Empire Federal Bancorp (EFBC) 10QSB 2002 Q3 Quarterly report (small business)

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.

FORM 10-QSB

ý QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2002

OR

o TRANSITION REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT

For the transition period from                            to                             

Commission File No. 0-28934

Empire Federal Bancorp, Inc.
(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)	81-0512374 (I.R.S. Employer Identification No.)
123 South Main Street, Livingston, Montana 59047 (Address of principal executive offices)
(406) 222-1981 (Registrant's telephone number, including area code)

        Check whether the issuer (1) filed all reports required to be filed by Sections 13 or 15(d) of the Exchange Act during the past 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 ý NO o

        State the number of shares outstanding of each of the issuer's classes of common equity as of the latest practicable date.

Class: Common Stock, par value $.01 per share
Outstanding at October 31, 2002: 1,507,643

        Transitional Small Business Disclosure Format (check one): YES o NO ý

EMPIRE FEDERAL BANCORP, INC.

INDEX TO FORM 10-QSB

		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets at September 30, 2002 and December 31, 2001 (unaudited)	1
	Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2002 and 2001 (unaudited)	2
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001 (unaudited)	3
	Notes to Unaudited Interim Consolidated Financial Statements	4
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Controls and Procedures	15
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	16
Item 2.	Changes in Securities	16
Item 3.	Defaults upon Senior Securities	16
Item 4.	Submission of Matters to a Vote of Security Holders	16
Item 5.	Other Information	16
Item 6.	Exhibits and Reports on Form 8-K	16
SIGNATURES		17
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER		18

Part I, Item 1—Financial Statements

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30, 2002 and December 31, 2001
(unaudited)

			September 30, 2002			December 31, 2001
Assets
Cash and due from banks			$	5,958,493		$	4,185,664
Interest-bearing deposits				47,597,580			42,350,439
	Cash and cash equivalents			53,556,073			46,536,103
Investments and mortgage-backed securities available-for-sale				83,004,002			35,945,324
Loans receivable, net				73,032,368			81,151,598
Loans held for sale				2,417,011			4,089,014
Stock in Federal Home Loan Bank of Seattle, at cost				1,746,600			1,670,600
Accrued interest receivable				1,084,339			629,245
Premises and equipment, net				4,869,348			4,596,212
Prepaid expenses and other assets				445,370			293,977
		Total assets	$	220,155,111		$	174,912,073
Liabilities and Stockholders' Equity
Liabilities:
	Demand deposits			4,664,438			3,498,227
	NOW accounts			19,746,752			12,211,546
	Money market			52,770,660			21,351,363
	Regular savings			13,013,140			11,124,193
	Certificates of deposit			86,470,828			78,754,686
		Total deposits		176,665,818			126,940,015
	Advances from Federal Home Loan Bank and other borrowed funds			13,000,000			17,000,000
	Note payable			—			464,306
	Advances from borrowers for taxes and insurance			266,954			245,522
	Accrued expenses and other liabilities			1,553,886			1,389,112
		Total liabilities		191,486,658			146,038,955
Stockholders' equity:
	Preferred stock, par value $.01 per share, 250,000 shares authorized, none issued and outstanding			—			—
	Common stock, par value $.01 per share, 4,000,000 shares authorized, 2,592,100 issued			25,921			25,921
	Additional paid-in capital			25,362,933			25,322,946
	Unearned ESOP and MRDP compensation			(1,367,915	)		(1,626,790	)
	MRDP shares acquired			(258,864	)		(258,864	)
	Retained earnings, substantially restricted			18,047,535			18,852,536
	Accumulated other comprehensive income, net			1,750,776			1,449,302
	Treasury shares acquired, at cost, 1,084,457 shares at September 30, 2002 and December 31, 2001			(14,891,933	)		(14,891,933	)
		Total stockholders' equity		28,668,453			28,873,118
		Total liabilities and stockholders' equity	$	220,155,111		$	174,912,073

See accompanying notes to unaudited interim consolidated financial statements.

1

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
Three and Nine Months Ended September 30, 2002 and 2001
(unaudited)

			Three Months Ended September 30					Nine Months Ended September 30
			2002			2001		2002			2001
Interest income:
	Loans receivable		$	1,408,921		$	1,853,292	$	4,393,485		$	5,561,833
	Mortgage-backed securities			374,332			390,039		1,128,456			1,381,385
	Investment securities			393,209			8,514		811,316			24,633
	Other			233,183			144,386		722,483			209,147
		Total interest income		2,409,645			2,396,231		7,055,740			7,176,998
Interest expense:
	Deposits			1,445,504			1,035,882		4,318,351			2,811,937
	FHLB advances and other borrowings			162,892			247,977		508,928			801,819
		Total interest expense		1,608,396			1,283,859		4,827,279			3,613,756
	Net interest income			801,249			1,112,372		2,228,461			3,563,242
Provision for loan losses				30,000			25,002		750,000			75,006
	Net interest income after provision for loan losses			771,249			1,087,370		1,478,461			3,488,236
Non-interest income:
	Insurance commission income			172,742			168,160		430,601			433,387
	Customer service charges			69,952			71,957		208,694			211,476
	Gain on sale of investments, net			61,406			—		507,628			—
	Gain on sale of loans			116,447			135,438		326,243			279,243
	Other			2,445			4,495		8,328			16,871
		Total non-interest income		422,992			380,050		1,481,494			940,977
Non-interest expense:
	Compensation and benefits			596,278			540,713		1,755,727			1,675,168
	Occupancy and equipment			179,476			152,829		514,641			475,113
	Deposit insurance premiums			24,750			13,326		62,290			51,321
	Merger and acquisition costs			221,581			—		263,179			—
	Other			260,938			231,490		869,178			737,201
Total non-interest expense				1,283,023			938,358		3,465,015			2,938,803
		Income (loss) before income taxes		(88,782	)		529,062		(505,060	)		1,490,410
Income tax expense (benefit)				(25,996	)		234,233		(170,912	)		637,047
		Net income (loss)	$	(62,786	)	$	294,829	$	(334,148	)	$	853,363
Basic earnings (loss) per share			$	(0.05	)	$	0.21	$	(0.25	)	$	0.62
Diluted earnings (loss) per share			$	(0.05	)	$	0.21	$	(0.25	)	$	0.62
Dividends declared per share			$	0.115		$	0.115	$	0. 345		$	0.345

See accompanying notes to unaudited interim consolidated financial statements.

2

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2002 and 2001
(unaudited)

				Nine Months Ended September 30,
				2002			2001
Cash flows from operating activities:
	Net (loss) income			$	(334,148	)	$	853,363
	Adjustments to reconcile net income to net cash provided by operating activities:
		Provision for loan losses			750,000			75,006
		Depreciation			288,930			246,524
		Loss on sale of premises and equipment			4,655			—
		ESOP shares committed to be released			151,241			142,743
		MRDP shares vested			147,621			147,097
		Gain on sale of investments and mortgage-backed securities available for sale			(507,628	)		—
		Gain on sale of loans			(326,243	)		(279,243	)
		Amortization of premium & discounts on mortgage-backed securities and investment securities			367,738			33,817
		Stock dividends reinvested in Federal Home Loan Bank			(76,000	)		(81,000	)
		Proceeds from sales of loans			26,594,922			21,004,970
		Origination of loans held for sale			(24,596,676	)		(23,430,122	)
		Increase in accrued interest receivable			(484,063	)		(90,371	)
		(Increase) decrease in prepaid expenses and other assets			(151,393	)		41,571
		(Decrease) increase in accrued expenses and other liabilities			(27,970	)		102,648
			Net cash provided (used) by operating activities		1,800,986			(1,232,997	)
Cash flows from investing activities:
	Net change in loans receivable				7,398,199			(5,428,932	)
	Proceeds from matured or called investment securities available for sale				2,000,000			—
	Proceeds from sale of investments and mortgage-backed securities available-for-sale				1,504,709			—
	Principal payments on mortgage-backed securities available-for-sale				8,560,512			6,644,317
	Purchases of mortgage-backed securities available-for-sale				(9,304,524	)		—
	Purchases of investment securities available-for-sale				(49,185,267	)		—
	Purchases of premises and equipment				(571,293	)		(809,985	)
	Proceeds from sale of premises and equipment				4,572			—
			Net cash (used) provided by investing activities		(39,593,092	)		405,400
Cash flows from financing activities:
	Net change in deposits				49,725,803			22,254,783
	Repayment of note payable				(464,306	)		(49,364	)
	Net change in advances from borrowers for taxes and insurance				21,432			86,900
	Dividends paid				(470,853	)		(483,871	)
	Proceeds from advances from FHLB				—			800,000
	Repayment of advances from FHLB				(4,000,000	)		(819,550	)
			Net cash provided by financing activities		44,812,076			21,788,898
Net increase in cash and cash equivalents					7,019,970			20,961,301
Cash and cash equivalents, beginning of period					46,536,103			2,647,700
Cash and cash equivalents, end of period				$	53,556,073		$	23,609,001
Cash paid during the period for:
	Interest			$	4,881,691		$	3,589,575
	Income taxes				56,500			576,067

See accompanying notes to unaudited interim consolidated financial statements

3

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES

Notes to Unaudited Interim Consolidated Financial Statements
September 30, 2002

Note 1Basis of Presentation

        The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for audited financial statements. They should be read in conjunction with the audited consolidated financial statements filed as part of the Annual Report on Form 10-KSB for the year ended December 31, 2001.

        The accompanying consolidated financial statements include the accounts of Empire Federal Bancorp, Inc. (the Holding Company) and its wholly owned subsidiary, Empire Bank (Empire or the Bank) and Dime Service Corporation (Dime), a wholly-owned subsidiary of Empire. The Holding Company, Empire and Dime are herein referred to collectively as "the Company." All significant intercompany balances and transactions have been eliminated in consolidation.

        In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for fair presentations have been included. The results of operations for the three and nine months ended September 30, 2002, and 2001 are not necessarily indicative of the results, which may be expected for an entire year or any other period.

        In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes both SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. SFAS No. 144 retains the fundamental provisions in SFAS No. 121 for recognizing and measuring impairment losses on long-lived assets held for use and long-lived assets to be disposed of by sale, while also resolving significant implementation issues associated with SFAS No. 121. SFAS No. 144 retains the basic provisions of APB Opinion 30 on how to present discontinued operations in the income statement but broadens that presentation to include a component of an entity rather than a segment of a business.

        The Company adopted the provisions of SFAS No. 144 as of January 1, 2002. The adoption of SFAS No. 144 for long-lived assets held for use did not have a material impact on the Company's financial statements because the impairment assessment under SFAS No. 144 is largely unchanged from SFAS No. 121. The provisions of the statement for assets held for sale or other disposal generally are required to be applied prospectively to newly initiated disposal activities.

Note 2Comprehensive Income

        The Company's only component of comprehensive income is the net unrealized gains or losses on securities available-for-sale. The following summarizes total comprehensive income (loss) for the noted periods:

Three Months Ended September 30,				Nine Months Ended September 30,
2002		2001		2002			2001
$	256,189	$	325,198	$	(32,674	)	$	1,142,257

4

Note 3Earnings Per Share

        Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Additionally, ESOP shares, which are unallocated and not yet committed to be released (unallocated), and unvested MRDP shares issued are excluded from the weighted-average common shares outstanding calculation. At September 30, 2002, included in the weighted average calculations were 59,144 allocated shares, 9,216 committed to be released ESOP shares and 76,368 vested MRDP shares.

        Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or resulted in the issuance of common stock that would share in the earnings of the entity. Dilutive potential common shares are added to the weighted-average shares used to compute basic EPS. The following information provides a reconciliation of the numerators and denominators of the basic and fully diluted EPS computation:

		For the nine months ended September 30
		2002							2001
		Net Loss			Shares	Per-Share Amount			Net Income		Shares	Per-Share Amount
Basic EPS
Net (loss) income available to common stockholders		$	(334,148	)	1,348,773	$	(0.25	)	$	853,363	1,374,112	$	0.62
Effect of Dilutive Securities
	Stock Options				5,605						4,258
	Unvested MRDP shares				954						1,028
Diluted EPS
	(Loss) income available to common stockholders plus assumed conversion	$	(334,148	)	1,355,332	$	(0.25	)	$	853,363	1,379,398	$	0.62

		For the three months ended September 30
		2002							2001
		Net Loss			Shares	Per-Share Amount			Net Income		Shares	Per-Share Amount
Basic EPS
Net (loss) income available to common stockholders		$	(62,786	)	1,343,437	$	(0.05	)	$	294,829	1,376,809	$	0.21
Effect of Dilutive Securities
	Stock Options				5,405						5,497
	Unvested MRDP shares				820						1,245
Diluted EPS
	(Loss) income available to common stockholders plus assumed conversion	$	(62,786	)	1,349,662	$	(0.05	)	$	294,829	1,383,551	$	0.21

Note 4Cash Dividend Declared

        On July 23, 2002, the Board of Directors declared a quarterly cash dividend of $0.115 per common share to stockholders of record on August 16, 2002 payable on August 30, 2002.

5

Note 5Capital Compliance

        The following table presents Empire's compliance with its regulatory capital requirements as of September 30, 2002 (dollars in thousands):

		Amount		Percentage of Assets
GAAP capital(1)		$	28,333	12.88	%
Tangible capital		$	26,101	12.04	%
Tangible capital requirement			3,251	1.50	%
	Excess	$	22,850	10.54	%
Core capital		$	26,101	12.04	%
Core capital requirement			8,670	4.00	%
	Excess	$	17,431	8.04	%
Total risk-based capital(2)		$	27,168	29.03	%
Total risk-based capital requirement(2)			7,487	8.00	%
	Excess	$	19,681	21.03	%

(1)

Empire's GAAP capital includes unrealized gains on certain available-for-sale securities of $1,751,000 and $481,000 of investments in Dime, which are excluded for purposes of calculating both tangible and core capital.

(2)

Based on risk-weighted assets of $93,585,000.

Note 6Operating Segment Information

        The Company evaluates segment performance internally based on its two primary lines of business, commercial banking and insurance, and thus the operating segments are so defined. The operating segment defined as "other" includes the Holding Company and elimination of transactions between segments.

        The accounting policies of the individual operating segments are the same as those of the Company. Transactions between operating segments are primarily conducted at fair value, resulting in profits that are eliminated for reporting consolidated results of operations.

6

        The following is a summary of selected operating segment information as of and for the nine months ended September 30, 2002 and 2001.

2002:		Empire		Dime		Other			Consolidated
Net interest income		$	2,222,652	$	5,809	$	—		$	2,228,461
Non-interest income(loss)			1,051,045		431,189		(740	)		1,481,494
	Total income(loss)		3,273,697		436,998		(740	)		3,709,955
Provision for loan losses			750,000		—		—			750,000
Other non-interest expense			2,483,658		435,380		545,977			3,465,015
	Income (loss) before income taxes		40,039		1,618		(546,717	)		(505,060	)
Income tax expense (benefit)			15,396		873		(187,181	)		(170,912	)
	Net income (loss)	$	24,643	$	745	$	(359,536	)	$	(334,148	)
Assets		$	220,105,692		523,388		(473,969	)		220,155,111
Net loans			75,449,379		—		—			75,449,379
Deposits			176,994,992		—		(329,174	)		176,665,818
Stockholders' equity			28,332,721		480,527		(144,795	)		28,668,453

2001:		Empire		Dime		Other			Consolidated
Net interest income		$	3,552,058	$	9,310	$	1,874		$	3,563,242
Non-interest income(loss)			621,834		439,348		(120,205	)		940,977
	Total income(loss)		4,173,892		448,658		(118,331	)		4,504,219
Provision for loan losses			75,006		—		—			75,006
Other non-interest expense			2,344,341		417,490		176,972			2,938,803
	Income (loss) before income taxes		1,754,545		31,168		(295,303	)		1,490,410
Income tax expense (benefit)			716,042		3,151		(82,146	)		637,047
	Net income (loss)	$	1,038,503		28,017		(213,157	)		853,363
Assets		$	148,674,974		544,547		(643,910	)		148,575,611
Net loans			89,918,302		—		—			89,918,302
Deposits			100,218,733		—		(297,306	)		99,921,427
Stockholders' equity			28,934,715		470,341		(361,158	)		29,043,898

7

        The following is a summary of selected operating segment information for the three months ended September 30, 2002 and 2001.

2002:		Empire		Dime		Other		Consolidated
Net interest income		$	799,291	$	1,958	—		801,249
Non-interest income (loss)			276,322		173,281	(26,611	)	422,992
	Total income (loss)		1,075,613		175,239	(26,611	)	1,224,241
Provision for loan losses			30,000		—	—		30,000
Other non-interest expense			838,275		147,755	296,993		1,283,023
	Income (loss) before income taxes		207,338		27,484	(323,604	)	(88,782	)
Income tax expense (benefit)			79,731		873	(106,600	)	(25,996	)
	Net income (loss)	$	127,607		26,611	(217,004	)	(62,786	)

2001:		Empire		Dime	Other		Consolidated
Net interest income		$	1,109,579	2,793	—		1,112,372
Non-interest income (loss)			246,132	168,160	(34,242	)	380,050
	Total income (loss)		1,355,711	170,953	(34,242	)	1,492,422
Provision for loan losses			25,002	—	—		25,002
Other non-interest expense			723,423	133,528	81,407		938,358
Income (loss) before income taxes			607,286	37,425	(115,649	)	529,062
Income tax expense (benefit)			254,801	3,151	(23,719	)	234,233
	Net income (loss)	$	352,485	34,274	(91,930	)	294,829

Note 7Definitive Agreement with Sterling Financial Corporation

        On September 19, 2002, Empire Federal Bancorp entered into an Agreement and Plan of Merger with Sterling Financial Corporation, a Washington corporation. Empire will be merged with and into Sterling, with Sterling being the surviving corporation in the merger.

        Under the terms of the merger, each share of Empire's outstanding common stock will be converted into the right to receive $19.25 per share in the form of Sterling common stock, provided the average closing price thereof within the ten-day period preceding the fifth trading day prior to the closing date is between $17.01 and $22.68. The merger exchange ratio provides that, regardless of the closing price of Sterling common stock, Sterling will issue no less than 0.849 and no more than 1.132 of a share of Sterling common stock for each share of Empire's common stock outstanding. The merger will be structured as a tax-free reorganization and is expected to be completed in the first quarter of 2003.

8

Part I, Item 2.—Management's Discussion and Analysis of Financial Condition and Results of Operations

General

        Management's discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of the Company.

Special Note Regarding Forward-Looking Statements

        Certain matters in the quarterly report constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements relate to, among others, expectations of the business environment in which the Company operates, projections of future performance, perceived opportunities in the market, potential future credit experience, and statements regarding the Company's business strategy. Specifically, the Company has changed its role as a traditional mortgage lender to that of a commercial bank by increasing its commercial and business lending during fiscal 2001. This reflects the Company's new growth-oriented expansion strategy, which is to pursue internal and external growth opportunities when management deems it appropriate. This new strategy may subject the Company to a greater degree of risk. Risks associated with this new business strategy include increased risk of losses on loans, provision for loan losses which exceed historical levels, difficulties in integrating or managing new branches or acquired institutions and problems related to the management of growth. There can be no assurance that the Company will be successful in implementing this new business strategy or in managing growth.

        These forward-looking statements are based upon current management expectations, and may, therefore, involve risks and uncertainties. The Company's actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements due to a wide range of factors including, but not limited to, the general business environment, the direction of future interest rates, the local real estate market, competitive conditions between banks and non-bank financial services providers, regulatory changes, labor market competitiveness, and other risks detailed in the Company's reports filed with the Securities and Exchange Commission.

Critical Accounting Policies

        Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. The Company considers its only critical accounting policy to be the allowance for loan losses. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio. The appropriate balance of allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans. Estimated loss factors are based on subjective measurements including management's assessment of the internal risk classifications, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company's consolidated financial statements, results of operation or liquidity.

Operating Strategy

        The Bank is a community oriented financial institution which has traditionally offered a variety of savings products to its retail customers while concentrating its lending activities on the origination of loans secured by one-to-four family residential dwellings. In the past, the Bank considered Gallatin, Park and Sweet Grass counties in south central Montana as its primary market area. During 1999, the Bank received regulatory approval to open a de novo branch in Billings, Montana, and management

9

opened the new branch in April 2001. In addition, the Bank opened a loan production office in Missoula, Montana during the third quarter of 2000, which was converted to a full service branch that opened during March 2002. Lending activities also have included the origination of multi-family, commercial, business, commercial real estate and home equity loans. The Bank's primary business has been that of a traditional financial institution, originating loans in its primary market area for its portfolio. In addition, the Bank has maintained a significant portion of its assets in investment and mortgage-backed securities. Similar to its lending activities, the Bank's investment portfolio has been weighted toward U.S. Government, U.S. Government agency and U.S. Government agency mortgage-backed securities secured by one-to-four family residential properties. The Bank plans to continue to fund its assets primarily with deposits, although FHLB advances are used as a supplemental source of funds.

        The Bank relies to a significant extent on borrowings from the FHLB of Seattle to finance its short-term and, to a certain extent, its longer term financing needs. The FHLB of Seattle functions as the central reserve bank providing credit for savings institutions and certain other member financial institutions.

        The Bank's profitability depends primarily on its net interest income, which is the difference between the income it receives on its loan and investment portfolio and its cost of funds, which consists of interest paid on deposits and FHLB advances. Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The level of other income and expenses also affects the Bank's profitability. Other income consists of service charges on checking and NOW accounts and other fees, insurance commissions and net gains or losses on the sale of investments and loans. Other expenses include compensation and employee benefits, occupancy expenses, deposit insurance premiums, equipment and data servicing expenses, professional fees and other operating costs. The Bank's results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government legislation and policies concerning monetary and fiscal affairs, housing and financial institutions and the attendant actions of the regulatory authorities.

        The Bank's strategy is to operate as a conservative, well-capitalized, profitable institution dedicated to offering a full line of community banking services and to providing quality service to all customers. The Bank believes that it has successfully implemented its strategy by (i) maintaining strong capital levels, (ii) maintaining effective control over operating expenses to attempt to achieve profitability under differing interest rate scenarios, (iii) emphasizing local loan originations, and (iv) emphasizing high-quality customer service with a competitive fee structure.

        As evidenced by the new branches in Billings and Missoula coupled with an increase in commercial and business loans, the Bank's strategy is changing from its historical role as a mortgage lender to a growth-oriented expansion strategy by pursuing internal and external growth opportunities, when appropriate. Further, during 2001 and the first two quarters of 2002, the Bank had undertaken an aggressive solicitation of deposits by paying higher than the usual interest rates in its markets. During the third quarter of 2002, interest rates were lowered by the Bank to be more competitive with interest rates in the Bank's market areas. Retention of these new depositors will require an increased emphasis on personal service, more products and expanded locations. The reinvestment of these deposits into loans and investments that will provide acceptable interest margins will be a critical element of this strategy. This strategy has subjected the Company to a greater degree of risk. This strategy presents increased risk of losses on loans, provision on loan losses which exceed historical levels, difficulties in integrating or managing new branches or acquired institutions and problems related to the investment of deposit growth.

10

        On September 19, 2002, the Company entered into an Agreement and Plan of Merger with Sterling Financial Corporation, a Washington corporation. Empire will be merged with and into Sterling, with Sterling being the surviving corporation in the merger.

        Under the terms of the merger, each share of the Company's outstanding common stock will be converted into the right to receive $19.25 per share in the form of Sterling common stock, provided the average closing price thereof within the ten-day period preceding the fifth trading day prior to the closing date is between $17.01 and $22.68. The merger exchange ratio provides that, regardless of the closing price of Sterling common stock, Sterling will issue no less than 0.849 and no more than 1.132 of a share of Sterling common stock for each share of Company's common stock outstanding. The merger will be structured as a tax-free reorganization and is expected to be completed in the first quarter of 2003. See note 7 of "Notes to Unaudited Interim Consolidated Financial Statements."

Financial Condition

        Consolidated assets increased by approximately $45.3 million, or 25.9%, from $174.9 million at December 31, 2001 to $220.2 million at September 30, 2002.

        Short term interest bearing deposits, primarily with the FHLB, increased from $42.4 million at December 31, 2001 to $47.6 million at September 30, 2002, an increase of $5.2 million, or 12.4%.

        Investment and mortgage-backed securities available-for-sale increased $47.1 million, or 130.9%, from $35.9 million at December 31, 2001 to $83.0 million at September 30, 2002 as the result of purchases totaling $58.5 million offset by maturities, sales and payments of $11.9 million and an increase in market value of $494,000.

        Net loans decreased $9.8 million, or 11.5%, from $85.2 million at December 31, 2001 to $75.4 million at September 30, 2002.

        Deposits increased $49.7 million or 39.2% from $126.9 million at December 31, 2001 to $176.7 million at September 30, 2002. This increase is the result of a program to attract depositors in all of the Bank's market. The majority of this increase in deposits was in one to two-year certificates and money market accounts. The increase in deposits has been invested primarily in short-term interest bearing deposits and investments.

        Premises and equipment increased by $273,000 from $4.6 million at December 31, 2001 to $4.9 million at September 30, 2002 primarily as the result of costs of $515,000 related to the construction of a new branch in Missoula. Depreciation of $289,000 partially offset this increase.

        Stockholders' equity decreased from $28.9 million at December 31, 2001, to $28.7 million at September 30, 2002. The change is the result of net loss of $334,000, the release of ESOP shares in the amount of $151,000 and an increase of $301,000 (net of taxes) related to the market value of securities available-for-sale. In addition, 9,334 shares of MRDP vested and unearned MRDP compensation was reduced by $148,000. Stockholders' equity was also decreased by the payment of $471,000 in dividends. There were 1,084,457 shares held in treasury at September 30, 2002 with an average price of $13.73. Book value per share at September 30, 2002 was $19.02. Stockholders' equity as a percentage of total assets amounted to 13.0% at September 30, 2002.

Asset Quality

        At September 30, 2002, the Bank had eight non-accrual loans amounting to $2.5 million compared to two loans amounting to $747,000 on December 31, 2001. At September 30, 2002, the Bank had nineteen loans delinquent over 30 days amounting to $2.5 million of which six loans amounting to $1.7 million were delinquent over 90 days. On December 31, 2001 the Bank had twenty-five loans delinquent over 30 days amounting to $4.5 million. The Bank had no real estate acquired through foreclosure at September 30, 2002.

11

Results of Operations

        The operating results of the Bank depend primarily on its net interest income. The Bank's net interest income is determined by its interest rate spread, which is the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities and the degree of mismatch in the maturity and re-pricing characteristics of its interest-earning assets and interest-bearing liabilities. The Bank's net earnings are also affected by the establishment of provisions for loan losses and the level of its other non-interest income, including insurance commission income and deposit service charges, as well as its other expenses and income tax provisions.

Comparison of Results of Operations for the Nine Months Ended September 30, 2002 and 2001

        Net Income.    Net income decreased by $1,187,000 from $853,000 for the nine months ended September 30, 2001 to a loss of $334,000 for the nine months ended September 30, 2002. The major cause of this decrease in net income is the result of the provision for loan losses of $750,000 primarily related to the deterioration of one multi-family construction loan. This loan was placed on non-accrual and all accrued interest was charged off as of March 31, 2002. Also $861,000 of the loan principal was charged off against the reserve in the third quarter of 2002. The Bank is in the process of foreclosure on this loan. The Company has incurred $263,000 in merger and acquisition related expense during 2002. $108,000 of this expense is related to failed mergers and acquisitions. The remaining $155,000 is related to the anticipated merger with Sterling. Further the Bank experienced a significant growth in interest bearing deposits over the past several quarters including a $49.7 million increase during the nine months ended September 30, 2002. Most of the deposit growth has been invested in short-term interest bearing deposits or investment securities. The effect of this deposit activity on the Bank's net interest income, interest rate spread and other factors are discussed in the following narrative.

        Net Interest Income.    Net interest income decreased $1.3 million, or 37.5%, from $3.6 million for the nine months ended September 30, 2001 to $2.2 million for the same period in 2002. The interest rate spread decreased from 2.72% for the nine months ended September 30, 2001 to 1.05% for the comparable period in 2002.

        Interest Income.    Total interest income decreased by $100,000, or 1.7% from $7.2 million for the nine months ended September 30, 2001 to $7.1 million for the same period in 2002. The change was primarily attributable to a decrease in the yield on interest earning assets from 7.6% for the nine months ended September 30, 2001 to 4.8% for the comparable period in 2002. Average interest earning assets increased $69.1 million, or 54.9% from $125.9 million for the nine months ended September 30, 2001 to $194.9 million for the same period in 2002. The major component of this increase was from average other interest earning assets, primarily short-term interest bearing deposits of $44.7 million.

        Interest Expense.    Total interest expense was $4.8 million for the nine months ended September 30, 2002, as compared to $3.6 million for the same period in 2001. Interest on deposits increased by $1.5 million, or 53.6%, from $2.8 million for the nine months ended September 30, 2001 to $4.3 million for the comparable period in 2002. Interest on notes payable and other debt decreased $293,000, or 36.5% from the nine months ended September 30, 2001 as compared to the same period in 2002.

        Average deposits for the nine months ended September 30, 2002 amounted to $156.7 million as compared to $79.4 million for the same period in 2001, an increase of $77.4 million or 97.5%. Included in the average deposits for the nine months ended September 30, 2002 was $88.5 million in certificates of deposit as compared to $46.2 million for the comparable period in 2001, an increase of $42.2 million or 91.3%. Offsetting the increase in average deposits, the cost of deposits decreased from 4.7% for the nine months ended September 30, 2001 to 3.7% for the same period in 2002. This increase in deposits is the result of a strategic emphasis by management to attract new depositors and borrowers. During the third quarter of 2002, deposit rates were lowered by the Bank to be more competitive with prevailing interest rates in the Bank's market areas. Due to the increased volume of deposits during the

12

last four quarters, the Bank will continue to experience increased cost of deposits through the end of 2002.

        Provision for Loan Losses.    The provision for loan losses was $750,000 for nine months ended September 30, 2002 as compared to $75,000 for the same period in 2001. The significant increase is the result of deterioration in a multi-family construction loan. At the end of both periods, the level of reserves was deemed to be adequate by management. Loan loss reserves were $434,000 and $411,000 at September 30, 2002 and 2001, respectively. Loan loss reserves as a percentage of loans were .59% at September 30, 2002, and .48% at September 30, 2001. Management's periodic evaluation of the adequacy of the allowance is based on factors such as the Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, current and prospective economic conditions, peer group comparisons, and independent appraisals. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to provide additions to the allowance based upon judgments different from management. Assessment of the adequacy of the allowance for credit losses involves subjective judgments regarding future events, and thus, there can be no assurance that additional provisions for credit losses will not be required in future periods. Although management uses the best information available, future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions that may be beyond the Bank's control. Any increase or decrease in the provision for loan losses has a corresponding negative or positive effect on net income.

        Non-Interest Income.    Non-interest income for the nine months ended September 30, 2002 amounted to $1.5 million as compared to $941,000 for the comparable period in 2001. The largest component of non-interest income was a gain of $508,000 on the sale of investments as compared to no sales of investments for the comparable period in 2001. Other significant components include the gain on sale of loans of $326,000 for the nine months ended September 30, 2002 as compared to $279,000 for the comparable period in 2001. This gain is the result of the Bank's activity in underwriting mortgage loans for sale in the secondary market on a servicing released basis. Insurance commissions received by Dime were $431,000 and $433,000 for the nine months ended September 30, 2002 and 2001, respectively.

        Non-Interest Expense.    Total non-interest expense amounted to $3.5 million for the nine months ended September 30, 2002 as compared to $2.9 million for the same period in 2001, an increase of $526,000. The opening of the full service branch in Missoula in early 2002 contributed to this increase. Also included in this increase is $263,000 related to acquisition and merger expense. There was no acquisition or merger expense for the comparable period in 2001.

        Income Taxes.    Income taxes decreased $808,000 to a $171,000 (benefit) for the nine months ended September 30, 2002, compared to $637,000 for the same period in 2001 as a result of the loss before income taxes in 2002. The effective combined federal and state tax rate was 42.7% and 33.8% (benefit) for the nine months ended September 30, 2001 and 2002, respectively. The primary difference between the expected and actual tax calculation relates to state taxes and mark-to-market adjustments on ESOP shares committed to be released and MRDP shares awarded during the period.

Comparison of Results of Operations for the Three Months Ended September 30, 2002 and 2001

        Net Income.    Net income decreased by $358,000 from $295,000 for the three months ended September 30, 2001 to a $63,000 loss for the three months ended September 30, 2002. The following narrative discusses the various components of the change:

        Net Interest Income.    Net interest income decreased $311,000, or 28.0%, from $1.1 million for the three months ended September 30, 2001 to $.8 million for the same period in 2002. The interest rate

13

spread decreased from 2.3% for the three months ended September 30, 2001 to 1.1% for the comparable period in 2002.

        Interest Income.    Total interest income increased by $13,000, or .6% from $2.4 million for the three months ended September 30, 2001 to $2.4 million for the same period in 2002. Average interest earning assets increased $72.7 million or 54.2% from $134.1 million for the three months ended September 30, 2001 to $206.8 million for the same period in 2002. Offsetting this increase the yield on interest earning assets decreased from 7.1% for the three months ended September 30, 2001 to 4.7% for the same period in 2002.

        Interest Expense.    Total interest expense was $1.6 million for the three months ended September 30, 2002, as compared to $1.3 million for the same period in 2001. Interest on deposits increased by $410,000, or 39.5%, from $1.0 million for the three months ended September 30, 2001 to $1.4 million for the comparable period in 2002. Interest on notes payable and other debt decreased $85,000, or 34.3% from the three months ended September 30, 2001 as compared to the same period in 2002.

        Average deposits for the three months ended September 30, 2001 amounted to $88.0 million as compared to $168.7 million for the same period in 2002, an increase of $80.8 million or 91.9%. Included in the average deposits for the three months ended September 30, 2002 was $88.7 million in certificates of deposit as compared to $53.8 million for the comparable period in 2001, an increase of $35.0 million or 65.0%. Offsetting the increase in average deposits, the cost of deposits decreased from 4.7% for the three months ended September 30, 2001 to 3.4% for the same period in 2002.

        Provision for Loan Losses.    The provision for loan losses was $30,000 for three months ended September 30, 2002 as compared to $25,000 for the same period in 2001. At the end of both periods, the level of reserves was deemed to be adequate by management. Loan loss reserves as a percentage of loans were .59% at September 30, 2002 and .48% at September 30, 2001. Loan loss reserves were $434,000 and $411,000 at September 30, 2002 and 2001, respectively.

        Non-Interest Income.    Non-interest income increased $43,000 for the three months ended September 30, 2002, as compared to the same period in 2001. During the three months ended September 30, 2002, the Bank recorded $61,000 in gains on sale of securities as compared to no sales of securities for the comparable period in 2001. Gain on sale of loans decreased slightly from $135,000 for the three months ended September 30, 2001 to $116,000 for the same period in 2002.

        Insurance commissions received by Dime are a large component of non-interest income. Insurance commissions of $173,000 and $168,000 were received for the three months ended September 30, 2002 and 2001, respectively.

        Non-Interest Expense.    Total non-interest expense increased $345,000 for the three months ended September 30, 2002 as compared to the same period in 2001. The opening of the full service branch in Missoula contributed to this increase. Included in this increase is $222,000 related to merger and acquisition expense. $66,000 of this expense is related to failed mergers and acquisitions. The remaining $155,000 is related to the anticipated merger with Sterling. There was no acquisition or merger expense for the comparable period in 2001. Also included in this expense is $596,000 in compensation and benefits for the three months ended September 30, 2002 as compared to $541,000 for the same period in 2001, an increase of $55,000.

        Income Taxes.    Income taxes decreased $260,000 to a $26,000 (benefit) for the three months ended September 30, 2002, compared to $234,000 for the same period in 2001, as a result of the loss in income before income taxes. The effective combined federal and state tax rate was 29.3% (benefit) and 44.3% for the three months ended September 30, 2002 and 2001, respectively. The primary difference

14

between the expected and actual tax calculation relates to state taxes and mark-to-market adjustments on ESOP shares committed to be released and MRDP shares awarded during the period.

Part 1—Item 3. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

        The Company's Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 240.13a-14(c) and 15d-14(c) as of a date within 90 days before the filing date of this quarterly report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company's current disclosure controls and procedures are effective and timely, providing them with material information relating to the Company required to be disclosed in the reports we file or submit under the Exchange act.

Changes in Internal Controls

        There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. We are not aware of any significant deficiencies or material weaknesses, therefore no corrective actions were taken.

15

Part II—Other Information

Item 1. Legal Proceedings

        There are no pending material legal proceedings to which the registrant or its subsidiaries are a party.

Item 2. Changes in Securities

        None.

Item 3. Defaults on Senior Securities

        Not applicable.

Item 4. Submission of Matters to a Vote of Securities Holders

        None.

Item 5. Other Information

        None.

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits

2.1	Agreement and Plan of Merger by and between Sterling Financial Corporation and Empire Federal Bancorp, Inc. dated as of September 19, 2002
3.1	Certificate of Incorporation of Empire Federal Bancorp, Inc(1)
3.2	Bylaws of Empire Federal Bancorp, Inc(1)
10.1	Employment Agreement with Kenneth P. Cochran(4)
10..2	Employment Agreement with William H. Ruegamer(3)
10..3	Employee Stock Ownership Plan(1)
10..5	Stock Option Plan(2)
10.6	Financial Institution's Thrift Plan 401(k)(3)
21	Subsidiaries of the Registrant(3)
99	Certification of Chief Executive Officer and Chief Financial Officer

(1)

Incorporated by reference to the Company's Registration Statement on Form SB-1, as amended (File No. 333-12653).

(2)

Incorporated by reference to the Company's Annual Meeting Proxy Statement dated March 16, 1998.

(3)

Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999.

(4)

Incorporated by reference to the Company's Quarterly Report on Form 10-QSB for the three months ended March 31, 2000.

(b)

Report on Form 8-K            One Form 8-K was filed on September 19, 2002.

16

SIGNATURES

        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.

Empire Federal Bancorp, Inc.

By	s/sWILLIAM H. RUEGAMERWilliam H. Ruegamer President & Chief Executive Officer (Principal Executive Officer)	November 14, 2002Date
By	s/sLINDA M. ALKIRELinda M. Alkire Treasurer & Chief Financial Officer	November 14, 2002Date

17

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES

I, William H. Ruegamer, certify that:

1.

I have reviewed this quarterly report on Form 10QSB of Empire Federal Bancorp, Inc.

2.

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.

The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b)

evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

c)

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date:

5.

The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the Equivalent function):

a)

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and

b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and

6.

The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

   
November 14, 2002

/s/  WILLIAM H. RUEGAMER      William H. Ruegamer
President and CEO

18

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES

I, Linda M. Alkire, certify that:

1.

I have reviewed this quarterly report on Form 10QSB of Empire Federal Bancorp, Inc.

2.

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.

The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b)

evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

c)

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date:

5.

The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the Equivalent function):

a)

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and

b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and

6.

The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

   
November 14, 2002

/s/  LINDA M. ALKIRE      Linda M. Alkire
CFO and Treasurer

19

QuickLinks

EMPIRE FEDERAL BANCORP, INC. INDEX TO FORM 10-QSB

Part I, Item 1—Financial Statements

EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES Consolidated Balance Sheets September 30, 2002 and December 31, 2001 (unaudited)
EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES Consolidated Statements of Operations Three and Nine Months Ended September 30, 2002 and 2001 (unaudited)
EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Nine Months Ended September 30, 2002 and 2001 (unaudited)
EMPIRE FEDERAL BANCORP, INC. AND SUBSIDIARIES Notes to Unaudited Interim Consolidated Financial Statements September 30, 2002

Part I, Item 2.—Management's Discussion and Analysis of Financial Condition and Results of Operations
Part 1—Item 3. Controls and Procedures

Part II—Other Information
Item 1. Legal Proceedings
Item 2. Changes in Securities
Item 3. Defaults on Senior Securities
Item 4. Submission of Matters to a Vote of Securities Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K

SIGNATURES