid for interest bearing deposits decreased 8 basis points to 3.12%. For the three months ended March 31, 2008, the average balance of certificates of deposits $100,000 or more increased by 13.5% when compared to the same period last year, and the average rate paid for those certificates of deposit decreased 24 basis points to 4.60%. Interest expense decreased 2.2% when compared to the fourth quarter of 2007.

 

The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid through March 31, 2008 and 2007:

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 35% exclusive of the

alternative minimum tax rate 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.

Noninterest income for the first quarter of 2008 increased $1.9 million when compared to the first quarter of 2007. The increase was primarily the result of the acquisition of two insurance agencies during the fourth quarter of 2007. Service charges on deposit accounts increased $182 thousand, other service charges and fees increased $265 thousand and insurance agency commissions increased $1.4 million for the first quarter of 2008 when compared to the first quarter of 2007. Noninterest income increased $787 thousand from the fourth quarter of 2007 primarily due to an increase in insurance agency commissions.

Noninterest expense for the first quarter of 2008 increased $1.7 million when compared to the first quarter of 2007. The increase was primarily attributable to the operating expenses of the two insurance agencies acquired during the fourth quarter of 2007. Salaries and benefits increased $1.1 million and other noninterest expenses increased $610 thousand for the first quarter of 2008 when compared to the first quarter of 2007. Included in other noninterest expenses was $611 thousand in commissions paid to unrelated insurance companies relating to wholesale insurance company activities. Noninterest expense increased $289 thousand from the fourth quarter of 2007 primarily due to an increase in salaries and benefits partially offset by a decrease in other noninterest expenses.

The effective tax rate was 38.5% for the three months ended March 31, 2008 compared to 37.2% for the same period 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 $808.6 million at March 31, 2008, an increase of $32.2 million, or 4.2%, since December 31, 2007. Average loans, net of unearned income, were $796.8 million for the three months ended March 31, 2008, an increase of $98.1 million, or 14.0%, 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-offs 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-month periods ended March 31, 2008 and 2007 was $462 thousand and $242 thousand, respectively. The provision for credit losses for the fourth quarter of 2007 was $465 thousand. The increased provision for the first quarter of 2008 when compared to the same period last year reflected the overall growth in the loan portfolio and current economic conditions. The overall credit quality of the portfolio remains strong as evidenced by loan delinquency and charge-off data at March 31, 2008. Management believes that we continue to maintain strong underwriting guidelines.

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 $87 thousand for the three-month period ended March 31, 2008, compared to $36 thousand for the same period last year and $135 thousand for the fourth quarter of 2007. The allowance for credit losses as a percentage of average loans was 0.99% at March 31, 2008, compared to 0.93% at March 31, 2007. Loans past due 90 days and still accruing at March 31, 2008 were $1.1 million compared to $1.6 million at December 31, 2007. Nonperforming assets decreased to $3.4 million at March 31, 2008 from $3.7 million at December 31, 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 March 31, 2008.

 

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

We have a concentration of commercial real estate loans. Commercial real estate loans, excluding construction and land development loans, at March 31, 2008 were approximately $266.4 million, or 33.0% of total loans, compared to $249.5 million, or 32.1% of total loans at December 31, 2007. Construction and land development loans at March 31, 2008 were $166.6 million, or 20.6% of total loans, compared to $155.5 million, or 20.0% of total loans at December 31, 2007. We do not engage in foreign or subprime lending activities.

The following table summarizes our past due and nonperforming assets:

Investment securities totaled $99.1 million at March 31, 2008, compared to $110.0 million at December 31, 2007. The decreased balance reflects that a portion of maturing securities were used to fund loan growth. The average balance of investment securities was $104.2 million for the three months ended March 31, 2008, compared to $130.0 million for the same period in 2007. The tax equivalent yields on investment securities were 4.90% and 4.54% for the three-month periods ended March 31, 2008 and 2007, respectively.

Total deposits at March 31, 2008 were $808.9 million, compared to $765.9 million at December 31, 2007. Certificates of deposit of $100,000 or more increased $27.0 million, or 16.7%, due primarily to increased deposits of a large municipal customer, and money market and savings deposits increased $14.6 million, or 8.6%, since the end of 2007. Growth in other time and demand deposits have remained relatively flat since December 31, 2007.

 

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 $74.3 million in the aggregate at March 31, 2008. 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 $122.7 million at March 31, 2008, an increase of 2.0% since December 31, 2007. Accumulated other comprehensive income, which consists solely of net unrealized gains or losses on investment securities available for sale, increased by $714 thousand since the end of 2007, resulting in accumulated other comprehensive income of $961 thousand at March 31, 2008.

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 average 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 March 31, 2008 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, 2007 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, 2007.

An evaluation of the effectiveness of these disclosure controls as of March 31, 2008 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 first quarter of 2008, 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, 2007. 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.