Civitas Bankgroup (CVBG) 10-Q 2004 Q1 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

Commission File Number 0-27393

CIVITAS BANKGROUP, INC.

(Exact Name of Registrant As Specified in Its Charter)

Tennessee	62-1297760
(State or Other Jurisdiction of	(IRS Employer Identification No.)
Incorporation or Organization)

4 Corporate Centre
810 Crescent Centre Dr, Suite 320	Franklin, Tennessee 37067

(Address of Principal Executive Offices and Zip Code)

(615) 383-6619

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YESx       NOo

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

YESo       NOx

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

Common stock outstanding: 17,469,848 shares at April 30, 2004.

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CIVITAS BANKGROUP, INC.
TABLE OF CONTENTS

PART I: FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets – March 31, 2004 (unaudited)	3
and December 31, 2003
Consolidated Statements of Earnings — For the three months	4
ended March 31, 2004 and 2003 (unaudited)
Consolidated Statements of Changes in Shareholders’ Equity — For the	5
three months ended March 31, 2004 and 2003 (unaudited)
Consolidated Statements of Cash Flows — For the three months	6
ended March 31, 2004 and 2003 (unaudited)
Notes to Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition	8-15
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk	15
Item 4. Controls and Procedures	15
PART II: OTHER INFORMATION
Item 1. Legal Proceedings	16
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity 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
EX-31.1 SECTION 302 CERTIFICATION OF THE CEO
EX-31.2 SECTION 302 CERTIFICATION OF THE CFO
EX-32.1 CEO & CFO SECTION 906 CERTIFICATIONS

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PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

CIVITAS BANKGROUP, INC.

CONSOLIDATED BALANCE SHEET
MARCH 31, 2004 AND DECEMBER 31, 2003
(UNAUDITED)

	March 31,			December 31,
	2004			2003
Assets:
Cash and due from banks	$	22,300		$	19,977
Federal funds sold		11,189			15,081
Cash and cash equivalents		33,489			35,058
Interest-bearing deposits in financial institutions		4,533			4,046
Securities available for sale, at fair value		134,114			140,844
Securities held to maturity, fair value $62,473 at March 31, 2004 and $62,984 at December 31, 2003		60,170			62,527
Loans		551,750			550,565
Allowance for loan losses		(8,463	)		(8,414	)
Loans, net		543,287			542,151
Premises and equipment		22,510			22,280
Restricted equity securities		5,522			5,478
Other real estate		4,030			3,793
Investment in unconsolidated affiliates		7,161			6,977
Goodwill		1,596			1,596
Accrued interest receivable		3,928			3,896
Other assets		4,502			4,674
Total assets	$	824,842		$	833,320
Liabilities and Shareholders’ Equity:
Liabilities
Deposits
Noninterest-bearing	$	80,606		$	68,032
Interest-bearing		592,023			603,604
Total deposits		672,629			671,636
Notes payable		4,650			4,700
Federal funds purchased and securities sold under repurchase agreements		22,088			33,886
Advances from Federal Home Loan Bank		51,852			51,852
Accrued interest payable		2,213			2,350
Other liabilities		2,909			2,155
Subordinated debentures		12,000			12,000
Total liabilities		768,341			778,579
Shareholders’ equity:
Common stock, $0.50 par value, authorized 20,000,000 shares; shares issued - 17,465,121 at March 31, 2004 and 17,135,056 at December 31, 2003		8,733			8,568
Additional paid-in capital		36,718			35,930
Retained earnings		10,369			9,877
Accumulated other comprehensive income		681			366
Total shareholders’ equity		56,501			54,741
Total liabilities and shareholders’ equity	$	824,842		$	833,320

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CIVITAS BANKGROUP, INC.

CONSOLIDATED STATEMENTS OF EARNINGS
(UNAUDITED)

	Three Months Ended
	March 31,
	2004			2003
Interest income
Loans, including fees	$	8,415		$	9,030
Securities		2,106			1,187
Deposits in financial institutions		6			24
Federal funds sold		15			36
Federal Home Loan Bank dividends		59			55
Total interest income		10,601			10,332
Interest expense
Time deposits of $100,000 or more		1,348			1,096
Other deposits		1,629			2,151
Federal funds purchased and securities sold under repurchase agreements		49			21
Advances from Federal Home Loan Bank		629			623
Subordinated debentures		140			153
Notes payable		76			102
Total interest expense		3,871			4,146
Net interest income		6,730			6,186
Provision for loan losses		561			424
Net interest income after provision for loan losses		6,169			5,762
Other income
Service charges on deposit accounts		896			914
Other service charges, commissions and fees		130			243
Mortgage banking activities		225			306
Income of unconsolidated affiliates		0			46
Net gain on securities transactions		300			21
Net gain (loss) on sale of other real estate		(20	)		45
Other income		246			71
Total other income		1,777			1,646
Other expenses
Salaries and employee benefits		3,520			3,550
Occupancy expense		949			876
Other real estate expense		184			271
Data processing		396			392
Communications		151			148
Deposit insurance premiums		125			70
Other operating expenses		1,504			1,461
Total other expenses		6,829			6,768
Income before income taxes		1,117			640
Income tax expense		363			238
Net earnings	$	754		$	402
Net earnings per share — basic	$	0.04		$	0.03
Net earnings per share — diluted		0.04			0.03
Weighted average shares outstanding — basic		17,309,303			15,383,945
Weighted average shares outstanding — diluted		17,359,468			15,610,675

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CIVITAS BANKGROUP, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
THREE MONTHS ENDED MARCH 31, 2004
UNAUDITED

										Accumulated
	Common Stock				Additional					Other			Total
					Paid-in		Retained			Comprehensive			Shareholders’
(Dollars in thousands)	Shares		Amount		Capital		Earnings			Income (Loss)			Equity
Balance, December 31, 2002		15,382,626	$	7,691	$	27,504	$	9,749		$	529		$	45,473
Exercise of stock options		13,800		7		34		0			0			41
Dividends $0.015 per share		0		0		0		(229	)		0			(229	)
Comprehensive Income:
Net earnings		0		0		0		402			0			402
Other Comprehensive Income
Change in unrealized gain (loss) on securities available for sale net of $299 in income taxes		0		0		0		0			(463	)		(463	)
Less: adjustment for realized gains included in net income, net of $13 in income taxes		0		0		0		0			(21	)		(21	)
Total Comprehensive Income (loss)														(82	)
Balance, March 31, 2003		15,396,426	$	7,698	$	27,538	$	9,922		$	45		$	45,203
Balance, December 31, 2003		17,135,056	$	8,568	$	35,930	$	9,877		$	366		$	54,741
Exercise of stock options		321,635		161		748		0			0			909
Issuance of common stock		8,430		4		40		0			0			44
Dividends $0.015 per share		0		0		0		(262	)		0			(262	)
Comprehensive Income:
Net earnings		0		0		0		754			0			754
Other Comprehensive Income
Change in unrealized gain (loss) on securities available for sale, net of $123 in income taxes		0		0		0		0			201			201
Less: adjustment for realized gains included in net income, net of $186 in income taxes		0		0		0		0			114			114
Total Comprehensive Income (loss)														1,069
Balance, March 31, 2004		17,465,121	$	8,733	$	36,718	$	10,369		$	681		$	56,501

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CIVITAS BANKGROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, 2004 AND 2003
UNAUDITED

	Three Months Ended
	2004			2003
Cash flows from operating activities:
Net earnings	$	754		$	402
Adjustments to reconcile net earnings to net cash provided by operating activities:
Provision for loan losses		561			424
Depreciation and amortization		215			420
Operations of unconsolidated affiliates		(164	)		54
Origination of mortgage loans held for sale		(8,956	)		(17,653	)
Proceeds from sale of mortgage loans held for sale		7,245			17,546
Federal Home Loan Bank stock dividend		(47	)		0
Net (gain) on securities transactions		(300	)		(21	)
Net (gain)/loss on sale of other real estate		20			(45	)
Net change in:
Accrued interest receivable		(32	)		94
Accrued interest payable and other liabilities		617			1,098
Other, net		126			(925	)
Total adjustments		(715	)		992
Net cash provided by operating activities		39			1,394
Cash flows from investing activities:
Net change in interest-bearing deposits in financial institutions		(487	)		6,243
Purchases of securities available for sale		(39,215	)		(26,083	)
Proceeds from maturities, redemptions, and sales of securities available for sale		46,560			9,311
Purchases of securities held to maturity		(1,017	)		(31,510	)
Proceeds from maturities, redemptions, and sales of securities held to maturity		3,374			3,187
Net change in loans		(799	)		(21,395	)
Investment in unconsolidated affiliates		24			(507	)
Purchases of premises and equipment		(445	)		(447	)
Proceeds from sale of other real estate		556			1,219
Net cash provided (used) by investing activities		8,551			(59,982	)
Cash flows from financing activities:
Net change in deposits		993			47,694
Increase (decrease) in federal funds purchased		0			(4,097	)
Change in securities sold under agreements for repurchase		(11,798	)		1,844
Repayments of Federal Home Loan Bank advances		0			0
Advances from Federal Home Loan Bank		0			1,000
Repayments of notes payable		(50	)		(50	)
Dividends paid		(257	)		(229	)
Repurchase and retirement of common stock		0			0
Proceeds from issuance of common stock		953			41
Net cash provided (used) by financing activities		(10,159	)		46,203
Net change in cash and cash equivalents		(1,569	)		(12,385	)
Cash and cash equivalents at beginning of period		35,058			49,242
Cash and cash equivalents at end of period	$	33,489		$	36,857
Supplemental disclosure of cash flow information:
Interest paid	$	4,008		$	4,080
Income taxes paid		0			0
Non-Cash Activities:
Assets acquired through foreclosure		842			2,348

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CIVITAS BANKGROUP, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2004

UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The unaudited consolidated financial statements as of March 31, 2004 and for the three month periods ended March 31, 2004 and 2003 were prepared on the same basis as the audited financial statements and, in the opinion of management, include all adjustments, consisting of normal recurring adjustments, to present fairly the information. They do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. Operating results for the three month period ended March 31, 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 2003 consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K.

On January 1, 2003, the Company adopted SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”. This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. As the Company continues to account for stock-based employee compensation under APB 25, the adoption of this statement did not have a material impact on the financial statements or results of operations.

On January 1, 2003, the Company adopted Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees. On July 1, 2003, the Company adopted Statement 149, amendment of Statement 133 on Derivative Instruments and Hedging Activities, and Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities. On October 1, 2003, the Company adopted Interpretation 46, Consolidation of Variable Interest Entities. Adoption of the new standards did not materially affect the Company’s operating results or financial condition.

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CIVITAS BANKGROUP, INC.
FORM 10-Q, CONTINUED

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The purpose of this discussion is to provide insight into the financial condition and results of operations of Civitas BankGroup, Inc. and its subsidiaries (the “Company”). This discussion should be read in conjunction with the consolidated financial statements. Reference should also be made to the Company’s Annual Report on Form 10-K, for a more complete discussion of factors that impact liquidity, capital and the results of operations.

FORWARD-LOOKING STATEMENTS

This Form 10-Q contains certain forward-looking statements regarding, among other things, the anticipated financial and operating results of the Company. The words “anticipate,” “could,” “expects,” and “believes” and similar expressions are intended to identify such forward-looking statements but other statements not based on historical information may also be considered forward-looking. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to publicly release any modifications or revisions to these forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions investors that future financial and operating results may differ materially from those projected in forward-looking statements made by, or on behalf of, the Company. Such forward-looking statements involve known and unknown risks and uncertainties, including, but not limited to, (i) increased competition with other financial institutions; (ii) lack of sustained growth in the economy in the Company’s market area; (iii) rapid fluctuations in interest rates; (iv) significant downturns in the businesses of one or more large customers; (v) risks inherent in originating loans, including prepayment risks; (vi) the fluctuations in collateral values, the rate of loan charge-offs and the level for the provision for loan losses; (vii) changes in the legislative and regulatory environment; and (viii) loss of key personnel. These risks and uncertainties may cause the actual results or performance of the Company to be materially different from any future results or performance expressed or implied by such forward-looking statements. The Company’s future operating results depend on a number of factors which were derived utilizing numerous assumptions and other important factors that could cause actual results to differ materially from those projected in forward-looking statements.

CRITICAL ACCOUNTING POLICIES

The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States and with general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Critical accounting policies relate to investments, loans, allowance for loan losses, intangibles, revenues, expenses, stock options and income taxes.

The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. The Company estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance

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is available for any loan that, in management’s judgment, should be charged off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan loss reserve.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.

A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.

OVERVIEW

Net income for the three months ended March 31, 2004, totaled $754,000 compared to $402,000 for the same period for 2003, an 87.6% increase. The Company experienced this improved performance notwithstanding a 23.6% increase in nonperforming assets during the quarter, which continues to negatively impact earnings performance in many ways.

Assets declined from $833.3 million at December 31, 2003, to $824.8 million at March 31, 2004, an $8.5 million or 1.02% decrease. The primary changes in assets were the $9.1 million decrease in securities offset by modest loan growth of $1.2 million. Total liabilities declined from $778.6 million at December 31, 2003 to $768.3 million at March 31, 2004, a $10.2 million decrease or 1.3% of which $11.8 million represents a decrease in repurchase agreements.

During the quarter ended March 31, 2004, the Company’s management continued to focus on improving the Company’s operating efficiencies throughout its bank subsidiaries. The ongoing evaluation of its operations and related operational improvements includes the continued centralization of certain backroom operations, reduction of duplicate operational processes and consideration of the disposal of underperforming branches or subsidiaries in markets offering limited growth potential. In furtherance of this operational improvement program, the Company recently filed applications to merge its Cumberland Bank and Cumberland Bank South bank subsidiaries, both of which operate in the Nashville metropolitan market.

RESULTS OF OPERATIONS

The Company’s results of operations depend primarily upon the level of net interest income, provision for loan losses, noninterest income and noninterest expenses. For the three months ended March 31, 2004, net earnings totaled $754,000 as compared to $402,000 for the three months ended March 31, 2003. Provision for loan losses increased $137,000 for the first three months of 2004 to $561,000 from $424,000 for the same period in 2003.

Net Interest Income

Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities and is the most significant component of the Company’s earnings. The Company’s total interest income, excluding tax equivalent adjustments related to the Company’s tax exempt securities, increased $269,000 or 2.6% to $10.6 million during the three months ended March 31, 2004 as compared to the same period in 2003. Interest income generated from the investment portfolio increased $919,000 as a result of the leverage transactions completed in 2003 and described more fully in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Interest income continues to be adversely impacted by the level of nonperforming assets which totaled $20.0 million at March 31, 2004, a $3.8 million increase from the level at December 31, 2003. Had such loans been performing, interest income for the three months ended March 31, 2004, would have increased by $217,000. Interest income from loans declined by $615,000 from the first quarter 2003 to

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the first quarter 2004. The declining yield is largely the result of declines in market interest rates and the continued runoff of loans that do not meet the risk characteristics targeted by management.

Interest expense decreased $275,000 or 6.6% to $3.9 million for the three months ended March 31, 2004 as compared to the three months ended March 31, 2003. The overall decrease in total interest expense was driven by a decline in the interest paid for interest bearing deposits. The decrease in the average rate paid primarily resulted from the lower interest rate environment, change in deposit mix and increases in balances of lower cost sources of funds such as noninterest bearing deposits and repurchase agreements. The Company’s $51.9 million in fixed rate borrowings primarily from the Federal Home Loan Bank that carry high costs and substantial prepayment penalties limited further reductions in interest expense.

The foregoing resulted in an increase in net interest income, before the $561,000 in provision for loan losses, of $544,000 or 8.8% for the three months ended March 31, 2004 as compared to the same period in 2003. As discussed in “Item 3,” the Company’s interest rate risk modeling reflects an asset sensitive bias and therefore net interest income is positioned to benefit from increases in interest rates.

Provision for Loan Losses

The provision for loan losses totaled $561,000 for the three months ended March 31, 2004 compared to $424,000 for the three months ended March 31, 2003. Net charge-offs of $512,000 over the three month period ended March 31, 2004 warranted the additional provision. The Company has placed a greater emphasis on identifying at-risk borrowers as our banks have experienced a higher than normal amount of bankruptcies by their borrowers which account for a large portion of our loan charge offs. Additionally, deteriorating economic conditions have resulted in some of our commercial and consumer borrowers experiencing financial difficulty and even the inability to pay their obligations to us. The provision for loan losses is based on past loan experience and other factors, which in management’s judgment, deserve current recognition in estimating possible loan losses. Such factors include past loan loss experience, growth and composition of the loan portfolio, review of specific problem loans, the relationship of the allowance for loan losses to outstanding loans, and current economic conditions that may affect the borrower’s ability to repay. Management has in place a system designed for monitoring its loan portfolio in an effort to identify potential problem loans and additional provisions will likely be appropriate as a result of ongoing efforts to better assess problem loans. Until the Company can achieve significant reductions in problem assets it is likely that loan charge-offs will continue to be incurred, resulting in additional provisions for loan losses, which will negatively impact future earnings.

Noninterest Income

The components of the Company’s noninterest income include service charges on deposit accounts, other fees and commissions, mortgage banking activities, gain on sale of securities and gain on sale of assets. Total noninterest income increased 8.0% to $1.8 million for the three month period ending March 31, 2004 compared to the same period in 2003. The largest component of the Company’s noninterest income is revenue generated on deposit accounts. Service charges on deposit accounts decreased $18,000 or 2.0% to $896,000 during the three months ended March 31, 2004 compared to the same period in 2003. Revenue from mortgage banking activities totaled $225,000 a decline of $81,000 or 26.5% during the three months ended March 31, 2004 compared to the same period last year. The mortgage industry experienced high levels of refinancing during 2003 due to low interest rates. Since the second half of 2003, mortgage activity has slowed significantly. Other service charges, fees and commissions totaled $130,000 for the current quarter a decrease of $113,000 or 46.5%. The deferral of loan fee income and a reduction in credit life sales account for this decrease. Profits from first quarter sale of securities increased from $21,000 to $300,000 as compared to the same period last year. Market conditions provided swap opportunities for profit taking while maintaining yield with limited extension risk.

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Noninterest Expense

Noninterest expense consists primarily of salaries and employee benefits, occupancy expenses, furniture and equipment expenses, data processing expenses and other operating expenses. Total noninterest expense increased $61,000 or 0.9% to $6.8 million during the three months ended March 31, 2004 compared to the same period in 2003. Salaries and employee benefits make up the largest category in noninterest operating expenses. This expense decreased $18,000 or 2.0% as management believes the Company is experiencing results from the centralization of its backroom operations, revised management structure and overall cost savings through the reduction of the level of duplicate operational processes and by the performance of these operations by specialized personnel. The Company believes that realization of cost savings from these efficiencies will be dependent upon effective implementation and may not be fully recognized until the second half of 2004. Although expenses relating to foreclosed properties are $87,000 lower in the first quarter of 2004 as compared to 2003, management believes it is likely this expense will increase as the Company continues to manage non-performing loans. Deposit insurance premiums increased by $55,000 from the same period last year.

FINANCIAL CONDITION

Balance Sheet Summary

The Company’s total assets decreased 1.0% to $824.8 million at March 31, 2004 from $833.3 million at December 31, 2003. The majority of this decline was in the securities portfolio as a result of paydowns in the mortgage-backed securities portfolio and security sales discussed earlier. Federal funds sold balances decreased 25.8% or $3.9 million to $11.2 million since December 31, 2003. Investment securities and federal funds sold represent 24.9% of the Company’s assets. Loans totaled $551.8 million at March 31, 2004, an increase of $1.2 million or 0.22% over year-end 2003 balances.

Total liabilities decreased 1.3% to $768.3 million at March 31, 2004 compared to $778.6 million at December 31, 2003. This $10.2 million decrease was composed primarily of an account of one of the Company’s largest customers. Outstanding Federal Home Loan Bank advances remained constant for the period at $51.9 million. Notes payable have declined $50,000 since year-end.

The Company follows the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan” and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan — Income Recognition and Disclosures”. These pronouncements apply to impaired loans except for large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment including residential mortgage and consumer installment loans.

A loan is impaired when it is probable that the Company will be unable to collect the scheduled payments of principal and interest due under the contractual terms of the loan agreement. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. If the measure of the impaired loan is less than the recorded investment in the loan, the Company shall recognize an impairment by creating a valuation allowance with a corresponding charge to the provision for loan losses or by adjusting an existing valuation allowance for the impaired loan with a corresponding charge or credit to the provision for loan losses.

The Company’s first mortgage single family residential and consumer loans are divided into various groups of smaller-balance homogeneous loans that are collectively evaluated for impairment and thus are not subject to the provisions of SFAS Nos. 114 and 118. Substantially all other loans of the Company are evaluated for impairment under the provisions of SFAS Nos. 114 and 118.

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The Company considers all loans subject to the provisions of SFAS 114 and 118 that are on nonaccrual status to be impaired. Loans are placed on nonaccrual status when doubt as to timely collection of principal or interest exists, or when principal or interest is past due 90 days or more unless such loans are well-secured and in the process of collection. Delays or shortfalls in loan payments are evaluated with various other factors to determine if a loan is impaired. The decision to place a loan on nonaccrual status is also based on an evaluation of the borrower’s financial condition, collateral, liquidation value, and other factors that affect the borrower’s ability to pay.

Generally, at the time a loan is placed on nonaccrual status, all interest accrued on the loan in the current fiscal year is reversed from income, and all interest accrued and uncollected from the prior year is charged off against the allowance for loan losses. Thereafter, interest on nonaccrual loans is recognized as interest income only to the extent that cash is received and future collection of principal is not in doubt. If the collectibility of outstanding principal is doubtful, such interest received is applied as a reduction of principal. A nonaccrual loan may be restored to accruing status when principal and interest are no longer past due and unpaid and future collection of principal and interest on a timely basis is not in doubt.

Other loans may be classified as impaired when the current net worth and financial capacity of the borrower or of the collateral pledged, if any, is viewed as inadequate. In those cases, such loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt, and if such deficiencies are not corrected, there is a probability that the Company will sustain some loss. In such cases, interest income continues to accrue as long as the loan does not meet the Company’s criteria for nonaccrual status.

The Company’s charge-off policy for impaired loans is similar to its charge-off policy for all loans in that loans are charged-off in the month when they are considered uncollectible.

Net charge-offs were $512,000 and $981,000 for the three month periods ended March 31, 2004 and 2003, respectively. Provision expense equaled $561,000 and $424,000 for these same time periods. The allowance for loan losses was $8.5 million or 1.5% of total loans at March 31, 2004 compared to $8.4 million or 1.5% of total loans at December 31, 2003. Total non-performing assets (non-accrual loans and foreclosed properties) at March 31, 2004 increased to $20.0 million from $16.2 million, an increase of $3.8 million since December 31, 2003. Nonperforming assets as a percentage of total assets were 2.42% and 1.93% at March 31, 2004 and December 31, 2003.

Management has internally classified an additional $20.5 million in loans as substandard based upon other possible credit problems. These loans are not included in the above amounts. These loans are performing loans but are classified as substandard due to payment history, decline in the borrowers’ financial position or decline in collateral value. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Loans classified as doubtful have all the weaknesses inherent in one classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Doubtful loans totaled $1.5 million at March 31, 2004. Loans classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. There were no loans classified as loss as of March 31, 2004.

It is anticipated that the level of nonperforming loans will gradually improve as management resolves problem loans. Management believes the balance of the allowance for loan losses to be adequate as of March 31, 2004 based on its internal evaluation of the allowance for loan losses and loan portfolio. Ongoing review of the Company’s loan portfolio assists management in identifying potential problem credits and determining the level of the allowance for loan losses. Quarterly, the allowance for loan losses is evaluated under the provision of SFAS 114 and 118 as discussed above. Under these provisions, specific provisions are made for loans considered impaired. A general reserve is also maintained for the Company’s homogenous loans.

The level of the allowance and the amount of the provision involve evaluation of uncertainties and matters of judgment. Although management believes the allowance for loan losses at March 31, 2004 to be adequate, further deterioration in problem credits, the results of the loan review process, or the impact of deteriorating economic conditions on other businesses, could require increases in the provision for loan losses and could result in future charges to earnings which could have a significant negative impact on net earnings. Furthermore, management believes that continued deterioration in the economy in both the Company’s primary market area and nationally could have a significant impact on loans not currently identified as problems as well as those that are identified.

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Liquidity and Asset Management

The Company’s management seeks to maximize net interest income by managing the Company’s assets and liabilities within appropriate constraints on capital, liquidity and interest rate risk. Liquidity is the ability to maintain sufficient cash levels necessary to fund operations, meet the requirements of depositors and borrowers and fund attractive investment opportunities. Higher levels of liquidity bear corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher interest expense involved in extending liability maturities. Liquid assets including cash, due from banks and federal funds sold totaled $33.5 million. In addition, the Company has $51.1 million in unpledged securities classified as available for sale that could be sold for liquidity needs.

The Company’s primary source of liquidity is a stable core deposit base. In addition, payments from the loan and investment portfolios provide a secondary source. Borrowing lines with correspondent banks, the Federal Home Loan Bank and the Federal Reserve augment these traditional sources. Repurchase agreements, brokered CDs, and public fund deposits are alternative sources of funding to which the Company has access.

The Company’s securities portfolio consists of earning assets that provide interest income. For those securities classified as held-to-maturity the Company has the ability and intent to hold these securities to maturity or on a long-term basis. Securities classified as available-for-sale include securities intended to be used as part of the Company’s asset/liability strategy and/or securities that may be sold in response to changes in interest rate, prepayment risk, the need or desire to increase capital and similar economic factors. Securities totaling approximately $8.8 million mature or will be subject to rate adjustments within the next twelve months.

A secondary source of liquidity is the Company’s loan portfolio. At March 31, 2004, loans of approximately $207.6 million either will become due or will be subject to rate adjustments within twelve months from the respective date. Continued emphasis will be placed on structuring adjustable rate loans.

As for liabilities, certificates of deposits of approximately $226.3 million will become due during the next twelve months. Historically, there has been no significant reduction in immediately withdrawable accounts such as negotiable order of withdrawal accounts, money market demand accounts, demand deposit and regular savings. Management anticipates that there will be no significant withdrawals from these accounts in the future. However, future decreases in rates could have a negative effect on total deposits.

Management believes that with current liquid assets, present maturities, borrowing sources and the efforts of management in its asset/liability management program, liquidity will not pose a problem in the near term future. However, the Company’s bank borrowings and trust preferred securities have certain interest payment requirements and the Company has certain operating expenses at the holding company level, which require dividends or management fees from the Company’s bank subsidiaries in order to be funded. The Company’s recent asset quality problems have resulted in regulatory restrictions (approval) on its subsidiaries’ ability to pay dividends to the holding company, which could require the holding company to raise additional capital in order to make such payments. The Company anticipates that it will be able to meet required payments on its outstanding debt and trust preferred securities for the next four quarters through available cash resources and such additional capital. However, the Company’s regulators have considerable discretion in determining whether to grant required approvals, and no assurance can be given that such approvals will be forthcoming.

Off Balance Sheet Arrangements

At March 31, 2004, the Company had unfunded loan commitments outstanding of $99.5 million and unfunded lines of credit and letters of credit of $3.8 million. Because these commitments generally have fixed expiration dates and

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many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Company’s bank subsidiaries have the ability to liquidate Federal funds sold or securities available-for-sale or on a short-term basis to borrow and purchase Federal funds from other financial institutions. Additionally, the Company’s bank subsidiaries could sell participations in these or other loans to correspondent banks.

Capital Position and Dividends

At March 31, 2004, total shareholders’ equity was $56.5 million or 6.8% of total assets. The increase of $1.8 million in shareholders’ equity during the three months ended March 31, 2004 results from exercise of stock options totaling $909,000, the Company’s net income of $754,000, $44,000 in issuance of common stock through the Company’s Employee Stock Purchase Plan, and a $315,000 increase in other comprehensive income, which is offset by the declaration of cash dividends of $262,000.

The Company’s principal regulators have established minimum risk-based capital requirements and leverage capital requirements for the Company and its subsidiary banks. These guidelines classify capital into two categories of Tier I and total risk-based capital. Total risk-based capital consists of Tier I (or core) capital (essentially common equity less intangible assets) and Tier II capital (essentially qualifying long-term debt, of which the Company and subsidiary banks have none, and a part of the allowance for loan losses). In determining risk-based capital requirements, assets are assigned risk-weights of 0% to 100%, depending on regulatory assigned levels of credit risk associated with such assets. The risk-based capital guidelines require the subsidiary banks and the Company to have a total risk-based capital ratio of 8.0% and a Tier I risk-based capital ratio of 4.0%. Trust preferred securities are allowed to be counted in Tier I capital, subject to certain limitations. At March 31, 2004, the Company’s total risk-based capital ratio was 13.91% and its Tier I risk-based capital ratio was approximately 12.67% compared to ratios of 13.53% and 12.27%, respectively at December 31, 2003. The required Tier I leverage capital ratio (Tier I capital to average assets for the most recent quarter) for the Company is 4.0%. At March 31, 2004, the Company had a leverage ratio of 8.03%, compared to 7.86% at December 31, 2003.

The Company and its subsidiaries, Cumberland Bank, BankTennessee and Bank of Dyer, have agreed with or committed to bank regulatory officials to take various actions, including to reduce the level of criticized or non-performing loans, to improve loan underwriting, problem loan resolution and collection, and strategic and capital planning, to obtain prior regulatory approval before incurring additional holding company indebtedness, repurchasing shares, or paying dividends from certain subsidiary banks to the holding company or from the holding company to shareholders, and to maintain certain capital levels at subsidiary banks in excess of those required for well capitalized status. The most restrictive of these provisions would require the Company to maintain a Tier I leverage ratio of at least 7.0% at BankTennessee, Bank of Dyer and Cumberland Bank. The Company and its subsidiaries believe they were in compliance in all material respects with these agreements at March 31, 2004. The Company and its subsidiaries intend to continue to comply with these agreements, and the Company received approval to pay dividends for the first quarter of 2004. The Company believes that the earnings from operations and available funds will be sufficient to allow the Company to meet all these commitments and the requirements for well-capitalized status through the end of 2004. However, the Company’s regulators have considerable discretion in determining whether to grant required approvals, and no assurance can be given that such approvals will be forthcoming.

Impact of Inflation

Although interest rates are significantly affected by inflation, the inflation rate is immaterial when reviewing the Company’s results of operations.

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Effect of New Accounting Standards

A new accounting standard dealing with asset retirement obligations was adopted during 2003. The Company’s management does not believe this standard has a material affect on its financial position of results of operations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on a large portion of the Company’s assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which possess a short term to maturity. Based upon the nature of the Company’s operations, the Company does not maintain any foreign currency exchange or commodity price risk.

Interest rate risk (sensitivity) management focuses on risk to long-term earnings capacity and economic value of equity associated with changing interest rates. As the Company’s rate sensitivity position has an important impact on earnings, management seeks to maintain profitability in both immediate and long-term earnings through funds management/interest rate risk management. Responsibility for managing interest rate risk and liquidity rests with the Asset/Liability Committee (ALCO). ALCO reviews interest rate and liquidity exposures, adopts balance sheet strategies, and ensures policy compliance. Simulation and Gap analysis are utilized to measure the interest sensitivity of assets and liabilities. Cash flow, maturing and repricing information from the company’s balance sheet are quantified using a variety of potential interest rate environments to estimate earnings sensitivity and capital risk to changing interest rates.

Net interest income should benefit from an increase in market interest rates. This position reflects the asset sensitive bias of the balance sheet. Net interest income is exposed to falling interest rates. Market indicators suggest significant further declines in short-term interest rate are unlikely in the near future.

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to its management, including its principal executive officer and its principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation of its management, including its principal executive officer and its principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this report. Based on the evaluation of these disclosure controls and procedures, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     None

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

As discussed in Part I, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Company’s ability to pay dividends is subject to its receipt of prior approval by bank regulatory officials.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None

ITEM 5. OTHER INFORMATION

     None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

     (a) Exhibits

31.1	Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002
31.2	Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002
32.1	Certification of the Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

     (b) The following reports on Form 8-K have been filed during the quarter for which this report is filed:

     On January 23, 2004, the Company furnished a Current Report on Form 8-K pursuant to Item 9 and Item 12 announcing the Company’s results of operations for the year ended December 31, 2003. Notwithstanding the foregoing, information furnished under Item 9 or Item 12 of Form 8-K, including the related exhibits, shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934.

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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.

		CIVITAS BANKGROUP, INC. (Registrant)
DATE:	05/17/04	/s/ Richard Herrington Richard Herrington, President and Chief Executive Officer
DATE:	05/17/04	/s/ Andy LoCascio Andy LoCascio, Chief Financial Officer (Principal Accounting and Financial Officer)

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