Southern First Bancshares - 10-Q quarterly report FY

GREENVILLE FIRST BANCSHARES, INC.

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

The financial statements of Greenville First Bancshares, Inc. and Subsidiary are set forth in the following pages.

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

(Unaudited)

See notes to consolidated financial statements that are an integral part of these consolidated statements.

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

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GREENVILLE FIRST BANCSHARES, INC.  AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Nature of Business and Basis of Presentation

Business activity

Greenville First Bancshares, Inc.  (the “company”) is a South Carolina corporation that owns all of the capital stock of Greenville First Bank, N.A.  (the “bank”) and all of the stock of Greenville First Statutory Trust I (the “Trust”).  The bank is a national bank organized under the laws of the United States located in Greenville County, South Carolina.  The bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the Federal Deposit Insurance Corporation, and providing commercial, consumer and mortgage loans to the general public.  The Trust is a special purpose subsidiary for the sole purpose of issuing trust preferred securities.

Basis of Presentation

The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-QSB.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company’s Form 10-KSB (Registration Number 000-27719) as filed with the Securities and Exchange Commission.  The consolidated financial statements include the accounts of Greenville First Bancshares, Inc., and its wholly owned subsidiary Greenville First Bank, N.A.  As discussed in Note 7, the financial statements related to the special purpose subsidiary, Greenville First Statutory Trust I, have not been consolidated in accordance with FASB Interpretation No. 46.

Cash and Cash Equivalents

For purposes of the Consolidated Statement of Cash Flows, cash and federal funds sold are included in “cash and cash equivalents.”  These assets have contractual maturities of less than three months.

Note 2 – Reclassifications

Certain amounts, previously reported, have been reclassified to state all periods on a comparable basis that had no effect on shareholders’ equity or net income.

Note 3 – Stock Split

On November 17, 2003, shareholders of record as of November 3, 2003, received one additional share of stock for every two shares of stock owned prior to the 3 for 2 stock split.  All factional shares were paid in cash.  The earnings per share amounts for all periods shown have been adjusted to reflect the 3 for 2 split.

Note 4 – Secondary Offering

On September 24, 2004, the company received $14.3 million from the sale of 800,000 shares of common stock at a price of $17.875.  On October 15, 2004, the company’s underwriter exercised its option to purchase an additional 120,000 shares at the same price.  The total gross proceeds were $16.4 million.  The net proceeds to the company after offering costs and underwriter’s discount were approximately $15.0 million.

Note 5 – Note Payable

At September 30, 2004, the company had an unused $4.5 million revolving line of credit with another bank.  This line of credit has a maturity of March 20, 2005. At December 31, 2003, the outstanding balance was $3.0 million.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at September 30, 2004 was 4.02%.  The company has pledged the stock of the bank as collateral for this line of credit. The line of credit agreement contains various covenants related to earnings and asset quality.  As of September 30, 2004, the company believes it is in compliance with all covenants.

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Note 6 – Earnings per Share

The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three months and nine months ended September 30, 2004 and 2003.  Dilutive common shares arise from the potentially dilutive effect of Greenville First Bancshares, Inc.’s stock options and warrants that are outstanding.  The assumed conversion of stock options and warrants can create a difference between basic and dilutive net income per common share.  The average dilutive shares have been computed utilizing the “treasury stock” method.  The number of shares and the earnings per share have been adjusted for the 3 for 2 stock split.

Note 7 – Accounting for Variable Interest Entities

Effective January 1, 2004, the company adopted FASB Interpretation No. 46, (“FIN 46”), “Consolidation of Variable Interest Entities.” In accordance with FIN 46, the $186,000 investment by the parent company, Greenville First Bancshares, Inc, in the special purpose subsidiary, Greenville First Statutory Trust I, results in the special purpose subsidiary being treated as a “variable interest entity” as defined in FIN 46.  Therefore, in accordance with the revised rules, the company did not consolidate its special purpose trust subsidiary.  Prior to the January 1, 2004, the effective date on the adoption of FIN 46, the company had consolidated the special purpose subsidiary.  The 2003, consolidated financial statements have been restated, resulting in the “deconsolidation” of this wholly-owned subsidiary.  The deconsolidation of this wholly-owned subsidiary, increased both the company’s other assets by $186,000, and the debt associated with the junior subordinated debentures.  The company’s maximum exposure to loss is the $186,000 invested in the special purpose subsidiary.  In addition to the loss exposure related to the investment in the special purpose subsidiary, the company has a full and unconditional guarantee for the $6,000,000 junior subordinate debentures that were issued.  The special purpose subsidiary was formed for the sole purpose of issuing the junior subordinate debentures.

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Note 8 – Stock Based Compensation

The company has a stock-based employee compensation plan.  The company accounts for the plan under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net income, as all stock options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

The fair value of the option grant is estimated on the date of grant using the Black-Scholes option-pricing model.  The following assumptions were used for grants: expected volatility of 10% for 2004 and 2003, risk-free interest rate of 3.00% for 2004 and 2003 respectively, expected lives of the options 10 years, and the assumed dividend rate was zero.

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In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers.  We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2003, as filed in our annual report on Form 10-KSB.

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Effect of Economic Trends

During the three years ended December 31, 2003, and the first six months of 2004, our rates on both short-term or variable rate earning assets and short-term or variable rate interest-bearing liabilities declined primarily as a result of the actions taken by the Federal Reserve.  Our rates on both short-term or variable earning assets and short-term or variable rate interest-bearing liabilities began to increase in the third quarter of 2004, as a result of actions taken by the Federal Reserve to increase short-term rates.

During most of 2001 and during 2002, the United States experienced an economic decline.  During this period, the economy was affected by lower returns of the stock markets.  Economic data led the Federal Reserve to begin an aggressive program of reducing rates that moved the Federal Funds rate down 11 times during 2001 for a total reduction of 475 basis points.  During the fourth quarter of 2002 and the first nine months of 2003, the Federal Reserve reduced the Federal Funds rate down an additional 75 basis points, bringing the Federal Funds rate to its lowest level in 40 years.

Despite sharply lower short-term rates, stimulus to the economy during 2003 was muted and consumer demand and business investment activity remained weak.  During all of 2003 and substantially all of the nine months ended September 30, 2004, the financial markets operated under historically low interest rates. As a result of these unusual conditions, Congress passed an economic stimulus plan in 2003.  During the first nine months of 2004, many economists believed the economy began to show signs of strengthening and at the end of the second quarter and near the end of the third quarter, the Federal Reserve increased the short-term interest rate each time by 25 basis points.  Many economists believe that the Federal Reserve will continue to increase rates during the remainder of 2004 and during most of 2005.  However, no assurance can be given that the Federal Reserve will take such action.

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Results of Operations

Income Statement Review

Summary

Three months ended September 30, 2004 and 2003

Our net income was $506,906 and $267,482 for the three months ended September 30, 2004 and 2003, respectively, an increase of $239,424, or 89.5%.  Our income was fully taxable in both three month periods.  The $239,424 increase in net income resulted primarily from increases of $628,412 in net interest income and $69,103 in noninterest income.  These increases were partly offset by $186,156 of additional noninterest expense, a $125,000 increase in provisions for loan losses, and a $146,935 increase in income tax expense.  Our efficiency ratio has continued to improve because we have been earning more income without substantially increasing our overhead expenses.  Our efficiency ratio was 49.79% and 59.39% for the three months ended September 30, 2004 and 2003, respectively.

Nine months ended September 30, 2004 and 2003

Our net income was $1.3 million and $663,863 for the nine months ended September 30, 2004 and 2003, respectively, an increase of $644,844, or 97.1%.  Our income was fully taxable in both nine month periods.  The $644,844 increase in net income resulted primarily from increases of $1.8 million in net interest income and $200,897 in noninterest income.  These increases were partly offset by $641,807 of additional noninterest expense, a $275,000 increase in provisions for loan losses, and a $395,427 increase in income tax expense.  Our efficiency ratio has continued to improve because we have been earning more income without substantially increasing our overhead expenses.  Our efficiency ratio was 52.71% and 61.05% for the nine months ended September 30, 2004 and 2003, respectively.

Net Interest Income

Our level of net interest income is determined by the level of earning assets and the management of our net interest margin.  The continuous growth in our loan portfolio is the primary driver of the increase in net interest income.  During the three months ended September 30, 2004, our loan portfolio had increased an average of $19.8 million compared to the second quarter of 2004.  The growth in the first nine months of 2004 was $58.2 million.  We anticipate the growth in loans will continue to drive the growth in assets and the growth in net interest income.  However, no assurance can be given that we will be able to continue to increase loans at the same levels we have experienced in the past.

Our decision to grow the loan portfolio at the current pace created the need for a higher level of capital and the need to increase deposits and borrowings.  This loan growth strategy also resulted in a significant portion of our assets being in higher earning loans than in lower yielding investments.  At September 30, 2004, loans represented 90.2% of total assets, while investments and federal funds sold represented 7.2% of total assets.  While we plan to continue our focus on increasing the loan portfolio, as rates on investment securities begin to rise and additional deposits are obtained, we also anticipate increasing the size of the investment portfolio.

The historically low interest rate environment in the last three years allowed us to obtain short-term borrowings and wholesale certificates of deposit at rates that were lower than certificate of deposit rates being offered in our local market.  Therefore, we decided not to begin our retail deposit office expansion program until the beginning of 2005.  This funding strategy allowed us to continue to operate in one location, maintain a smaller staff, and not incur marketing costs to advertise deposit rates, which in turn allowed us to focus on the fast growing loan portfolio.  At September 30, 2004, retail deposits represented $114.3 million, or 39.0% of total assets, borrowings represented $80.6 million, or 27.5% of total assets, and wholesale out-of-market deposits represented $70.0 million, or 23.5% of total assets.

In anticipation of rising interest rates, we are planning to open two retail deposit offices, one in the first quarter of 2005 and the other in the third quarter of 2005.  We plan to focus our efforts in these two locations to obtain low cost transaction accounts that are less affected by rising rates.  Also, in anticipation of rising rates, during the first nine months of 2004 we offered aggressive promotional rates on new checking accounts and new money market accounts.  The promotional rates offered are 2.00% on checking accounts and 2.25% on money market accounts and are guaranteed until January 31, 2005.  Based on prior experience, we anticipate the majority of these funds to be retained at the end of the promotion.  Our goal is to increase both the percentage of assets being funded by “in market” retail deposits and to

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$80.5 million during the three months ended September 30, 2004 compared to the same period in 2003.

As previously discussed, our net interest margin for the three months ended September 30, 2004 and 2003, was 3.15% and 3.16%, respectively.

The $628,412 increase in net interest income for the three months ended September 30, 2004 compared to the same period in 2003 resulted primarily from a $597,000 increase in net income related to the impact of higher average earning assets and interest-bearing liabilities in the three months ended September 30, 2004 compared to the same period in 2003.  The higher rates in the 2004 third quarter compared to the 2003 third quarter contributed to the remaining increase in net interest income.

Interest income for the three months ended September 30, 2004 was $3.6 million, consisting of $3.4 million on loans, $224,993 on investments, and $6,184 on federal funds sold.  Interest income for the three months ended September 30, 2003 was $2.5 million, consisting of $2.4 million on loans, $139,249 on investments, and $2,957 on federal funds sold.  Interest on loans for the three months ended September 30, 2004 and 2003 represented 93.6% and 94.3%, respectively, of total interest income, while income from investments and federal funds sold represented only 6.4% and 5.7% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 91.8% and 92.6% of average interest-earning assets for the three months ended September 30, 2004 and 2003, respectively.  Included in interest income on loans for the three months ended September 30, 2004 and 2003, was $115,641 and $86,231, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the three months ended September 30, 2004 was $1.4 million, consisting of $943,048 related to deposits and $501,075 related to borrowings.  Interest expense for the three months ended September 30, 2003 was $932,385, consisting of $685,441 related to deposits and $246,944 related to borrowings.  Interest expense on deposits for the three months ended September 30, 2004 and 2003 represented 65.3% and 73.5%, respectively, of total interest expense, while interest expense on borrowings represented 34.7% and 26.5%, respectively, of total interest expense for the three months ended September 30, 2004 and 2003.  The lower percentage of interest expense on deposits and the higher percentage of interest on borrowings for the three months ended September 30, 2004 compared to the three months ended September 30, 2003 resulted from our decisions to delay our retail deposit office expansion program and instead utilize additional borrowings from the FHLB and from the sale of securities under agreements to repurchase with brokers.   During the three months ended September 30, 2004, average interest-bearing deposits increased by $34.8 million over the same period in 2003, while other borrowing during the three months ended September 30, 2004 increased $44.4 million over the same period in 2003.  During the three months ended September 30, 2004, we were able to pledge additional collateral to the FHLB, allowing us the ability to increase our FHLB borrowings.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments.

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The $1.8 million increase in net interest income for the nine months ended September 30, 2004 compared to the same period in 2003 resulted substantially from higher average earning assets and interest-bearing liabilities.  The higher balances accounted from 99.3% of the increase.

Interest income for the nine months ended September 30, 2004 was $9.8 million, consisting of $9.1 million on loans, $670,171 on investments, and $15,477 on federal funds sold.  Interest income for the nine months ended September 30, 2003 was $7.0 million, consisting of $6.7 million on loans, $338,362 on investments, and $14,625 on federal funds sold.  Interest on loans for the nine months ended September 30, 2004 and 2003 represented 93.0% and 95.0%, respectively, of total interest income, while income from investments and federal funds sold represented only 7.0% and 5.0% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 91.2% and 92.8% of average interest-earning assets for the nine months ended September 30, 2004 and 2003, respectively.  Included in interest income on loans for the nine months ended September 30, 2004 and 2003, was $347,960 and $266,164, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the nine months ended September 30, 2004 was $3.7 million, consisting of $2.5 million related to deposits and $1.2 million related to borrowings.  Interest expense for the nine months ended September 30, 2003 was $2.7 million, consisting of $2.1 million related to deposits and $587,338 related to borrowings.  Interest expense on deposits for the nine months ended September 30, 2004 and 2003 represented 68.0% and 78.1%, respectively, of total interest expense, while interest expense on borrowings represented 32.0% and 21.9%, respectively, of total interest expense for the nine months ended September 30, 2004 and 2003.  The lower percentage of interest expense on deposits and the higher percentage of interest on borrowings for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003 resulted from our decisions to delay our retail deposit office expansion program and instead utilize additional borrowings from the FHLB and from the sale of securities under agreements to repurchase with brokers.   During the nine months ended September 30, 2004, average deposits increased by $36.7 million over the same period in 2003, while other borrowing during the nine months ended September 30, 2004 increased $40.0 million over the same period in 2003.  During the nine months ended September 30, 2004, we were able to pledge additional collateral to the FHLB, allowing us the ability to increase our FHLB borrowings.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments.

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Provision for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statement of income.  We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.  Please see the discussion below under “Balance Sheet Review - Provision and Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Three months ended June 20, 2004 and 2003

For the three months ended September 30, 2004 and 2003, there was a noncash expense related to the provision for loan losses of $375,000 and $250,000, respectively.  The additional provisions and recoveries on charged-off loans added to our allowance for loan losses in the three months ended September 30, 2004 and 2003.  The net increase in the allowance for loan losses in the three months ended September 30, 2004 was $397,463 and was $147,936 in the three months ended September 30, 2003.  The allowance for loan losses increased $22,463 more than the provision for loan losses in the three months ended September 30, 2004 as a result of a $22,463 recovery combined with no charge-offs in the three month period.  The allowance for loan losses at September 30, 2003 did not increase by the entire amount of the provision for loan losses because we reported net charge-offs of $102,064 for the three months ended September 30, 2003.  The $102,064 net charge-offs during the third quarter 2003 represented less than 0.05% of the average outstanding loan portfolio for the three months ended September 30, 2003.  The $397,463 and the $147,936 increases in the allowance for the three months ended September 30, 2004 and 2003, respectively, related to our decision to increase the allowance in response to the $20.2 million and the $12.5 million growth in loans for the three months ended September 30, 2004 and 2003, respectively.  The loan loss reserve was $3.6 million and $2.5 million as of September 30, 2004 and 2003, respectively.  The allowance for loan losses as a percentage of gross loans was 1.33% at September 30, 2004 and 1.31% at September 30, 2003, while the percentage of nonperforming loans to gross loans was 0.07% and 0.22% at September 30, 2004 and 2003, respectively

Nine months ended June 20, 2004 and 2003

For the nine months ended September 30, 2004 and 2003, there was a noncash expense related to the provision for loan losses of $1.0 million and $750,000, respectively.  The additional provisions added to our allowance for loan losses in the nine months ended September 30, 2004 and 2003 resulted in a net increase in the allowance for loan losses of $867,943 in the nine months ended September 30, 2004 and $637,161 in the nine months ended September 30, 2003.  The allowance for loan losses did not increase by the entire amount of the provisions for loan losses because we reported net charge-offs of $157,057 and $112,839 for the nine months ended September 30, 2004 and 2003, respectively.  The $157,057 net charge-offs during the first nine months of 2004 represented 0.07% of the average outstanding loans portfolio for the nine months ended September 30, 2004.  The $112,839 net charge-offs during the first nine months of 2003 represented 0.05% of the average outstanding loan portfolio for the nine months ended September 30, 2003.  The $867,943 and the $637,161 increases in the allowance for the nine months ended September 30, 2004 and 2003, respectively, related to our decision to increase the allowance in response to the $59.0 million and the $38.8 million growth in loans for the nine months ended September 30, 2004 and 2003, respectively.  The loan loss reserve was $3.6 million and $2.5 million as of September 30, 2004 and 2003, respectively.  The allowance for loan losses as a percentage of gross loans was 1.33% at September 30, 2004 and 1.31% at September 30, 2003, while the percentage of nonperforming loans to gross loans was 0.07% and 0.22% at September 30, 2004 and 2003, respectively.

We expect that our net income will continue to be negatively affected by larger than normal provisions for loan losses as we continue to focus on growing our loan portfolio.  During the three months and the nine months ended September 30, 2004, 100.0%, and 84.7%, respectively, of the provision for loan losses was related primarily to the growth in loans, with 0.0%, and 15.3%, respectively, related to net charge-offs.  If the quality of the loan portfolio declines or a higher percentage of the portfolio is charged-off, additional provisions may be required.

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Noninterest Income

The following tables set forth information related to our noninterest income.