EXHIBIT (13)
APPENDIX A
PEOPLES BANCORP OF NORTH CAROLINA, INC.
General Description of Business
Peoples Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”). The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). The Company’s sole activity consists of owning the Bank. The Company’s principal source of income is any dividends which are declared and paid by the Bank on its capital stock. The Company has no operations and conducts no business of its own other than owning the Bank. Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated.
The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 16 offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory and Charlotte, North Carolina. At December 31, 2004, the Company had total assets of $686.3 million, net loans of $527.4 million, deposits of $556.5 million, investment securities of $105.6 million, and shareholders’ equity of $50.9 million.
The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans. Real estate loans are predominately variable rate commercial property loans. Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio. The majority of the Bank's deposit and loan customers are individuals and small to medium-sized businesses located in the Bank's market area.
The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the "Commissioner").
At December 31, 2004, the Bank employed 209 full-time equivalent employees.
The Bank is a subsidiary of the Company. The Bank has two subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank's customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services. Real Estate Advisory Services, Inc., provides real estate appraisal and real estate brokerage services.
In December 2001 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay interest at a floating rate equal to the prime rate plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. As discussed under the heading entitled “Recent Accounting Pronouncements” in note 1 to the consolidated financial statements included in the 2004 Annual Report of Peoples Bancorp, Inc., attached hereto as Exhibit 13, PEBK Trust was deconsolidated by the Company under FIN 46 as of December 31, 2003.
This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of Peoples Bancorp of North Carolina, Inc. (the “Company”). These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank (the “Bank”), (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission. The Company undertakes no obligation to update any forward-looking statements.
A-1
SELECTED FINANCIAL DATA | |||||||
Dollars in Thousands Except Per Share Amounts | |||||||
2004 | 2003 | 2002 | 2001 | 2000 | |||
Summary of Operations | |||||||
Interest income | $ | 36,255 | 34,854 | 36,624 | 41,898 | 40,859 | |
Interest expense | 12,335 | 12,749 | 15,777 | 23,027 | 19,432 | ||
Net interest income | 23,920 | 22,105 | 20,847 | 18,871 | 21,427 | ||
Provision for loan losses | 3,256 | 6,744 | 5,432 | 3,545 | 1,879 | ||
Net interest income after provision for loan losses | 20,664 | 15,361 | 15,415 | 15,326 | 19,548 | ||
Non-interest income | 6,057 | 5,926 | 6,491 | 8,263 | 3,915 | ||
Non-interest expense | 20,057 | 18,228 | 16,758 | 16,752 | 15,509 | ||
Income before taxes | 6,664 | 3,059 | 5,148 | 6,837 | 7,954 | ||
Income taxes | 2,233 | 1,055 | 1,712 | 2,262 | 2,576 | ||
Net income | $ | 4,431 | 2,004 | 3,436 | 4,575 | 5,378 | |
Selected Year-End Balances | |||||||
Assets | $ | 686,348 | 674,032 | 645,638 | 619,505 | 519,002 | |
Available for sale securities | 105,598 | 79,460 | 71,736 | 84,286 | 71,565 | ||
Loans, net | 527,419 | 542,404 | 519,122 | 484,517 | 406,226 | ||
Mortgage loans held for sale | 3,783 | 587 | 5,065 | 5,339 | 1,564 | ||
Interest-earning assets | 652,678 | 639,501 | 608,619 | 586,496 | 490,449 | ||
Deposits | 556,522 | 549,802 | 515,739 | 490,223 | 450,073 | ||
Interest-bearing liabilities | 553,135 | 550,357 | 527,525 | 516,422 | 420,594 | ||
Shareholders' equity | $ | 50,938 | 48,554 | 48,605 | 45,401 | 43,039 | |
Shares outstanding* | 3,448,581 | 3,448,722 | 3,446,902 | 3,540,585 | 3,540,585 | ||
Selected Average Balances | |||||||
Assets | $ | 684,384 | 660,644 | 624,796 | 575,142 | 469,536 | |
Available for sale securities | 93,770 | 72,072 | 77,414 | 84,549 | 66,218 | ||
Loans | 547,753 | 539,559 | 507,879 | 454,371 | 374,226 | ||
Interest-earning assets | 650,095 | 625,764 | 592,947 | 545,945 | 447,645 | ||
Deposits | 558,141 | 533,704 | 499,224 | 481,289 | 408,210 | ||
Interest-bearing liabilities | 553,880 | 540,676 | 516,747 | 472,868 | 373,167 | ||
Shareholders' equity | $ | 51,978 | 49,914 | 48,257 | 47,432 | 42,852 | |
Shares outstanding* | 3,459,379 | 3,447,056 | 3,467,173 | 3,540,585 | 3,540,585 | ||
Profitability Ratios | |||||||
Return on average total assets | 0.65% | 0.30% | 0.55% | 0.80% | 1.15% | ||
Return on average shareholders' equity | 8.52% | 4.01% | 7.12% | 9.65% | 12.55% | ||
Dividend payout ratio | 28.37% | 62.56% | 36.58% | 28.14% | 23.39% | ||
Liquidity and Capital Ratios (averages) | |||||||
Loan to deposit | 98.14% | 101.10% | 101.73% | 94.41% | 91.67% | ||
Shareholders' equity to total assets | 7.59% | 7.56% | 7.72% | 8.25% | 9.13% | ||
Per share of common stock* | |||||||
Basic net income | $ | 1.28 | 0.58 | 0.99 | 1.29 | 1.52 | |
Diluted net income | $ | 1.26 | 0.58 | 0.99 | 1.29 | 1.52 | |
Cash dividends | $ | 0.36 | 0.36 | 0.36 | 0.36 | 0.32 | |
Book value | $ | 14.77 | 14.08 | 14.10 | 12.83 | 11.05 | |
*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividend during first | |||||||
quarter 2005 and a 10% stock dividend during second quarter 2000. |
A-2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. (the “Company”), for the years ended December 31, 2004, 2003 and 2002. The Company is a registered bank holding company operating under the supervision of the Federal Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander and Mecklenburg Counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).
Overview
Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.
Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that local employers may be required to eliminate employment positions of borrowers, and small businesses and other commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses, and changes in these economic conditions could result in increases or decreases to the provision for loan losses.
Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.
With the general slowdown in the economy that began in 2000, the Federal Reserve provided a stimulus through a series of interest rate reductions that lowered the prime rate from 9.50% in January 2001 to 4.00% in June 2003. These reductions in prime rate negatively impacted the Company's net interest margin and net interest spread in 2002 and 2003, which resulted in lower net interest income for the Company. The Company's asset growth has been slower as a result of heavy refinancing as customers have taken advantage of these attractive interest rates. The fee income associated with the heavy refinancing volume replaced some of the lost net interest income. The Company utilized interest rate swaps to convert some variable rate loans to fixed rate in order to offset some of the reduced earnings because of the decreases in the prime rate.
Between June and December 31, 2004, the Federal Reserve increased the federal funds rate a total of 1.25%, with the rate set at 2.25% as of December 31, 2004. These increases had a positive impact on 2004 earnings and should continue to have a positive impact on the Bank’s net interest income in the future periods.
A-3
Summary of Significant Accounting Policies
The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2005 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 5, 2005 Annual Meeting of Shareholders. The following is a summary of the more subjective and complex accounting policies of the Company.
Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to consolidated financial statements.
There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). For a more complete discussion of policies, see the notes to consolidated financial statements.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities - An Interpretation of Accounting Research Bulletin No. 51” (“FIN 46”). In December 2003, the FASB issued a revised version of FIN 46 to resolve certain questions and confusion related to the application of the original FIN 46. The Company adopted FIN 46 (Revised) as of December 31, 2003, and as a result, the Company’s wholly owned subsidiary, PEBK Capital Trust I, is no longer included in these consolidated financial statements. The consolidated financial statements have been restated for all periods presented to reflect this change in accounting, and the adoption of FIN 46 (Revised) had no impact on the Company’s reported results of operations or shareholders’ equity.
In January 2004, the FASB issued as tentative guidance, Derivatives Implementation Group Issue G25, “Cash Flow Hedges: Hedging the Variable Interest Payments on a Group of Prime-Rate-Based Interest-Bearing Loans.” Issue G25 provides guidance for entities wishing to hedge the variability in loan interest receipts that are tied to the prime rate and other issues associated with cash flow hedges. Issue G25 was revised and was cleared by the FASB in July 2004. The revised guidance does allow for hedging a pool of non-benchmark-rate assets or liabilities by entering into an interest rate swap whose floating leg is also based on the prime rate or another non-benchmark-rate. Therefore, management expects that the interest rate swaps hedging prime-rate based loans discussed in the section below entitled “Asset Liability and Interest Rate Risk Management” will continue to be treated as cash flow hedges and that the Company will not have to record changes in value as a component of current earnings nor terminate the swaps as long as the hedge is effective.
In November 2003, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on determining other-than-temporary impairments and its application to marketable equity securities and debt securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” In September 2004, the FASB issued FASB Staff Position (“FSP”) EITF Issue 03-1-1, which delayed the effective date for the measurement and recognition guidance contained in the EITF 03-1 pending finalization of the draft FSP EITF Issue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1.” The disclosure requirements of EITF 03-1 remain in effect. The Company adopted the disclosure requirements of EITF 03-1 as of September 30, 2004. The adoption of the recognition and measurement provisions of EITF 03-1 are not expected to have a material impact on the Company’s results of operations, financial position or cash flows.
A-4
In December 2004, the FASB revised SFAS No. 123 (“SFAS No. 123 (R)”). SFAS No. 123 (R), “Share-Based Payment”, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS No. 123 (R) is effective for periods beginning after June 15, 2005. The Company is still evaluating the transition provisions allowed by SFAS No. 123 (R) and expects to adopt in the third quarter of 2005. The financial statement impact is not expected to be materially different from that shown in the existing pro forma disclosure required under the original SFAS No. 123.
Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
The remainder of management’s discussion and analysis of the Company’s results of operations and financial position should be read in conjunction with the consolidated financial statements and related notes presented on pages A-25 through A-49.
Results of Operations
Summary.The Company reported earnings of $4.4 million in 2004, or $1.41 basic net earnings per share and $1.39 diluted net earnings per share, a 121% increase as compared to $2.0 million, or $0.64 basic net earnings per share and $0.63 diluted net earnings per share, for 2003. Net earnings from recurring operations for 2004 were $4.6 million, or $1.46 basic net earnings per share and $1.44 diluted net earnings per share, representing a 106% increase over net earnings from recurring operations of $2.2 million, or $0.71 basic and diluted net earnings per share in 2003. Net non-recurring losses on disposition of assets in 2004 amounted to $248,000. This is a reduction from net non-recurring losses on disposition of assets for the year ended December 31, 2003, which amounted to $355,000 and were comprised of a $747,000 net loss on repossessed assets and a $53,000 loss on sale of securities, which was partially offset by a $479,000 gain associated with the sale of the Bank’s $3.7 million credit card portfolio during 2003. The Company’s increase in recurring earnings for 2004 is primarily attributable to a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by an increase in non-interest expense.
Net earnings for 2003 represented a decrease of 42% as compared to 2002 net earnings of $3.4 million. Net earnings from recurring operations for 2003 decreased 26% when compared to $3.0 million, or $0.96 basic net earnings per share and $0.95 diluted net earnings per share for 2002. Net earnings for 2002 included non-recurring gains on the sale of securities of $626,000. The decline in 2003 year-to-date recurring earnings was primarily attributable to an increase in the provision for loan losses and an increase in non-interest expense.
The annualized return on average assets in 2004 was 0.65%, compared to 0.30% in 2003 and 0.55% in 2002. Excluding non-recurring gains and losses on disposition of assets, the annualized return on average assets was 0.67%, 0.34% and 0.48% in 2004, 2003 and 2002, respectively. Annualized return on average shareholders’ equity was 8.52% in 2004 compared to 4.01% in 2003 and 7.12% in 2002. Excluding non-recurring gains and losses on disposition of assets, the annualized return on average shareholders’ equity was 8.81%, 4.46% and 6.30% in 2004, 2003 and 2002, respectively.
Net Interest Income.Net interest income, the major component of the Company's net income, is the amount by which interest and fees are generated by interest-earning assets exceed the total cost of funds used to carry them. Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid. Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.
Net interest income was $23.9 million for 2004, or 8% over net interest income of $22.1 million in 2003. The increase was attributable to an increase in interest income due to an increase in the prime rate, as well as an increase in the average outstanding balance of available for sale securities and loans combined with a reduction in interest expense resulting from a decrease in the cost of funds. Net interest income increased 6% in 2003 from $20.8 million in 2002.
Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2004, 2003 and 2002. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 34% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt
A-5
securities. Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.
Table 1- Average Balance Table | ||||||||||||||||||||||||||||
December 31, 2004 | December 31, 2003 | December 31, 2002 | ||||||||||||||||||||||||||
(Dollars in Thousands) | Average Balance | Interest | Yield / Rate | Average Balance | Interest | Yield / Rate | Average Balance | Interest | Yield / Rate | |||||||||||||||||||
Interest-earning assets: | ||||||||||||||||||||||||||||
Loans | $ | 547,753 | 29,826 | 5.45 | % | 539,559 | 28,700 | 5.32 | % | 507,879 | 30,256 | 5.96 | % | |||||||||||||||
Interest rate swap agreements | - | 1,056 | 2.21 | % | - | 1,522 | 3.22 | % | - | 509 | 1.16 | % | ||||||||||||||||
Loan fees | - | 1,371 | 0.29 | % | - | 1,310 | 0.28 | % | - | 1,274 | 0.29 | % | ||||||||||||||||
Total loans | 547,753 | 32,252 | 5.89 | % | 539,559 | 31,532 | 5.84 | % | 507,879 | 32,039 | 6.31 | % | ||||||||||||||||
Investments - taxable | 35,920 | 1,545 | 4.30 | % | 49,082 | 2,186 | 4.45 | % | 63,792 | 3,726 | 5.84 | % | ||||||||||||||||
Investments - nontaxable* | 57,850 | 2,741 | 4.74 | % | 22,990 | 1,228 | 5.34 | % | 13,622 | 929 | 6.82 | % | ||||||||||||||||
Federal funds sold | 3,363 | 35 | 1.05 | % | 5,981 | 58 | 0.98 | % | 3,356 | 45 | 1.34 | % | ||||||||||||||||
Other | 5,209 | 141 | 2.70 | % | 8,152 | 174 | 2.14 | % | 4,298 | 201 | 4.68 | % | ||||||||||||||||
Total interest-earning assets | 650,095 | 36,714 | 5.65 | % | 625,764 | 35,178 | 5.62 | % | 592,947 | 36,940 | 6.23 | % | ||||||||||||||||
Cash and due from banks | 13,058 | 12,587 | 11,351 | |||||||||||||||||||||||||
Other assets | 30,601 | 31,008 | 27,536 | |||||||||||||||||||||||||
Allowance for loan losses | (9,369 | ) | (8,282 | ) | (6,607 | ) | ||||||||||||||||||||||
Total assets | $ | 684,384 | 661,077 | 625,227 | ||||||||||||||||||||||||
Interest-bearing liabilities: | ||||||||||||||||||||||||||||
NOW accounts | $ | 106,832 | 1,292 | 1.21 | % | 75,757 | 688 | 0.91 | % | 60,757 | 628 | 1.03 | % | |||||||||||||||
Regular savings accounts | 21,845 | 72 | 0.33 | % | 21,131 | 75 | 0.35 | % | 21,908 | 95 | 0.44 | % | ||||||||||||||||
Money market accounts | 51,069 | 535 | 1.05 | % | 58,134 | 556 | 0.96 | % | 72,170 | 1,282 | 1.78 | % | ||||||||||||||||
Time deposits | 300,175 | 7,145 | 2.38 | % | 310,991 | 8,157 | 2.62 | % | 285,133 | 10,358 | 3.63 | % | ||||||||||||||||
FHLB borrowings | 58,656 | 2,603 | 4.44 | % | 59,305 | 2,597 | 4.38 | % | 60,956 | 2,659 | 4.36 | % | ||||||||||||||||
Demand notes payable to U.S. Treasury | 678 | 8 | 1.14 | % | 710 | 7 | 0.99 | % | 811 | 12 | 1.46 | % | ||||||||||||||||
Trust preferred securities | 14,433 | 677 | 4.69 | % | 14,433 | 668 | 4.62 | % | 14,433 | 735 | 5.09 | % | ||||||||||||||||
Other | 192 | 3 | 1.46 | % | 215 | 1 | 0.47 | % | 579 | 8 | 1.38 | % | ||||||||||||||||
Total interest-bearing liabilities | 553,880 | 12,335 | 2.23 | % | 540,676 | 12,749 | 2.36 | % | 516,747 | 15,777 | 3.05 | % | ||||||||||||||||
Demand deposits | 78,221 | 67,690 | 59,256 | |||||||||||||||||||||||||
Other liabilities | 2,137 | 2,800 | 2,326 | |||||||||||||||||||||||||
Shareholders' equity | 51,978 | 49,971 | 48,257 | |||||||||||||||||||||||||
Total liabilities and shareholder's equity | $ | 686,216 | 661,137 | 626,586 | ||||||||||||||||||||||||
Net interest spread | $ | 24,379 | 3.42 | % | 22,430 | 3.26 | % | 21,163 | 3.18 | % | ||||||||||||||||||
Net yield on interest-earning assets | 3.75 | % | 3.58 | % | 3.57 | % | ||||||||||||||||||||||
Taxable equivalent adjustment | ||||||||||||||||||||||||||||
Investment securities | $ | 459 | 324 | 316 | ||||||||||||||||||||||||
Net interest income | $ | 23,920 | 22,106 | 20,847 | ||||||||||||||||||||||||
*Includes $40.4 million of U.S. government agency securities that are non-taxable for state income tax purposes. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities. |
Changes in interest income and interest expense can result from variances in both volume and rates. Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.
A-6
Table 2 - Rate/Volume Variance Analysis-Tax Equivalent Basis | |||||||||||||||||||
December 31, 2004 | December 31, 2003 | ||||||||||||||||||
(Dollars in Thousands) | Changes in average volume | Changes in average rates | Total Increase (Decrease) | Changes in average volume | Changes in average rates | Total Increase (Decrease) | |||||||||||||
Interest Income: | |||||||||||||||||||
Loans, net of unearned income | $ | 480 | 241 | 721 | 1,925 | (2,432 | ) | (507 | ) | ||||||||||
Investments - taxable | (575 | ) | (66 | ) | (641 | ) | (757 | ) | (783 | ) | (1,540 | ) | |||||||
Investments - nontaxable | 1,756 | (243 | ) | 1,513 | 570 | (271 | ) | 299 | |||||||||||
Federal funds sold | (26 | ) | 3 | (23 | ) | 30 | (17 | ) | 13 | ||||||||||
Other | (73 | ) | 40 | (33 | ) | 34 | (61 | ) | (27 | ) | |||||||||
Total interest income | $ | 1,562 | (25 | ) | 1,537 | 1,802 | (3,564 | ) | (1,762 | ) | |||||||||
Interest expense: | |||||||||||||||||||
NOW accounts | $ | 329 | 275 | 604 | 146 | (86 | ) | 60 | |||||||||||
Regular savings accounts | 2 | (5 | ) | (3 | ) | (3 | ) | (17 | ) | (20 | ) | ||||||||
Money market accounts | (71 | ) | 50 | (21 | ) | (192 | ) | (534 | ) | (726 | ) | ||||||||
Time deposits | (271 | ) | (741 | ) | (1,012 | ) | 809 | (3,010 | ) | (2,201 | ) | ||||||||
FHLB borrowings | (28 | ) | 34 | 6 | (72 | ) | 10 | (62 | ) | ||||||||||
Demand notes payable to U.S. Treasury | - | 1 | 1 | (1 | ) | (4 | ) | (5 | ) | ||||||||||
Junior subordinated debentures | - | 9 | 9 | - | (67 | ) | (67 | ) | |||||||||||
Other | - | 2 | 2 | (3 | ) | (4 | ) | (7 | ) | ||||||||||
Total interest expense | $ | (39 | ) | (375 | ) | (414 | ) | 684 | (3,712 | ) | (3,028 | ) | |||||||
Net interest income | $ | 1,601 | 350 | 1,951 | 1,118 | 147 | 1,266 |
Net interest income on a tax equivalent basis totaled $24.4 million in 2004, increasing 9% or $2.0 million from 2003. This increase was primarily attributable to an increase in the yield on interest-earning assets combined with a decrease in the cost of funds. The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.42% in 2004, an increase from the 2003 net interest spread of 3.26%. The net yield on interest-earning assets in 2004 increased to 3.75% from the 2003 net interest margin of 3.58%.
Tax equivalent interest income increased $1.5 million or 4% in 2004 primarily due to an increase in the Bank’s prime lending rate from an average rate of 4.12% in 2003 to 4.34% in 2004. The increase in rates combined with a $24.3 million increase in average interest-earning assets resulted in an increase in the yield on interest-earning assets to 5.65% in 2004 as compared to 5.62% in 2003. The $24.3 million increase in average interest-earning assets was attributable primarily to a $21.7 million increase in average investment securities. Average loans in 2004 increased 2% to $547.8 million when compared to 2003. All other interest-earning assets including federal funds sold decreased to $8.6 million in 2004 from $14.1 million in 2003.
Interest expense decreased $414,000 or 3% in 2004 due to a decrease in the average rate paid on interest-bearing liabilities, partially offset by an increase in volume of interest-bearing liabilities. The cost of funds decreased to 2.23% in 2004 from 2.36% in 2003. This decrease in the cost of funds was primarily attributable to a decrease in the average rate paid on certificates of deposit to 2.38% in 2004 from 2.62% in 2003. This decrease in cost was offset by growth in average interest-bearing liabilities, which increased by $13.2 million to $553.9 million in 2004 from $540.7 million in 2003. This growth in average interest-bearing liabilities was attributable to an increase in average interest-bearing deposits, which increased by $13.9 million, to $479.9 million in 2004 from $466.0 million in 2003.
In 2003 net interest income on a tax equivalent basis increased $1.3 million or 6% to $22.4 million in 2003 from $21.2 million in 2002. The interest rate spread was 3.26% in 2003, an increase from the 2002 net interest spread of 3.18%. The net yield on interest-earning assets in 2003 increased to 3.58% from the 2002 net interest margin of 3.57%.
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Provision for Loan Losses.Provision for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Company’s loan portfolio, including the valuation of impaired loans in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114 and No. 118, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.
The provision for loan losses was $3.3 million, $6.7 million, and $5.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. The decrease in the provision for loan losses for 2004 reflects a decrease in classified loans of $10.0 million. Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing possible loan losses
Non-Interest Income. Non-interest income for 2004 totaled $6.1 million, an increase of $132,000 or 2% from non-interest income of $5.9 million for 2003. The increases in non-interest income for 2004 are primarily due to an increase in service charge fee income associated with deposit growth. These increases were partially offset by a decrease in mortgage banking income. Non-interest income for 2003 decreased $565,000 or 9% from non-interest income of $6.5 million for 2002. The decrease in non-interest income for 2003 reflected reductions in gains on sales of securities and increased losses on repossessed assets. These decreases were partially offset by an increase in service charges. Excluding non-recurring gains or losses on the disposition of assets, non-interest income for 2004 and 2003 totaled $6.3 million. Non-interest income, excluding non-recurring gains or losses on the disposition of assets, increased 7% for 2003 when compared to 2002.
Service charges on deposit accounts totaled $3.4 million during 2004, an increase of $168,000, or 5% over 2003. Service charge income increased $206,000, or 7% in 2003 compared to 2002. These increases are primarily attributable to growth in the deposit base coupled with normal pricing changes, which resulted in an increase in account maintenance fees.
The Company reported a net loss on sale of securities of $64,000 in 2004, compared to a net loss on sale of securities of $53,000 during 2003. During 2002 a net gain on sale of securities of approximately $626,000 was recognized.
Mortgage banking income decreased to $394,000 in 2004 from $685,000 in 2003. Management expects that mortgage banking income will continue to be less than prior periods due to a reduction in refinancing activity and expected interest rate increases. In 2004 and 2003 the Company recognized no gains on sale of mortgage loans as compared to a $29,000 gain on sale of mortgage loans recognized during 2002. During 2003 mortgage banking income decreased $17,000 from the $702,000 reported in 2002. The decrease in mortgage banking income for 2003 was primarily attributable to a reduction in net gains recognized on the sale of mortgage loans.
Net losses on repossessed assets were $180,000 for 2004 compared to net losses on repossessed assets of $747,000 for 2003. During 2002 a net loss on repossessed assets of $600 was recognized.
The Company recognized a $479,000 gain on the sale of loans during 2003 as a result of the sale of the Bank’s $3.7 million credit card portfolio in 2003. There were no gains on the sale of loans recognized in 2004 and 2002.
Miscellaneous income for 2004 totaled $1.4 million, an increase of 8% from $1.3 million for 2003. The increase in miscellaneous income was primarily attributable to an increase in debit card fee income. During 2003, miscellaneous income increased 13% primarily due to an increase in vendor commissions.
Table 3 presents a summary of non-interest income for the years ended December 31, 2004, 2003 and 2002.
Table 3 - Non-Interest Income | |||
(Dollars in Thousands) | 2004 | 2003 | 2002 |
Service charges | $ 3,435 | 3,267 | 3,061 |
Other service charges and fees | 677 | 611 | 503 |
Gain (loss) on sale of securities | (64) | (53) | 626 |
Mortgage banking income | 394 | 685 | 702 |
Insurance and brokerage commissions | 430 | 421 | 478 |
Loss on foreclosed and repossessed assets | (179) | (747) | (1) |
Gain on sale of loans | - | 479 | - |
Miscellaneous | 1,365 | 1,263 | 1,122 |
Total non-interest income | $ 6,058 | 5,926 | 6,491 |
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Non-Interest Expense. Total non-interest expense amounted to $20.1 million for 2004, an increase of 10% from 2003. Non-interest expense for 2003 increased 9% to $18.2 million from non-interest expense of $16.8 million for 2002.
Salary and employee benefit expense was $11.5 million in 2004, compared to $10.1 million during 2003, an increase of $1.4 million or 14%, following a $531,000 or 6% increase in salary and employee benefit expense in 2003 over 2002. The 2004 increase in salary and employee benefits is due to normal salary increases, increased incentive expense and increased employee insurance costs. The increase during 2003 is attributable to normal salary increases and increased employee insurance costs.
The Company recorded occupancy expenses of $3.7 million in 2004, compared to $3.4 million during 2003, an increase of $282,000 or 8%, following an increase of $247,000 or 8% in occupancy expenses in 2003 over 2002. The increase in 2004 is primarily due to an increase in repairs and maintenance expense and an increase in lease expense resulting from lease agreements for branch facilities entered into during 2003 and 2004. Increases in 2003 are attributable to an increase in overhead expense associated with the Bank’s growth and expansion of its branch network. During 2003, the Company sold two branch locations with net book values of approximately $3.1 million and is currently leasing the facilities from the buyer. As a result of the sales, the Company deferred a gain of approximately $633,000 and is recognizing the gain over the lease term. Approximately $22,000 and $18,000 of the deferred gain was recognized for the years ended December 31, 2004 and 2003, respectively. Annual rent expense related to these two locations is $237,000.
The total of all other operating expenses increased $170,000 or 4% during 2004. Other operating expense increased $692,000 or 17% in 2003 over 2002. The increase in other expense for 2003 is primarily attributable an increase of $440,000 in consulting and advertising expense due to an aggressive marketing campaign started by the Bank in 2003 and an increase of $403,000 in non-income taxes primarily due to state franchise taxes.
Table 4 presents a summary of non-interest expense for the years ended December 31, 2004, 2003 and 2002.
Table 4 - Non-Interest Expense | ||||||||||
(Dollars in Thousands) | 2004 | 2003 | 2002 | |||||||
Salaries and wages | $ | 8,240 | 7,733 | 7,376 | ||||||
Employee benefits | 3,237 | 2,367 | 2,193 | |||||||
Total personnel expense | 11,477 | 10,100 | 9,569 | |||||||
Occupancy expense | 3,672 | 3,390 | 3,143 | |||||||
Office supplies | 314 | 270 | 283 | |||||||
FDIC deposit insurance | 81 | 82 | 157 | |||||||
Professional services | 290 | 333 | 264 | |||||||
Postage | 211 | 217 | 221 | |||||||
Telephone | 337 | 333 | 315 | |||||||
Director fees and expense | 351 | 234 | 352 | |||||||
Marketing and public relations | 620 | 541 | 219 | |||||||
Merchant processing expense | - | - | 78 | |||||||
Consulting fees | 306 | 280 | 160 | |||||||
Taxes and licenses | 200 | 443 | 40 | |||||||
Other operating expense | 2,198 | 2,005 | 1,957 | |||||||
Total non-interest expense | $ | 20,057 | 18,228 | 16,758 |
Income Taxes.Total income tax expense was $2.2 million in 2004 compared with $1.1 million in 2003 and $1.7 million in 2002. The primary reason for the increase in taxes for 2004 as compared to 2003 and 2002 was the increase in pretax income. The Company’s effective tax rates were 33.51%, 34.50% and 33.26% in 2004, 2003 and 2002, respectively.
Liquidity.The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of December 31, 2004 such unfunded commitments to extend credit were $123.1 million, while commitments in the form of standby letters of credit totaled $3.3 million.
The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which
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includes demand deposits, savings accounts and certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of December 31, 2004, the Company’s core deposits totaled $402.2 million, or 72% of total deposits.
The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased and FHLB advances. The Bank is also able to borrow from the Federal Reserve System on a short-term basis.
At December 31, 2004, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $39.4 million, which mature over the next two years. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits. For additional information, please see the section below entitled “Deposits”.
The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $59.0 million at December 31, 2004. The remaining availability at FHLB was $41.7 million at December 31, 2004. The Bank also had the ability to borrow up to $26.5 million for the purchase of overnight federal funds from three correspondent financial institutions as of December 31, 2004.
The liquidity ratio for the Bank, which is defined as net cash, interest bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 34.82% at December 31, 2004, 26.83% at December 31, 2003 and 17.85% at December 31, 2002. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.
As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $3.1 million during 2004. Net cash used in investing activities of $14.2 million consisted primarily of securities purchased of $48.7 million funded by sales, maturities and paydowns of investment securities of $22.4 million. Net cash provided by financing activities amounted to $7.1 million, consisting of a $6.7 million net increase in deposits.
Asset Liability and Interest Rate Risk Management.The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is to be done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 5 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2004.
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Table 5 - Interest Sensitivity Analysis | |||||||||||||||||||
Total Within | Over One year | ||||||||||||||||||
(Dollars in Thousands) | Immediate | 1-3 months | 4-12 months | One year | & non-sensitive | Total | |||||||||||||
Interest-earning assets: | |||||||||||||||||||
Loans | $ | 422,746 | 14,944 | 9,009 | 446,699 | 88,769 | $ | 535,468 | |||||||||||
Mortgage loans available for sale | 3,783 | - | - | 3,783 | - | 3,783 | |||||||||||||
Investment securities | - | 2,076 | - | 2,076 | 103,522 | 105,598 | |||||||||||||
Federal funds sold | 1,723 | - | - | 1,723 | - | 1,723 | |||||||||||||
Interest-bearing deposit accounts | 1,729 | - | - | 1,729 | - | 1,729 | |||||||||||||
Other interest-earning assets | - | - | - | - | 4,377 | 4,377 | |||||||||||||
Total interest-earning assets | $ | 429,981 | 17,020 | 9,009 | 456,010 | 196,668 | $ | 652,678 | |||||||||||
Interest-bearing liabilities: | |||||||||||||||||||
NOW, savings, and money market deposits | $ | 193,918 | - | - | 193,918 | - | $ | 193,918 | |||||||||||
Time deposits | 59,182 | 57,023 | 105,738 | 221,943 | 62,637 | 284,580 | |||||||||||||
Other short term borrowings | 1,204 | - | - | 1,204 | - | 1,204 | |||||||||||||
FHLB borrowings | 7,000 | - | 5,000 | 12,000 | 47,000 | 59,000 | |||||||||||||
Trust preferred securities | - | 14,433 | - | 14,433 | - | 14,433 | |||||||||||||
Total interest-bearing liabilities | $ | 261,304 | 71,456 | 110,738 | 443,498 | 109,637 | $ | 553,135 | |||||||||||
Interest-sensitive gap | $ | 168,677 | (54,436 | ) | (101,729 | ) | 12,512 | 87,031 | $ | 99,543 | |||||||||
Cumulative interest-sensitive gap | $ | 168,677 | 114,241 | 12,512 | 12,512 | 99,543 | |||||||||||||
Interest-earning assets as a percentage of interest-bearing liabilities | 164.55 | % | 23.82 | % | 8.14 | % | 102.82 | % |
The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.
The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. As shown in table 5, the Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates. Average rate sensitive assets at December 31, 2004 totaled $652.7 million, exceeding average rate sensitive liabilities of $553.1 million by $99.6 million.
In order to assist in achieving a desired level of interest rate sensitivity, the Company entered into off-balance sheet contracts that are considered derivative financial instruments. These contracts consist of interest rate swap agreements under which the Company converted $55.0 million of variable rate loans to a fixed rate. At December 31, 2004, the Company had two interest rate swap contracts outstanding. These swaps are accounted for as cash flow hedges. Under the first swap agreement, the Company receives a fixed rate of 5.22% and pays a variable rate based on the current prime rate (5.25% at December 31, 2004) on a notional amount of $25.0 million. The swap agreement matures in April 2006. Under the second swap agreement, the Company receives a rate of 5.41% and pays a variable rate based on the current prime rate (5.25% at December 31, 2004) on a notional amount of $30.0 million. The swap agreement matures in September 2006. Management believes that the risk associated with using this type of derivative financial instrument to mitigate interest rate risk should not have any material unintended impact on the Company’s financial condition or results of operations.
During 2003, the Company settled two previously outstanding interest rate swap agreements. The first swap, with a notional amount of $40.0 million and scheduled to mature in June 2004 was sold for a gain of $860,000. The second swap with a notional amount of $20.0 million and scheduled to mature in July 2004 was sold for a gain of $394,000. The
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gains realized upon settlement are being recognized over the original term of the agreements and during the year ended December 31, 2004, gains of approximately $553,000 were realized. For the year ended December 31, 2003, gains of approximately $701,000 were realized.
The Bank also utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At December 31, 2004, there were $3.6 million in loans that are tied to the prime rate and had interest rate floors in effect pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 0.43% higher than the indexed rate on the promissory notes without the interest rate floors.
An analysis of the Company’s financial condition and growth can be made be examining the changes and trends in interest-earning assets and interest-bearing liabilities, and a discussion of these changes and trends follows.
Analysis of Financial Condition
Investment Securities.All of the Company’s investment securities are held in the available-for-sale (“AFS”) category.At December 31, 2004 the market value of AFS securities totaled $105.6 million, compared to $79.5 million and $71.7 million at December 31, 2003 and 2002, respectively. The increase in 2004 investment securities is attributable to additional securities purchases, which were partially offset by paydowns on mortgage-backed securities and maturities during 2004. This increase in AFS securities reflects management’s directed effort to increase investment securities as a percentage of total assets in an effort to reduce the credit risk in the balance sheet. Table 6 presents the market value of the AFS securities held at December 31, 2004, 2003 and 2002.
Table 6 - Summary of Investment Portfolio | ||||||||||
(Dollars in Thousands) | 2004 | 2003 | 2002 | |||||||
Obligations of United States government | ||||||||||
agencies and corporations | $ | 46,570 | 34,517 | - | ||||||
Obligations of states and political subdivisions | 20,649 | 14,950 | 14,350 | |||||||
Mortgage backed securities | 36,543 | 24,920 | 52,386 | |||||||
Trust preferred securities | 1,750 | 5,000 | 5,000 | |||||||
Equity securities | 86 | 73 | - | |||||||
Total securities | $ | 105,598 | 79,460 | 71,736 |
The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.
The Company’s investment portfolio consists of U.S. government agency securities, municipal securities, U.S. government agency sponsored mortgage-backed securities, trust preferred securities and equity securities. AFS securities averaged $93.8 million in 2004, $72.1 million in 2003 and $77.4 million in 2002. Table 7 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2004. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity and yields are calculated on a tax equivalent basis.Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 34% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.
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Table 7 - Maturity Distribution and Weighted Average Yield on Investments | |||||||||||||||||||||||||||||||
One Year or Less | After One Year Through 5 Years | After 5 Years Through 10 Years | After 10 Years | Totals | |||||||||||||||||||||||||||
(Dollars in Thousands) | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | |||||||||||||||||||||
Book value: | |||||||||||||||||||||||||||||||
United States Government agencies | $ | - | - | 21,500 | 3.48 | % | 24,999 | 4.47 | % | - | - | $ | 46,499 | 4.01 | % | ||||||||||||||||
States and political subdivisions | 981 | 7.07 | % | 4,687 | 6.06 | % | 10,620 | 4.46 | % | 3,924 | 7.08 | % | 20,212 | 5.47 | % | ||||||||||||||||
Mortgage backed securities | - | - | - | - | 14,998 | 3.93 | % | 21,495 | 4.37 | % | 36,493 | 4.19 | % | ||||||||||||||||||
Trust preferred securities | - | - | - | - | - | - | 1,750 | 5.50 | % | 1,750 | 5.50 | % | |||||||||||||||||||
Equity securities | - | - | - | - | - | - | 100 | 1.58 | % | 100 | 1.58 | % | |||||||||||||||||||
Total securities | $ | 981 | 7.07 | % | 26,187 | 3.94 | % | 50,617 | 4.31 | % | 27,269 | 4.82 | % | $ | 105,054 | 4.38 | % |
LoansThe loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg County. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. In management’s opinion, there are nosignificant concentrations of credit with particular borrowers engaged in similar activities.
The composition of the Company’s loan portfolio is presented in table 8.
Table 8 - Loan Portfolio | |||||||||||||||||||||||||||||||
2004 | 2003 | 2002 | 2001 | 2000 | |||||||||||||||||||||||||||
(Dollars in Thousands) | Amount | % of Loans | Amount | % of Loans | Amount | % of Loans | Amount | % of Loans | Amount | % of Loans | |||||||||||||||||||||
Breakdown of loan receivables: | |||||||||||||||||||||||||||||||
Commercial | $ | 79,189 | 14.79 | % | 90,558 | 16.41 | % | 92,141 | 17.51 | % | 102,409 | 20.87 | % | 96,882 | 23.58 | % | |||||||||||||||
Real estate - mortgage | 312,988 | 58.45 | % | 332,730 | 60.26 | % | 322,987 | 61.36 | % | 277,737 | 56.61 | % | 229,260 | 55.79 | % | ||||||||||||||||
Real estate - construction | 127,042 | 23.73 | % | 110,392 | 19.99 | % | 80,552 | 15.30 | % | 82,791 | 16.88 | % | 58,939 | 14.34 | % | ||||||||||||||||
Consumer | 16,249 | 3.03 | % | 18,446 | 3.34 | % | 30,690 | 5.83 | % | 27,671 | 5.64 | % | 25,858 | 6.29 | % | ||||||||||||||||
Total loans | $ | 535,468 | 100.00 | % | 552,126 | 100.00 | % | 526,370 | 100.00 | % | 490,608 | 100.00 | % | 410,939 | 100.00 | % | |||||||||||||||
Less: Allowance for loan losses | $ | 8,049 | 9,722 | 7,248 | 6,091 | 4,713 | |||||||||||||||||||||||||
Net loans | $ | 527,419 | 542,404 | 519,122 | 484,517 | 406,226 |
As of December 31, 2004, gross loans outstanding were $535.5 million, a decrease of $16.7 million or 3% from the December 31, 2003 balance of $552.1 million. Commercial loans declined $11.3 million in 2004 primarily due to payoffs of several large commercial loans. Real estate mortgage loans decreased $19.7 million when compared to 2003 due to a decrease in commercial real estate loans. Real estate construction loans grew $16.7 million in 2004 as a result of an increase in real estate development loans. Consumer loans decreased $2.2 million in 2004.
Mortgage loans held for sale were $3.8 million at December 31, 2004, an increase of $3.2 million from the December 31, 2003 balance of $587,000 which represented a decrease of $4.5 million from the December 31, 2002 balance of $5.1 million.
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Table 9 identifies the maturities of all loans as of December 31, 2004 and addresses the sensitivity of these loans to changes in interest rates.
Table 9 - Maturity and Repricing Data for Loans | |||||||||||||
(Dollars in Thousands) | Within one year or less | After one year through five years | After five years | Total Loans | |||||||||
Commercial | $ | 73,727 | 4,249 | 1,213 | $ | 79,189 | |||||||
Real estate - mortgage | 246,341 | 34,265 | 32,382 | 312,988 | |||||||||
Real estate - construction | 119,732 | 6,962 | 348 | 127,042 | |||||||||
Consumer | 6,899 | 8,351 | 999 | 16,249 | |||||||||
Total loans | $ | 446,699 | 53,827 | 34,942 | $ | 535,468 | |||||||
Total fixed rate loans | $ | 13,514 | 53,040 | 34,942 | $ | 101,496 | |||||||
Total floating rate loans | 433,185 | 787 | - | 433,972 | |||||||||
Total loans | $ | 446,699 | 53,827 | 34,942 | $ | 535,468 |
In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2004, outstanding loan commitments totaled $123.1 million. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Additional information regarding commitments is provided below in the section entitled “Contractual Obligations” and in Note 10 to the Consolidated Financial Statements.
Allowance for Loan Losses.The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
· | the Bank’s loan loss experience; |
· | the amount of past due and non-performing loans; |
· | specific known risks; |
· | the status and amount of other past due and non-performing assets; |
· | underlying estimated values of collateral securing loans; |
· | current and anticipated economic conditions; and |
· | other factors which management believes affect the allowance for potential credit losses. |
An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank’s credit administration personnel and presented to the Bank’s Board of Directors on a monthly basis. The allowance is the total of specific reserves allocated to significant individual loans plus a general reserve. After individual loans with specific allocations have been deducted, the general reserve is calculated by applying general reserve percentages to the nine risk grades within the portfolio. Loans are categorized as one of nine risk grades based on management’s assessment of the overall credit quality of the loan, including payment history, financial position of the borrower, underlying collateral and internal credit review. The general reserve percentages are determined by management based on its evaluation of losses inherent in the various risk grades of loans. The allowance for loan losses is established through charges to expense in the form of a provision for loan losses. Loan losses and recoveries are charged and credited directly to the allowance
An allowance for loan losses is also established, as necessary, for individual loans considered to be impaired in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114. A loan is considered impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected. Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of collateral if the loan is collateral dependent. At December 31, 2004 and 2003, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $5.3 million and $4.6 million, respectively, with related allowance for
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loan losses of $787,000 and $1.5 million, respectively.
The Bank’s allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses compared to a group of peer banks identified by the regulators. During their routine examinations of banks, the FDIC and the North Carolina Commissioner of Banks may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
While it is the Bank's policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. After review of all relevant matters affecting loan collectability, management believes that the allowance for loan losses is appropriate.
The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg County. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. At December 31, 2004, approximately 6% of the Company’s portfolio was not secured by any type of collateral. Unsecured loans generally involve higher credit risk than secured loans, and in the event of customer default, the Company has a higher exposure to potential loan losses.
Net charge-offs for 2004 were $4.9 million. The ratio of net charge-offs to average total loans was 0.90% in 2004, 0.79% in 2003 and 0.84% in 2002. Charge-offs in 2004 included charges of $1.0 million and $550,000 related to loans to customers that were formerly directors of the Company. The allowance for loan losses decreased to $8.0 million or 1.50% of total loans outstanding at December 31, 2004. This decrease in the allowance for loan losses was the result of a reduction in classified loans. For December 31, 2003 and 2002, the allowance for loan losses amounted to $9.7 million, or 1.76% of total loans outstanding and $7.2 million, or 1.38% of total loans outstanding, respectively.
Table 10 presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at December 31, 2004 and 2003.
Table 10 - Loan Risk Grade Analysis | |||||||||||||
Percentage of Loans | General Reserve | ||||||||||||
By Risk Grade | Percentage | ||||||||||||
Risk Grade | 2004 | 2003 | 2004 | 2003 | |||||||||
Risk 1 (Excellent Quality) | 13.44 | % | 11.36 | % | 0.15 | % | 0.15 | % | |||||
Risk 2 (High Quality) | 23.03 | % | 24.03 | % | 0.50 | % | 0.50 | % | |||||
Risk 3 (Good Quality) | 53.89 | % | 53.80 | % | 1.00 | % | 1.00 | % | |||||
Risk 4 (Management Attention) | 5.67 | % | 5.11 | % | 2.50 | % | 2.50 | % | |||||
Risk 5 (Watch) | 0.95 | % | 1.15 | % | 7.00 | % | 7.00 | % | |||||
Risk 6 (Substandard) | 0.61 | % | 2.43 | % | 12.00 | % | 12.00 | % | |||||
Risk 7 (Low Substandard) | 1.46 | % | 1.33 | % | 25.00 | % | 25.00 | % | |||||
Risk 8 (Doubtful) | 0.00 | % | 0.00 | % | 50.00 | % | 50.00 | % | |||||
Risk 9 (Loss) | 0.00 | % | 0.00 | % | 100.00 | % | 100.00 | % |
At December 31, 2004, there was one relationship which exceeded $1.0 million totaling $1.2 million in the Watch risk grade, three relationships that exceeded $1.0 million each totaling $4.1 million in the Substandard risk grade and three relationships which exceed $1.0 million each totaling $8.7 million in the Low Substandard risk grade. Balances of individual relationships exceeding $1.0 million in these risk grades ranged from $1.2 million to $3.9 million. These customers continue to meet payment requirements and these relationships would not become non-performing assets unless they are unable to meet those requirements.
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Table 11 presents an analysis of the allowance for loan losses, including charge-off activity.
Table 11 - Analysis of Allowance for Loan Losses | |||||
(Dollars in Thousands) | 2004 | 2003 | 2002 | 2001 | 2000 |
Reserve for loan losses at beginning | $ 9,722 | 7,248 | 6,091 | 4,713 | 3,924 |
Loans charged off: | |||||
Commercial | 1,004 | 1,179 | 3,737 | 842 | 857 |
Real estate - mortgage | 3,842 | 2,422 | 158 | 790 | 10 |
Real estate - construction | 4 | 251 | - | 51 | 36 |
Consumer | 535 | 630 | 546 | 675 | 255 |
Total loans charged off | 5,385 | 4,482 | 4,441 | 2,358 | 1,158 |
Recoveries of losses previously charged off: | |||||
Commercial | 162 | 36 | 40 | 84 | 20 |
Real estate - mortgage | 144 | 18 | - | - | - |
Real estate - construction | - | 1 | 4 | 6 | - |
Consumer | 150 | 157 | 122 | 101 | 48 |
Total recoveries | 456 | 212 | 166 | 191 | 68 |
Net loans charged off | 4,929 | 4,270 | 4,275 | 2,167 | 1,090 |
Provision for loan losses | 3,256 | 6,744 | 5,432 | 3,545 | 1,879 |
Reserve for loan losses at end of year | $ 8,049 | 9,722 | 7,248 | 6,091 | 4,713 |
Loans charged off net of recoveries, as | |||||
a percent of average loans outstanding | 0.90% | 0.79% | 0.84% | 0.48% | 0.29% |
Non-performing Assets.Non-performing assets, comprised of non-accrual loans, other real estate owned, other repossessed assets and loans for which payments are more than 90 days past due totaled $6.0 million at December 31, 2004 compared to $6.3 million at December 31, 2003. Non-accrual loans were $5.1 million at December 31, 2004, an increase of $755,000 from non-accruals of $4.3 million at December 31, 2003. As a percentage of loans outstanding, non-accrual loans were 0.95% and 0.79% at December 31, 2004 and 2003, respectively. The Bank had loans ninety days past due and still accruing at December 31, 2004 of $245,000 as compared to $271,000 for the same period in 2003. Other real estate owned totaled $682,000 and $1.4 million as of December 31, 2004 and 2003, respectively. Repossessed assets, primarily consisting of aircraft taken in collection of loans, totaled $206,000 as of December 31, 2003. The Bank had no repossessed assets as of December 31, 2004.
At December 31, 2004 the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $5.3 million or 1.00% of total loans. Non-performing loans for 2003 were $4.6 million, or 0.84% of total loans and $4.8 million, or 0.92% of total loans for 2002. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2004, 2003 and 2002, had they performed in accordance with their original terms, amounted to approximately $264,000, $400,000 and $484,000 respectively. Interest income on impaired loans included in the results of operations for 2004, 2003, and 2002 amounted to approximately $130,000, $82,000 and $22,000, respectively.
Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing. Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans.
It is the general policy of the Company to stop accruing interest income and place the recognition of interest on a cash basis when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed
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against current income. Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.
A summary of non-performing assets at December 31 for each of the years presented is shown in Table 12.
Table 12 - Non-performing Assets | ||||||||||||||||
(Dollars in Thousands) | 2004 | 2003 | 2002 | 2001 | 2000 | |||||||||||
Non-accrual loans | $ | 5,097 | 4,343 | 4,602 | 3,756 | 5,421 | ||||||||||
Loans 90 days or more past due and still accruing | 245 | 271 | 239 | 655 | 545 | |||||||||||
Total non-performing loans | 5,342 | 4,614 | 4,841 | 4,411 | 5,966 | |||||||||||
All other real estate owned | 682 | 1,447 | 240 | 256 | 112 | |||||||||||
All other repossessed assets | - | 206 | 1,538 | 4 | 3 | |||||||||||
Total non-performing assets | $ | 6,024 | 6,267 | 6,619 | 4,671 | 6,081 | ||||||||||
As a percent of total loans at year end | ||||||||||||||||
Non-accrual loans | 0.95 | % | 0.79 | % | 0.87 | % | 0.77 | % | 1.32 | % | ||||||
Loans 90 days or more past due and still accruing | 0.05 | % | 0.05 | % | 0.05 | % | 0.13 | % | 0.13 | % | ||||||
Total non-performing assets | 1.12 | % | 1.14 | % | 1.26 | % | 0.95 | % | 1.48 | % |
Deposits.The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2004, total deposits were $556.5 million, an increase of $6.7 million or 1% increase over the December 31, 2003 balance of $549.8 million. The increase in deposits is primarily attributable to growth in core deposits, which include demand deposits, savings accounts and certificates of deposits of denominations less than $100,000, to $402.2 million at December 31, 2004 from $378.2 million at December 31, 2003. The increase in core deposits resulted primarily from an increase in the Bank’s Investment Checking product. The Company chose to price the Investment Checking product at a level which attracted new deposits but was more cost effective than brokered deposits.
Time deposits in amounts of $100,000 or more totaled $154.3 million at December 31, 2004, $171.6 million and $160.8 million at December 31, 2003 and 2002, respectively. This decrease is due to a reduction in brokered deposits that were replaced with core deposits. At December 31, 2004, brokered deposits amounted to $39.4 million as compared to $55.5 million at December 31, 2003. Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market. Brokered deposits outstanding as of December 31, 2004 have a weighted average rate of 2.38% with a weighted average original term of 23 months.
Table 13 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2004.
Table 13 - Maturities of Time Deposits over $100,000 | ||||
(Dollars in Thousands) | 2004 | |||
Three months or less | $ | 52,243 | ||
Over three months through six months | 19,933 | |||
Over six months through twelve months | 31,784 | |||
Over twelve months | 50,341 | |||
Total | $ | 154,301 |
Borrowed Funds.The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions. At December 31, 2004, FHLB borrowings totaled $59.0 million compared to $58.0 million at December 31, 2003 and $63.1 million at December 31, 2002. Average FHLB borrowings for 2004 were $58.7 million, compared to average balances of $59.3 million for 2003 and $61.0 million for 2002. The maximum amount of outstanding FHLB borrowings was $70.7 million in 2004, and $75.1 in 2003 and $74.2 in 2002. The FHLB advances outstanding at December 31, 2004 had both fixed and adjustable interest rates ranging from 2.19% to 6.49%. Currently $12.0 million of the FHLB advances outstanding have contractual maturities prior to December 31, 2005. As of December 31, 2004, the Company had $52.0 million in convertible FHLB advances. Additional information regarding FHLB advances is provided in note 6 to the consolidated financial statements.
Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from
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customers, amounted to approximately $1.2 million, $443,000 and $1.6 million at December 31, 2004, 2003 and 2002, respectively.
The Company had no federal funds purchased as of December 31, 2004, 2003 or 2002.
Junior Subordinated Debentures (related to Trust Preferred Securities).In December 2001 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier 1 capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay a floating rate equal to prime plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. PEBK Trust is not included in the consolidated financial statements at December 31, 2004, 2003 or 2002.
The trust preferred securities accrue and pay quarterly distributions based on the liquidation value of $50,000 per capital security at a floating rate of prime plus 50 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.
The trust preferred securities are mandatorily redeemable upon maturity of the debentures on December 31, 2031, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust, in whole or in part, on or after December 31, 2006. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
Contractual Obligations and Off-Balance Sheet Arrangements.The Company’s contractual obligations and other commitments as of December 31, 2004 are summarized in Table 14 below. The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
Table 14 - Contractual Obligations and Other Commitments | ||||||||||||||||
(Dollars in Thousands) | Within one year | One to Three Years | Three to Five Years | Five Years or More | Total | |||||||||||
Contractual Cash Obligations | ||||||||||||||||
Long-term borrowings* | $ | 10,000 | - | - | 47,000 | $ | 57,000 | |||||||||
Junior subordinated debentures | - | - | - | 14,433 | 14,433 | |||||||||||
Operating lease obligations | 811,653 | 1,324,960 | 1,316,550 | 4,826,917 | 8,280,080 | |||||||||||
Total | $ | 821,653 | 1,324,960 | 1,316,550 | 4,888,350 | $ | 8,351,513 | |||||||||
Other Commitments | ||||||||||||||||
Commitments to extend credit | $ | 48,441 | 12,070 | 15,354 | 47,229 | $ | 123,094 | |||||||||
Standby letters of credit | ||||||||||||||||
and financial guarantees written | 3,144 | 134 | - | - | 3,278 | |||||||||||
Total | $ | 51,585 | 12,204 | 15,354 | 47,229 | $ | 126,372 | |||||||||
*Excludes $2.0 million adjustable rate credit due to the FHLB, which matured in February 2005. |
The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Therefore, the derivative liabilities recorded on the balance sheet under “Accrued interest payable and other liabilities” as of December 31, 2004 do not represent the amounts that may ultimately be paid under these contracts. Further discussions of derivative instruments are
A-18
included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-10 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.
Capital Resources.Shareholders’ equity at December 31, 2004 was $50.9 million compared to $48.6 million at December 31, 2003 and 2002. At December 31, 2004, unrealized gains and losses, net of taxes, amounted to a loss of $121,000. For the years ended December 31, 2003 and 2002, unrealized gains and losses, net of taxes, amounted to gains of $588,000 and $1.4 million, respectively. Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength. Average shareholders’ equity as a percentage of total average assets was 7.59%, 7.56% and 7.72% for 2004, 2003 and 2002. The return on average shareholders’ equity was 8.52% at December 31, 2004 as compared to 4.01% and 7.12% as of December 31, 2003 and December 31, 2002, respectively. Total cash dividends paid during 2004, 2003 and 2002 amounted to $1.3 million.
In 2004, the Company repurchased $291,000, or 15,100 shares of its common stock as part of the stock repurchase plan implemented in November 2004, which expires in November 2005. The Company repurchased $1.3 million, or 85,500 shares of its common stock in 2002 as part of the stock repurchase plan implemented in February 2002, which expired in February 2003.
Under regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital at December 31, 2004, 2003 and 2002 includes $14.0 million in trust preferred securities. The Company’s Tier I capital ratio was 10.97%, 10.50% and 10.76% at December 31, 2004, 2003 and 2002, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 12.22%, 11.75% and 12.01% at December 31, 2004, 2003 and 2002, respectively. In addition to the Tier I and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier I leverage capital ratio was 9.50%, 9.37% and 9.78% at December 31, 2004, 2003 and 2002, respectively.
The Bank’s Tier 1 risk-based capital ratio was 10.35%, 9.87% and 10.48% at December 31, 2004, 2003 and 2002, respectively. The total risk-based capital ratio for the Bank was 11.60%, 11.13% and 11.73% at December 31, 2004, 2003 and December 31, 2002, respectively. The Bank’s Tier 1 leverage capital ratio was 8.95%, 8.80% and 9.52% at December 31, 2004, 2003 and 2002 respectively.
A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at December 31, 2004, 2003 and 2002.
The capital treatment of trust preferred securities has been reviewed recently by the Federal Reserve Bank. The Federal Reserve Bank’s proposal for capital treatment of trust preferred securities, released May 4, 2004, would continue to permit the inclusion of trust preferred securities in Tier 1 capital of bank holding companies. Further discussions of FIN 46 are included under “Recent Accounting Pronouncements” in Note 1 of the Notes to Consolidated Financial Statements.
The Company’s key equity ratios as of December 31, 2004, 2003 and 2002 are presented in Table 15.
Table 15 - Equity Ratios | |||
2004 | 2003 | 2002 | |
Return on average assets | 0.65% | 0.30% | 0.55% |
Return on average equity | 8.52% | 4.01% | 7.12% |
Dividend payout ratio | 28.37% | 62.56% | 36.58% |
Average equity to average assets | 7.59% | 7.56% | 7.72% |
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Quarterly Financial Data.The Company’s consolidated quarterly operating results for the years ended December 31, 2004 and 2003 are presented in table 16.
Table 16 - Quarterly Financial Data | |||||||||||||||||||||||||
2004 | 2003 | ||||||||||||||||||||||||
(Dollars in thousands, except per share amounts) | First | Second | Third | Fourth | First | Second | Third | Fourth | |||||||||||||||||
Total interest income | $ | 8,928 | 8,841 | 9,125 | 9,361 | $ | 8,694 | 8,651 | 8,610 | 8,899 | |||||||||||||||
Total interest expense | 3,066 | 3,002 | 3,103 | 3,164 | 3,238 | 3,216 | 3,193 | 3,101 | |||||||||||||||||
Net interest income | 5,862 | 5,839 | 6,022 | 6,197 | 5,456 | 5,435 | 5,417 | 5,798 | |||||||||||||||||
Provision for loan losses | 859 | 868 | 931 | 598 | 793 | 2,277 | 1,560 | 2,114 | |||||||||||||||||
Other income | 1,508 | 1,536 | 1,559 | 1,455 | 1,984 | 1,056 | 1,590 | 1,295 | |||||||||||||||||
Other expense | 4,720 | 4,873 | 4,990 | 5,474 | 4,447 | 4,175 | 4,821 | 4,785 | |||||||||||||||||
Income before income taxes | 1,791 | 1,634 | 1,660 | 1,580 | 2,200 | 39 | 626 | 194 | |||||||||||||||||
Income taxes | 613 | 547 | 552 | 522 | 782 | (52 | ) | 307 | 18 | ||||||||||||||||
Net earnings | $ | 1,178 | 1,087 | 1,108 | 1,058 | $ | 1,418 | 91 | 319 | 176 | |||||||||||||||
Basic earnings per share | $ | 0.38 | 0.35 | 0.35 | 0.34 | $ | 0.45 | 0.03 | 0.10 | 0.06 | |||||||||||||||
Diluted earnings per share | $ | 0.37 | 0.34 | 0.35 | 0.33 | $ | 0.45 | 0.03 | 0.10 | 0.06 |
A-20
QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates. This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.
The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off balance sheet derivative instruments. During the years ended December 31, 2004, 2003 and 2002, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management”.
Table 17 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments and the notional amount and estimated fair value of the Company’s off-balance sheet derivative instruments at their expected maturity dates for the period ended December 31, 2004. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2004. As of December 31, 2004, all fixed rate advances are callable at the option of FHLB. For core deposits without contractual maturity (i.e. interest bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.
Table 17 - Market Risk Table | ||||||||||||||||||||||
(Dollars In Thousands) | Principal/Notional Amount Maturing in Year Ended December 31, | |||||||||||||||||||||
Loans Receivable | 2005 | 2006 | 2007 | 2008 & 2009 | Thereafter | Total | Fair Value | |||||||||||||||
Fixed rate | $ | 21,608 | 14,883 | 13,375 | 24,393 | 27,237 | $ | 101,496 | $ | 99,895 | ||||||||||||
Average interest rate | 6.78 | % | 7.09 | % | 7.08 | % | 6.51 | % | 6.44 | % | ||||||||||||
Variable rate | $ | 164,485 | 58,032 | 47,387 | 69,035 | 95,033 | $ | 433,972 | $ | 433,972 | ||||||||||||
Average interest rate | 6.04 | % | 5.97 | % | 6.03 | % | 6.11 | % | 5.89 | % | ||||||||||||
$ | 535,468 | $ | 533,867 | |||||||||||||||||||
Investment Securities | ||||||||||||||||||||||
Interest-bearing cash | $ | - | - | - | - | 1,729 | $ | 1,729 | $ | 1,729 | ||||||||||||
Average interest rate | - | - | - | - | 2.13 | % | ||||||||||||||||
Federal funds sold | $ | 1,723 | - | - | - | - | $ | 1,723 | $ | 1,723 | ||||||||||||
Average interest rate | 2.09 | % | - | - | - | - | ||||||||||||||||
Securities available for sale | $ | 23,132 | 2,433 | 1,633 | 28,948 | 49,452 | $ | 105,598 | $ | 105,598 | ||||||||||||
Average interest rate | 4.64 | % | 3.40 | % | 6.15 | % | 3.18 | % | 4.48 | % | ||||||||||||
Nonmarketable equity securities | $ | - | - | - | - | 4,377 | $ | 4,377 | $ | 4,377 | ||||||||||||
Average interest rate | - | - | - | - | 3.42 | % | ||||||||||||||||
Debt Obligations | ||||||||||||||||||||||
Deposits | $ | 192,910 | 37,496 | 43,025 | 13,782 | 269,309 | $ | 556,522 | $ | 555,808 | ||||||||||||
Average interest rate | 2.04 | % | 2.73 | % | 3.58 | % | 3.57 | % | 0.90 | % | ||||||||||||
Advances from FHLB | $ | 12,000 | 35,000 | - | 12,000 | - | $ | 59,000 | $ | 61,637 | ||||||||||||
Average interest rate | 4.22 | % | 4.08 | % | - | 6.04 | % | - | ||||||||||||||
Demand notes payable to U.S. Treasury | $ | 1,184 | - | - | - | - | $ | 1,184 | $ | 1,184 | ||||||||||||
Average interest rate | 2.19 | % | - | - | - | - | ||||||||||||||||
Junior subordinated debentures | $ | - | - | - | - | 14,433 | $ | 14,433 | $ | 14,433 | ||||||||||||
Average interest rate | - | - | - | - | 5.47 | % |
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Table 18 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps”. The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1% and 2% as compared to the estimated theoretical impact of rates remaining unchanged. The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the theoretical impact of rates remaining unchanged. The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates. This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes. Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.
Table 18 - Interest Rate Risk | |||||||
(Dollars in thousands) | |||||||
Estimated Resulting Theoretical Net Interest Income | |||||||
Hypothetical rate change (ramp over 12 months) | Amount | % Change | |||||
+2% | $ | 28,572 | 7.66% | ||||
+1% | $ | 27,591 | 3.96% | ||||
0% | $ | 26,540 | 0.00% | ||||
-1% | $ | 25,501 | -3.91% | ||||
-2% | $ | 24,619 | -7.24% | ||||
Estimated Resulting Theoretical Market Value of Equity | |||||||
Hypothetical rate change (immediate shock) | Amount | % Change | |||||
+2% | $ | 48,415 | -8.31% | ||||
+1% | $ | 51,097 | -3.23% | ||||
0% | $ | 52,801 | 0.00% | ||||
-1% | $ | 52,629 | -0.33% | ||||
-2% | $ | 51,181 | -3.07% |
A-22
MARKET FOR THE COMPANY’S COMMON EQUITY
AND RELATED SHAREHOLDER MATTERS
Peoples Bancorp common stock is traded on the over-the-counter (OTC) market and quoted on the Nasdaq National Market, under the symbol “PEBK”. Scott and Stringfellow, Inc., Ryan, Beck & Co., Sterne Agee & Leach, Inc. and Trident Securities, Inc. are market makers for the Company’s shares.
Although the payment of dividends by the Company is subject to certain requirements and limitations of North Carolina corporate law, neither the Commissioner nor the FDIC have promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares. However, the ability of the Company to pay dividends and repurchase shares may be dependent upon the Company’s receipt of dividends from the Bank. The Bank’s ability to pay dividends is limited. North Carolina commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. Dividends may be paid by the Bank from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by North Carolina law. Also, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is defined in the applicable law and regulations). Based on its current financial condition, the Bank does not expect that this provision will have any impact on the Bank’s ability to pay dividends.
As of March 11, 2005, the Company had 704 shareholders of record, not including the number of persons or entities whose stock is held in nominee or street name through various brokerage firms or banks. The market price for the Company’s common stock was $18.69 on March 11, 2005.
Table 19 presents certain market and dividend information for the last two fiscal years. Over-the-counter quotations reflect inter-dealer prices, without retail mark-up, mark down or commission and may not necessarily represent actual transactions.
Table 19 - Market and Dividend Data | ||||||||||
Cash Dividend | ||||||||||
2004 | Low Bid | High Bid | Per Share | |||||||
First Quarter | $ | 17.42 | $ | 20.07 | $ | 0.10 | ||||
Second Quarter | $ | 17.70 | $ | 19.74 | $ | 0.10 | ||||
Third Quarter | $ | 18.19 | $ | 19.90 | $ | 0.10 | ||||
Fourth Quarter | $ | 18.03 | $ | 20.00 | $ | 0.10 | ||||
Cash Dividend | ||||||||||
2003 | Low Bid | High Bid | Per Share | |||||||
First Quarter | $ | 13.91 | $ | 15.10 | $ | 0.10 | ||||
Second Quarter | $ | 14.75 | $ | 18.25 | $ | 0.10 | ||||
Third Quarter | $ | 16.38 | $ | 19.00 | $ | 0.10 | ||||
Fourth Quarter | $ | 16.91 | $ | 20.82 | $ | 0.10 |
A-23
DIRECTORS AND OFFICERS OF THE COMPANY
DIRECTORS
Robert C. Abernethy - Chairman
Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;
President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)
James S. Abernethy
President and Assistant Secretary, Midstate Contractors, Inc. (paving company)
Douglas S. Howard
Vice President, Howard Ventures, Inc.
John W. Lineberger, Jr.
President, Lincoln Bonded Warehouse Company (commercial warehousing and distribution facility)
Gary E. Matthews
President and Director, Matthews Construction Company, Inc.
Charles F. Murray
President, Murray’s Hatchery, Inc.
Billy L. Price, Jr. MD
Practicing Internist and Partner, Catawba Valley Internal Medicine, P.A.
Larry E. Robinson
President and Chief Executive Officer, Blue Ridge Distributing Co., Inc. (beer and wine distributor)
& President and Chief Executive Officer, Associated Brands, Inc. (beer and wine distributor)
Fred L. Sherrill, Jr.
Retired (furniture manufacturing executive)
William Gregory (Greg) Terry
Executive Vice President, Drum & Willis Funeral Homes and Crematory
Dan Ray Timmerman, Sr.
President, Timmerman Manufacturing, Inc. (wrought iron furniture manufacturer)
Benjamin I. Zachary
General Manager, Treasurer, Secretary and Member of the Board of Directors,
Alexander Railroad Company
OFFICERS
Tony W. Wolfe
President and Chief Executive Officer
Joseph F. Beaman, Jr.
Executive Vice President and Corporate Secretary
Lance A. Sellers
Executive Vice President and Assistant Corporate Secretary
William D. Cable
Executive Vice President and Assistant Corporate Treasurer
A. Joseph Lampron
Executive Vice President, Chief Financial Officer and Corporate Treasurer
A-24
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Peoples Bancorp of North Carolina, Inc.
Newton, North Carolina
We have audited the consolidated balance sheets ofPeoples Bancorp of North Carolina, Inc.as of December 31, 2004 and 2003,and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provided a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position ofPeoples Bancorp of North Carolina, Inc.as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity withaccounting principles generally accepted in the United States of America.
/s/ Porter Keadle Moore, LLP
Atlanta, Georgia
January 13, 2005
A-25
PEOPLES BANCORP OF NORTH CAROLINA, INC. | |||||||
Consolidated Balance Sheets | |||||||
December 31, 2004 and 2003 | |||||||
Assets | 2004 | 2003 | |||||
Cash and due from banks, including reserve requirements | |||||||
of $4,643,000 and $3,262,000 | $ | 15,067,871 | 18,413,786 | ||||
Federal funds sold | 1,723,000 | 2,369,000 | |||||
Cash and cash equivalents | 16,790,871 | 20,782,786 | |||||
Investment securities available for sale | 105,598,106 | 79,460,452 | |||||
Other investments | 5,396,959 | 4,216,973 | |||||
Total securities | 110,995,065 | 83,677,425 | |||||
Mortgage loans held for sale | 3,783,175 | 587,495 | |||||
Loans | 535,467,733 | 552,126,189 | |||||
Less allowance for loan losses | (8,048,627 | ) | (9,722,267 | ) | |||
Net loans | 527,419,106 | 542,403,922 | |||||
Premises and equipment, net | 12,742,730 | 12,537,230 | |||||
Cash surrender value of life insurance | 6,034,188 | 5,045,449 | |||||
Accrued interest receivable and other assets | 8,582,937 | 8,998,137 | |||||
Total assets | $ | 686,348,072 | 674,032,444 | ||||
Liabilities and Shareholders' Equity | |||||||
Deposits: | |||||||
Non interest-bearing demand | $ | 78,024,194 | 72,420,923 | ||||
NOW, MMDA and savings | 193,917,507 | 158,677,445 | |||||
Time, $100,000 or more | 154,300,926 | 171,596,789 | |||||
Other time | 130,279,446 | 147,107,075 | |||||
Total deposits | 556,522,073 | 549,802,232 | |||||
Demand notes payable to U.S. Treasury | 1,184,392 | 443,384 | |||||
FHLB borrowings | 59,000,000 | 58,000,000 | |||||
Junior subordinated debentures | 14,433,000 | 14,433,000 | |||||
Accrued interest payable and other liabilities | 4,270,755 | 2,799,932 | |||||
Total liabilities | 635,410,220 | 625,478,548 | |||||
Shareholders' equity: | |||||||
Preferred stock, no par value; authorized | |||||||
5,000,000 shares; no shares issued | |||||||
and outstanding | - | - | |||||
Common stock, no par value; authorized | |||||||
20,000,000 shares; issued and | |||||||
outstanding 3,135,074 shares in 2004 | |||||||
and 3,135,202 shares in 2003 | 35,040,390 | 35,121,510 | |||||
Retained earnings | 16,018,206 | 12,844,524 | |||||
Accumulated other comprehensive income | (120,744 | ) | 587,862 | ||||
Total shareholders' equity | 50,937,852 | 48,553,896 | |||||
Total liabilities and shareholders' equity | $ | 686,348,072 | 674,032,444 | ||||
See accompanying notes to consolidated financial statements. |
A-26
PEOPLES BANCORP OF NORTH CAROLINA, INC. | ||||||||||
Consolidated Statements of Earnings | ||||||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||||||
2004 | 2003 | 2002 | ||||||||
Interest income: | ||||||||||
Interest and fees on loans | $ | 32,253,161 | 31,531,673 | 32,038,359 | ||||||
Interest on federal funds sold | 35,236 | 58,384 | 45,271 | |||||||
Interest on investment securities: | ||||||||||
U.S. Government agencies | 2,903,865 | 2,244,375 | 3,439,814 | |||||||
States and political subdivisions | 660,227 | 577,339 | 613,219 | |||||||
Other | 402,080 | 441,958 | 487,284 | |||||||
Total interest income | 36,254,569 | 34,853,729 | 36,623,947 | |||||||
Interest expense: | ||||||||||
NOW, MMDA and savings deposits | 1,899,249 | 1,318,820 | 2,006,077 | |||||||
Time deposits | 7,145,486 | 8,157,388 | 10,358,168 | |||||||
FHLB borrowings | 2,602,866 | 2,597,043 | 2,658,742 | |||||||
Junior subordinated debentures | 676,547 | 667,526 | 735,000 | |||||||
Other | 10,518 | 7,891 | 19,344 | |||||||
Total interest expense | 12,334,666 | 12,748,668 | 15,777,331 | |||||||
Net interest income | 23,919,903 | 22,105,061 | 20,846,616 | |||||||
Provision for loans losses | 3,256,000 | 6,743,900 | 5,431,600 | |||||||
Net interest income after provision for loan losses | 20,663,903 | 15,361,161 | 15,415,016 | |||||||
Other income: | ||||||||||
Service charges | 3,434,544 | 3,266,949 | 3,060,581 | |||||||
Other service charges and fees | 677,191 | 610,591 | 503,165 | |||||||
Gain (loss) on sale of securities | (63,688 | ) | (52,855 | ) | 625,616 | |||||
Mortgage banking income | 394,456 | 685,343 | 702,290 | |||||||
Insurance and brokerage commissions | 429,788 | 420,762 | 477,765 | |||||||
Gain (loss) on sale of repossessed assets | (179,886 | ) | (746,543 | ) | (564 | ) | ||||
Gain on sale of loans | - | 478,759 | - | |||||||
Miscellaneous | 1,365,397 | 1,262,883 | 1,121,762 | |||||||
Total other income | 6,057,802 | 5,925,889 | 6,490,615 | |||||||
Other expense: | ||||||||||
Salaries and employee benefits | 11,477,495 | 10,099,811 | 9,569,016 | |||||||
Occupancy | 3,672,051 | 3,389,857 | 3,142,712 | |||||||
Other | 4,907,923 | 4,738,253 | 4,046,347 | |||||||
Total other expenses | 20,057,469 | 18,227,921 | 16,758,075 | |||||||
Earnings before income taxes | 6,664,236 | 3,059,129 | 5,147,556 | |||||||
Income taxes | 2,233,300 | 1,055,538 | 1,712,000 | |||||||
Net earnings | $ | 4,430,936 | 2,003,591 | 3,435,556 | ||||||
Basic earnings per share | $ | 1.28 | 0.58 | 0.99 | ||||||
Diluted earnings per share | $ | 1.26 | 0.58 | 0.99 | ||||||
Cash dividends per share | $ | 0.36 | 0.36 | 0.36 | ||||||
See accompanying notes to consolidated financial statements. |
A-27
PEOPLES BANCORP OF NORTH CAROLINA, INC. | ||||||||||||||||
Consolidated Statements of Changes in Shareholders' Equity | ||||||||||||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||||||||||||
Accumulated | ||||||||||||||||
Other | ||||||||||||||||
Common Stock | Retained | Comprehensive | ||||||||||||||
Shares | Amount | Earnings | Income (Loss) | Total | ||||||||||||
Balance, December 31, 2001 | 3,218,714 | $ | 36,407,798 | 9,915,399 | (922,094 | ) | 45,401,103 | |||||||||
Cash dividends declared | - | - | (1,256,592 | ) | - | (1,256,592 | ) | |||||||||
Repurchase and retirement of common | ||||||||||||||||
stock | (85,500 | ) | (1,314,250 | ) | - | - | (1,314,250 | ) | ||||||||
Exercise of stock options | 333 | 4,225 | - | - | 4,225 | |||||||||||
Net earnings | - | - | 3,435,556 | - | 3,435,556 | |||||||||||
Change in accumulated other | ||||||||||||||||
comprehensive income (loss), net of tax | - | - | - | 2,334,691 | 2,334,691 | |||||||||||
Balance, December 31, 2002 | 3,133,547 | 35,097,773 | 12,094,363 | 1,412,597 | 48,604,733 | |||||||||||
Cash dividends declared | - | - | (1,253,430 | ) | - | (1,253,430 | ) | |||||||||
Exercise of stock options | 1,655 | 23,737 | - | - | 23,737 | |||||||||||
Net earnings | - | - | 2,003,591 | - | 2,003,591 | |||||||||||
Change in accumulated other | ||||||||||||||||
comprehensive income (loss), net of tax | - | - | - | (824,735 | ) | (824,735 | ) | |||||||||
Balance, December 31, 2003 | 3,135,202 | 35,121,510 | 12,844,524 | 587,862 | 48,553,896 | |||||||||||
Cash dividends declared | - | - | (1,257,254 | ) | - | (1,257,254 | ) | |||||||||
Repurchase and retirement of common | ||||||||||||||||
stock | (15,100 | ) | (290,826 | ) | - | - | (290,826 | ) | ||||||||
Exercise of stock options | 14,972 | 209,706 | - | - | 209,706 | |||||||||||
Net earnings | - | - | 4,430,936 | - | 4,430,936 | |||||||||||
Change in accumulated other | ||||||||||||||||
comprehensive income (loss), net of tax | - | - | - | (708,606 | ) | (708,606 | ) | |||||||||
Balance, December 31, 2004 | 3,135,074 | $ | 35,040,390 | 16,018,206 | (120,744 | ) | 50,937,852 | |||||||||
See accompanying notes to consolidated financial statements. |
A-28
PEOPLES BANCORP OF NORTH CAROLINA, INC. | ||||||||||
Consolidated Statements of Comprehensive Income | ||||||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||||||
2004 | 2003 | 2002 | ||||||||
Net earnings | $ | 4,430,936 | 2,003,591 | 3,435,556 | ||||||
Other comprehensive income (loss): | ||||||||||
Unrealized holding gains (losses) on securities | ||||||||||
available for sale arising during the year | 30,988 | (419,147 | ) | 2,951,843 | ||||||
Reclassification adjustment for gains (losses) on | ||||||||||
sales of securities available for sale included | ||||||||||
in net earnings | 63,688 | 52,855 | (625,616 | ) | ||||||
Unrealized holding gains (losses) on derivative | ||||||||||
financial instruments qualifying as cash flow | ||||||||||
hedges arising during the year | (702,000 | ) | (284,000 | ) | 1,498,000 | |||||
Reclassification adjustment for gains on derivative | ||||||||||
financial instruments qualifying as cash flow | ||||||||||
hedges included in net earnings | (553,375 | ) | (700,626 | ) | - | |||||
Total other comprehensive income (loss), | ||||||||||
before income taxes | (1,160,699 | ) | (1,350,918 | ) | 3,824,227 | |||||
Income tax expense (benefit) related to other | ||||||||||
comprehensive income: | ||||||||||
Unrealized holding gains (losses) on securities | ||||||||||
available for sale arising during the year | 12,070 | (163,258 | ) | 1,149,742 | ||||||
Reclassification adjustment for gains (losses) on | ||||||||||
sales of securities available for sale included | ||||||||||
in net earnings | 24,806 | 20,587 | (243,677 | ) | ||||||
Unrealized holding gains (losses) on derivative | ||||||||||
financial instruments qualifying as cash flow | ||||||||||
hedges arising during the year | (273,429 | ) | (110,618 | ) | 583,471 | |||||
Reclassification adjustment for gains on derivative | ||||||||||
financial instruments qualifying as cash flow | ||||||||||
hedges included in net earnings | (215,540 | ) | (272,894 | ) | - | |||||
Total income tax expense (benefit) related to | ||||||||||
other comprehensive income | (452,093 | ) | (526,183 | ) | 1,489,536 | |||||
Total other comprehensive income (loss), | ||||||||||
net of tax | (708,606 | ) | (824,735 | ) | 2,334,691 | |||||
Total comprehensive income | $ | 3,722,330 | 1,178,856 | 5,770,247 | ||||||
See accompanying notes to consolidate financial statements. |
A-29
PEOPLES BANCORP OF NORTH CAROLINA, INC. | ||||||||||
Consolidated Statements of Cash Flows | ||||||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||||||
2004 | 2003 | 2002 | ||||||||
Cash flows from operating activities: | $ | 4,430,936 | 2,003,591 | 3,435,556 | ||||||
Net earnings | ||||||||||
Adjustments to reconcile net earnings to | ||||||||||
net cash provided by operating activities: | ||||||||||
Depreciation, amortization and accretion | 1,563,245 | 1,963,995 | 1,685,715 | |||||||
Provision for loan losses | 3,256,000 | 6,743,900 | 5,431,600 | |||||||
Deferred income taxes | 341,441 | (1,526,062 | ) | (318,921 | ) | |||||
Loss (gain) on sale of investment securities | 63,688 | 52,855 | (625,616 | ) | ||||||
Recognition of gain on sale of derivative instruments | (553,375 | ) | (700,626 | ) | - | |||||
Gain on sale of loans | - | (478,759 | ) | - | ||||||
Amortization of deferred gain on sale of premises | (22,412 | ) | - | - | ||||||
Loss (gain) on sale of repossessed assets | 15,412 | 262,840 | (19,981 | ) | ||||||
Writedown of other real estate and repossessions | 164,474 | 483,703 | - | |||||||
Change in: | ||||||||||
Mortgage loans held for sale | (3,195,680 | ) | 4,477,140 | 274,296 | ||||||
Cash surrender value of life insurance | (988,739 | ) | (216,741 | ) | (245,708 | ) | ||||
Other assets | (3,442,472 | ) | 377,900 | (595,240 | ) | |||||
Other liabilities | 1,470,823 | (4,582 | ) | 178,282 | ||||||
Net cash provided by operating activities | 3,103,341 | 13,439,154 | 9,199,983 | |||||||
Cash flows from investing activities: | ||||||||||
Purchases of investment securities available for sale | (48,667,610 | ) | (55,439,455 | ) | (48,339,951 | ) | ||||
Proceeds from calls and maturities of investment securities | ||||||||||
available for sale | 19,413,975 | 27,158,675 | 28,609,785 | |||||||
Proceeds from sales of investment securities available | ||||||||||
for sale | 2,986,313 | 19,896,324 | 35,191,263 | |||||||
Purchases of other investments | (4,822,500 | ) | (925,000 | ) | (300,000 | ) | ||||
Proceeds from sale of other investments | 3,642,514 | 953,600 | 557,200 | |||||||
Net change in loans | 12,578,820 | (31,533,937 | ) | (42,113,346 | ) | |||||
Proceeds from sale of loans | - | 4,207,206 | - | |||||||
Purchases of premises and equipment | (1,502,346 | ) | (1,913,876 | ) | (2,614,380 | ) | ||||
Proceeds from sale of premises and equipment | - | - | 412,289 | |||||||
Proceeds from sale of repossessed assets | 2,153,103 | 1,502,891 | 488,647 | |||||||
Proceeds from sale of derivative financial instruments | - | 1,254,000 | - | |||||||
Net cash used by investing activities | (14,217,731 | ) | (34,839,572 | ) | (28,108,493 | ) | ||||
Cash flows from financing activities: | ||||||||||
Net change in deposits | 6,719,841 | 34,063,277 | 25,515,766 | |||||||
Net change in demand notes payable to U.S. Treasury | 741,008 | (1,156,616 | ) | 1,482,013 | ||||||
Proceeds from FHLB borrowings | 95,850,000 | 46,650,000 | 68,100,000 | |||||||
Repayments of FHLB borrowings | (94,850,000 | ) | (51,721,429 | ) | (73,242,857 | ) | ||||
Transaction costs associated with junior | ||||||||||
subordinated debentures | - | - | (105,450 | ) | ||||||
Proceeds from exercise of stock options | 209,706 | 23,737 | 4,225 | |||||||
Common stock repurchased | (290,826 | ) | - | (1,314,250 | ) | |||||
Cash dividends paid | (1,257,254 | ) | (1,253,430 | ) | (1,256,592 | ) | ||||
Net cash provided by financing activities | 7,122,475 | 26,605,539 | 19,182,855 | |||||||
Net change in cash and cash equivalent | (3,991,915 | ) | 5,205,121 | 274,345 | ||||||
Cash and cash equivalents at beginning of period | 20,782,786 | 15,577,665 | 15,303,320 | |||||||
Cash and cash equivalents at end of period | $ | 16,790,871 | 20,782,786 | 15,577,665 | ||||||
A-30
PEOPLES BANCORP OF NORTH CAROLINA, INC. | ||||||||||
Consolidated Statements of Cash Flows, continued | ||||||||||
For the Years ended December 31, 2004, 2003 and 2002 | ||||||||||
2004 | 2003 | 2002 | ||||||||
Supplemental disclosures of cash flow information: | ||||||||||
Cash paid during the year for: | ||||||||||
Interest | $ | 11,833,234 | 12,975,587 | 16,006,155 | ||||||
Income taxes | $ | 2,483,394 | 2,093,000 | 2,235,500 | ||||||
Noncash investing and financing activities: | ||||||||||
Change in unrealized gain (loss) on investment securities | ||||||||||
available for sale, net | $ | 57,800 | (223,621 | ) | 2,334,691 | |||||
Change in unrealized gain (loss) on derivative financial | ||||||||||
instruments, net | $ | (766,406 | ) | (173,382 | ) | - | ||||
Transfer of loans to other real estate and repossessions | $ | 1,362,138 | 3,382,633 | 2,077,057 | ||||||
Financed portion of sale of other real estate | $ | 2,212,142 | 1,258,500 | - | ||||||
Financed portion of sale of premises and equipment | $ | - | 3,729,932 | - | ||||||
See accompanying notes to consolidated financial statements. |
A-31
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Notes to Consolidated Financial Statements
(1) Summary of Significant Accounting Policies
Organization
Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999. Bancorp is primarily regulated by the Federal Reserve Bank, and serves as the one-bank holding company for Peoples Bank.
Peoples Bank (the “Bank”) commenced business in 1912 upon receipt of its banking charter from the North Carolina State Banking Commission (the “SBC”). The Bank is primarily regulated by the SBC and the Federal Deposit Insurance Corporation and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg and Iredell counties in North Carolina.
Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.
Real Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.
Principles of Consolidation
The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
Basis of Presentation
The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.
Cash and Cash Equivalents
Cash and due from banks and federal funds sold are considered cash and cash equivalents for cash flow reporting purposes. Generally, federal funds are sold for one-day periods.
Investment Securities
The Company classifiesits securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2004 and 2003, the Company had classified all of its investment securities as available for sale.
Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.
A decline in the market value of any available for sale investment below cost that is deemed other than temporary is charged to earnings and establishes a new cost basis for the security.
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment t to the yield. Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.
A-32
Other Investments
Other investments include equity securities with no readily determinable fair value. These investments are carried at cost.
Mortgage Loan Held for Sale
Mortgage loans heldfor sale are carried at the lower of aggregate cost or market value. At December 31, 2004 and 2003, the cost of mortgage loans held for sale approximates the market value.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. Loan origination fees and direct origination costs of loans are recognized at the time the loan is recorded on the books. Because the loan origination fee approximates the cost of most loans, the effect on net income is immaterial.
Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected.
Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings and interest is recognized on a cash basis when such loans are placed on nonaccrual status.
Allowance for Loan Losses
The allowance for loanlosses is established through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. The allowance represents an amount, which, in management’s judgment, will be adequate to absorb probable losses on existing loans that may become uncollectible.
Management’s judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans. These evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay, overall portfolio quality, and review of specific problem loans. In determining the adequacy of the allowance for loan losses, management uses a loan grading system that rates individual loans into nine risk classifications. These risk categories are assigned allocations of loss based on management’s estimate of potential loss which is generally based on an analysis of historical loss experience, current economic conditions, performance trends, and discounted collateral deficiencies. The combination of these results is compared monthly to the recorded allowance for loan losses and material differences are adjusted by increasing or decreasing the provision for loan losses. Management uses an independent external loan reviewer to challenge and corroborate the loan grading system and provide additional analysis in determining the adequacy of the allowance for loan losses and the future provisions for estimated losses.
While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. 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 recognize additions to the allowance based on judgments different than those of management.
Mortgage Banking Activities
Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Company’s origination of single-family residential mortgage loans.
Mortgage servicing rights represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee. Mortgage servicing rights are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans. The Company recognized new servicing assets of approximately $37,600 during 2002 and amortized approximately $88,000, $338,000 and $310,000 during 2004, 2003 and 2002, respectively. No new servicing assets were recognized during 2004 and 2003.
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Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $22.6 million, $29.7 million and $56.7 million at December 31, 2004, 2003 and 2002, respectively.
The Company originates certain fixed rate mortgage loans and commits these loans for sale. The commitments to originate fixed rate mortgage loans and the commitments to sell these loans to a third party are both derivative contracts. These derivative contracts, which exactly and equally offset each other, are entered into simultaneously and therefore have no effect on the recorded amounts in the financial statements.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for the period. The cost of maintenance and repairs which do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:
Buildings and improvements | 10 - 50 years | |
Furniture and equipment | 3 - 10 years |
Foreclosed Assets
Foreclosed assetsinclude all assets received in full or partial satisfaction of a loan and include real and personal property. Foreclosed assets are reported at the lower of carrying amount or net realizable value, and are included in other assets on the balance sheet.
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.
In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.
Derivative Financial Instruments and Hedging Activities
In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.
On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.
If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.
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The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.
Advertising Costs
The costs of advertising costs are expensed as incurred.
Accumulated Other Comprehensive Income
At December 31, 2004, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $332,000 and net unrealized losses on derivatives of $453,000. At December 31, 2003, accumulated other comprehensive income (loss) consisted of net unrealized gains on securities available for sale of $274,000, net unrealized losses on derivatives of $24,000 and net deferred gains on the sale of derivative financial instruments of $338,000.
Stock-Based Compensation
The Company’s stock-based compensation plan is accounted for under Accounting Principles Board Opinion No. 25 and related interpretations. No compensation expense has been recognized related to the grant of the incentive stock options. Had compensation cost been determined based upon the fair value of the options at the grant dates, the Company’s net earnings and net earnings per share would have been reduced to the proforma amounts indicated below.
2004 | 2003 | 2002 | |||||||||||
Net earnings | As reported | $ | 4,430,936 | 2,003,591 | 3,435,556 | ||||||||
Effect of grants, net of tax | (190,747 | ) | - | (276,415 | ) | ||||||||
Effect of forfeitures, net of tax | 8,603 | - | 42,982 | ||||||||||
Proforma | $ | 4,248,792 | 2,003,591 | 3,202,123 | |||||||||
Basic earnings per share | As reported | $ | 1.28 | 0.58 | 0.99 | ||||||||
Proforma | $ | 1.23 | 0.58 | 0.92 | |||||||||
Diluted earnings per share | As reported | $ | 1.26 | 0.58 | 0.99 | ||||||||
Proforma | $ | 1.21 | 0.58 | 0.92 |
The weighted average fair value of options at grant date in 2004 and 2002 was $4.27 and $6.60, respectively. The fair value of each option is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted average assumptions used for grants in 2004 and 2002, respectively - dividend yield of 2.14% and 2.8%, respectively; risk free interest rate of 4.22% and 4.00%, respectively; expected volatility of 0.153 and 0.53, respectively; and an expected life of 10 years.
Net Earnings Per Share
Net earnings per share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per share. The average market price during the year is used to compute equivalent shares. For the year ended December 31, 2002 net earnings per share equaled diluted earnings per share, as the potential common shares outstanding during the period had no effect on the computation.
The reconciliations of the amounts used in the computation of both “basic earnings per share” and “diluted earnings per share” for the years ended December 31, 2004, 2003 and 2002 are as follows:
For the year ended December 31, 2004: | Net Earnings | Common Shares | Per Share Amount | ||||
Basic earnings per share | $ | 4,430,936 | 3,459,379 | $ | 1.28 | ||
Effect of dilutive securities: | |||||||
Stock options | - | 47,604 | |||||
Diluted earnings per share | $ | 4,430,936 | 3,506,983 | $ | 1.26 |
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For the year ended December 31, 2003: | Net Earnings | Common Shares | Per Share Amount | ||||
Basic earnings per share | $ | 2,003,591 | 3,447,056 | $ | 0.58 | ||
Effect of dilutive securities: | |||||||
Stock options | - | 29,703 | |||||
Diluted earnings per share | $ | 2,003,591 | 3,476,759 | $ | 0.58 | ||
For the year ended December 31, 2002: | Net Earnings | Common Shares | Per Share Amount | ||||
Basic earnings per share | $ | 3,435,556 | 3,467,173 | $ | 0.99 | ||
Effect of dilutive securities: | |||||||
Stock options | - | 8,023 | |||||
Diluted earnings per share | $ | 3,435,556 | 3,475,196 | $ | 0.99 |
At December 31, 2002 a total of 93,023 potential common shares related to stock options were not included in the computation of diluted earnings per share because they would have been antidulutive.
During first quarter 2005, the Company declared and distributed a 10% stock dividend to its shareholders. All previously reported per share amounts have been restated to reflect the stock dividend.
Recent Accounting Pronouncements
In January2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51” (“FIN 46”). In December 2003, the FASB issued a revised version of FIN 46 to resolve certain questions and confusion related to the application of the original FIN 46. The Company adopted FIN 46 (Revised) as of December 31, 2003, and as a result, the Company’s wholly owned subsidiary, PEBK Capital Trust I, is no longer included in these consolidated financial statements. The consolidated financial statements have been restated for all periods presented to reflect this change in accounting, and the adoption of FIN 46 (Revised) had no impact on the Company’s reported results of operations or stockholders’ equity.
In January 2004, the FASB issued as tentative guidance, Derivatives Implementation Group Issue G25, “Cash Flow Hedges: Hedging the Variable Interest Payments on a Group of Prime-Rate-Based Interest-Bearing Loans.” Issue G25 provides guidance for entities wishing to hedge the variability in loan interest receipts that are tied to the prime rate and other issues associated with cash flow hedges. Issue G25 was revised and was cleared by the FASB in July 2004. The revised guidance does allow for hedging a pool of non-benchmark-rate assets or liabilities by entering into an interest rate swap whose floating leg is also based on the prime rate or another non-benchmark-rate. Therefore, management expects that the interest rate swaps hedging prime-rate based loans discussed in note 11 to the consolidated financial statements will continue to be treated as cash flow hedges and that the Company will not have to record changes in value as a component of current earnings nor terminate the swaps as long as the hedge is effective
In November 2003, the Emerging Issues Task Force (“EITF”) of the Financial Accounting Standards Board (“FASB”) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on determining other-than-temporary impairments and its application to marketableequity securities and debt securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” In September 2004, the FASB issued FASB Staff Position (“FSP”) EITF Issue 03-1-1 which delayed the effective date for the measurement and recognition guidance contained in the EITF 03-1 pending finalization of the draft FSP EITF Issue 03-1-a, “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1.” The disclosure requirements of EITF 03-1 remain in effect. The Company adopted the disclosure requirements of EITF 03-1 as of December 31, 2003. The adoption of the recognition and measurement provisions of EITF 03-1 are not expected to have a material impact on the Company’s results of operations, financial position or cash flows.
In December 2004, the FASB revised SFAS No. 123 (“SFAS No. 123 (R)”). SFAS No. 123 (R), “Share-Based Payment”, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS No. 123 (R) is effective for periods beginning after June 15, 2005. The Company is still evaluating the transition provisions allowed by SFAS No. 123 (R) and expects to adopt in the third quarter of 2005. The financial statement impact is not expected to be materially different from that shown in the existing pro forma disclosure required under the original SFAS No. 123.
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(2) Investment Securities
Investment securities available for sale at December 31, 2004 and 2003 are as follows:
December 31, 2004 | |||||||||||||
Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Estimated Fair Value | ||||||||||
Mortgage-backed securities | $ | 36,492,826 | 188,816 | 138,443 | 36,543,199 | ||||||||
U.S. government agencies | 46,498,958 | 170,574 | 99,195 | 46,570,337 | |||||||||
State and political subdivisions | 20,212,105 | 546,905 | 110,189 | 20,648,821 | |||||||||
Trust preferred securities | 1,750,000 | - | - | 1,750,000 | |||||||||
Equity securities | 99,995 | - | 14,246 | 85,749 | |||||||||
Total | $ | 105,053,884 | 906,295 | 362,073 | 105,598,106 | ||||||||
December 31, 2003 | |||||||||||||
Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Estimated Fair Value | ||||||||||
Mortgage-backed securities | $ | 24,911,000 | 96,142 | 87,282 | 24,919,860 | ||||||||
U.S. government agencies | 34,545,774 | 107,847 | 136,375 | 34,517,246 | |||||||||
State and political subdivisions | 14,454,137 | 559,907 | 64,137 | 14,949,907 | |||||||||
Trust preferred securities | 5,000,000 | - | - | 5,000,000 | |||||||||
Equity securities | 99,995 | - | 26,556 | 73,439 | |||||||||
Total | $ | 79,010,906 | 763,896 | 314,350 | 79,460,452 |
The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2004 are summarized in the table below, with the length of time the individual securities have been in a continuous loss position.
December 31, 2004 | ||||||||||||
Less than 12 Months | 12 Months or More | Total | ||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||
Mortgage-backed securities | $ | 9,706,756 | 100,854 | 2,625,755 | 37,589 | 12,332,511 | 138,443 | |||||
U.S. government agencies | 14,910,156 | 85,488 | 2,986,293 | 13,707 | 17,896,449 | 99,195 | ||||||
State and political subdivisions | 7,118,463 | 110,189 | - | - | 7,118,463 | 110,189 | ||||||
Equity securities | - | - | 85,749 | 14,246 | 85,749 | 14,246 | ||||||
Total | $ | 31,735,375 | 296,531 | 5,697,797 | 65,542 | 37,433,172 | 362,073 | |||||
December 31, 2003 | ||||||||||||
Less than 12 Months | 12 Months or More | Total | ||||||||||
Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||
Mortgage-backed securities | $ | 11,510,389 | 87,282 | - | - | 11,510,389 | 87,282 | |||||
U.S. government agencies | 7,911,840 | 136,375 | - | - | 7,911,840 | 136,375 | ||||||
State and political subdivisions | 2,267,965 | 64,137 | - | - | 2,267,965 | 64,137 | ||||||
Equity securities | 73,439 | 26,556 | - | - | 73,439 | 26,556 | ||||||
Total | $ | 21,763,633 | 314,350 | - | - | 21,763,633 | 314,350 |
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At December 31, 2004, unrealized losses in the investment securities portfolio related to debt securities totaled $347,827. The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary. From the December 31, 2004 tables above, 19 out of 67 securities issued by state and political subdivisions contained unrealized losses and 25 out of 51 securities issued by U.S. government agencies and government sponsored corporations, including mortgage-backed securities, contained unrealized losses. These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.
The amortized cost and estimated fair value of investment securities available for sale at December 31, 2004, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Cost | Estimated Fair Value | ||||
Due within one year | $ | 981,041 | 990,079 | ||
Due from one to five years | 26,186,619 | 26,351,012 | |||
Due from five to ten years | 35,619,670 | 35,725,854 | |||
Due after ten years | 5,673,733 | 5,902,213 | |||
Mortgage-backed securities | 36,492,826 | 36,543,199 | |||
Equity securities | 99,995 | 85,749 | |||
Total | $ | 105,053,884 | 105,598,106 |
Proceeds from sales of securities available for sale during 2004, 2003 and 2002 were $3.0 million, $19.9 million and $35.2 million, respectively. Gross gains of $626,000 for 2002, along with gross losses of $64,000 and $53,000 for 2004 and 2003, respectively, were realized on those sales.
Securities with a carrying value of approximately $23.7 million and $20.1 million at December 31, 2004 and 2003, respectively, were pledged to secure public deposits and for other purposes as required by law.
(3) Loans
Major classifications of loans at December 31, 2004 and 2003 are summarized as follows:
2004 | 2003 | ||||
Commercial | $ | 79,189,073 | 90,557,643 | ||
Real estate - mortgage | 312,988,293 | 332,729,979 | |||
Real estate - construction | 127,041,980 | 110,392,005 | |||
Consumer | 16,248,387 | 18,446,562 | |||
Total loans | 535,467,733 | 552,126,189 | |||
Less allowance for loan losses | 8,048,627 | 9,722,267 | |||
Total net loans | $ | 527,419,106 | 542,403,922 |
The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg County.Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate which is dependent upon the real estate market.
At December 31, 2004 and 2003, the recorded investment in loans that were considered to be impaired was approximately $5.3 million and $4.6 million, respectively, of which approximately $5.1 million at December 31, 2004 and $4.3 million at December 31, 2003 was on nonaccrual. In addition, the Company had approximately $245,000 and $271,000 in loans past due more than ninety days and still accruing interest at December 31, 2004 and 2003, respectively. The related allowance for loan losses on impaired loans was approximately $787,000 and $1.5 million at December 31, 2004 and 2003, respectively. The average recorded investment in impaired loans for
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the twelve months ended December 31, 2004 and 2003 was approximately $5.3 million and $7.7 million, respectively. For the years ended December 31, 2004, 2003 and 2002, the Company recognized approximately $130,000, $82,000 and $22,000, respectively, of interest income on impaired loans.
Changes in the allowance for loan losses were as follows:
2004 | 2003 | 2002 | ||||
Balance at beginning of year | $ | 9,722,267 | 7,247,906 | 6,090,570 | ||
Amounts charged off | (5,385,199) | (4,481,548) | (4,441,007) | |||
Recoveries on amounts previously charged off | 455,559 | 212,009 | 166,743 | |||
Provision for loan losses | 3,256,000 | 6,743,900 | 5,431,600 | |||
Balance at end of year | $ | 8,048,627 | 9,722,267 | 7,247,906 |
(4) Premises and Equipment
Major classifications of premises and equipment are summarized as follows:
2004 | 2003 | |||
Land | $ | 2,170,514 | 1,915,954 | |
Buildings and improvements | 10,138,526 | 9,982,688 | ||
Furniture and equipment | 11,679,698 | 10,618,908 | ||
Total premises and equipment | 23,988,738 | 22,517,550 | ||
Less accumulated depreciation | 11,246,008 | 9,980,320 | ||
Total net premises and equipment | $ | 12,742,730 | 12,537,230 |
Depreciation expense was approximately $1.3 million for the years ended December 31, 2004, 2003 and 2002.
During 2003, the Company sold two branch locations with net book values of approximately $3,115,000 and is currently leasing the facilities from the buyer. As a result of the sales, the Company deferred a gain of approximately $633,000 and is recognizing the gain over the lease term. For the periods ended December 31, 2004 and 2003, the Company recognized approximately $22,000 and $18,000 of the deferred gain, respectively.
(5) Time Deposits
At December 31, 2004, the scheduled maturities of time deposits are as follows:
2005 | $ | 221,940,040 | |
2006 | 30,697,184 | ||
2007 | 18,161,287 | ||
2008 | 6,660,115 | ||
2009 and thereafter | 7,121,746 | ||
Total | $ | 284,580,372 |
At December 31, 2004 and 2003, the Company has approximately $39.4 million and $55.5 million, respectively, in time deposits purchased through third party brokers. The weighted average rate of brokered deposits as of December 31, 2004 was 2.38%.
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(6) Federal Home Loan Bank Advances
The Bank has advances from theFederal Home Loan Bank (“FHLB”) with monthly interest payments at various maturity dates and interest rates ranging from 2.19% to 6.49% at December 31, 2004. The FHLB advances are collateralized by a blanket assignment on all residential first mortgage loans, commercial real estate loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns. At December 31, 2004, the carrying value of loans pledged as collateral totaled approximately $169.9 million.
Advances from the FHLB outstanding at December 31, 2004 consist of the following:
Maturity Date | Call Date | Rate | Rate Type | Amount | |
February 5, 2005 | N/A | 2.440% | Daily Rate | $ | 2,000,000 |
July 5, 2005 | October 5, 2000 and every three | ||||
months thereafter | 6.160% | Convertible | 5,000,000 | ||
March 30, 2010 | March 30, 2001 and every three | ||||
months thereafter | 6.020% | Convertible | 5,000,000 | ||
March 30, 2010 | September 30, 2000 and every three | ||||
months thereafter | 5.880% | Convertible | 5,000,000 | ||
May 24, 2010 | May 24, 2001 and every three | ||||
months thereafter | 6.490% | Convertible | 2,000,000 | ||
January 10, 2011 | January 10, 2002 and every three | ||||
months thereafter | 4.200% | Convertible | 5,000,000 | ||
May 2, 2011 | May 2, 2002 and every three | ||||
months thereafter | 4.055% | Convertible | 30,000,000 | ||
January 26, 2005 | N/A | 2.190% | Adjustable | 5,000,000 | |
$ | 59,000,000 |
TheFHLB has the option to convert $52.0 million of the total advances outstanding into three month LIBOR-based floating rate advances. If the FHLB elects to convert the advances, the Bank may terminate the transaction without payment of a prepayment fee.
The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. At December 31, 2004 and 2003, the Bank owned FHLB stock amounting to $4.0 million and $3.1 million, respectively.
(7) Junior Subordinated Debentures
In December 2001, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay interest at a floating rate equal to prime plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. As discussed in note 1, PEBK Trust was deconsolidated by the Company under FIN 46 (Revised).
The trust preferred securities accrue and pay quarterly distributions based on the liquidation value of $50,000 per capital security at a floating rate of prime plus 50 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.
The trust preferred securities are mandatorily redeemable upon maturity of the debentures on December 31, 2031, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures
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purchased by PEBK Trust, in whole or in part, on or after December 31, 2006. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
(8) Income Taxes
The provision for income taxes in summarized as follows:
2004 | 2003 | 2002 | ||||
Current | $ | 1,891,859 | 2,581,600 | 2,030,921 | ||
Deferred | 341,441 | (1,526,062) | (318,921) | |||
Total | $ | 2,233,300 | 1,055,538 | 1,712,000 |
The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:
��
2004 | 2003 | 2002 | ||||
Pre-tax income at statutory rates (34%) | $ | 2,265,840 | 1,040,104 | 1,750,169 | ||
Differences: | ||||||
Tax exempt interest income | (243,346) | (216,431) | (231,395) | |||
Nondeductible interest and other expense | 21,588 | 18,668 | 24,088 | |||
Cash surrender value of life insurance | (65,871) | (73,692) | (83,541) | |||
State taxes, net of federal benefits | 236,544 | 270,493 | 230,088 | |||
Other, net | 18,545 | 16,396 | 22,591 | |||
Total | $ | 2,233,300 | 1,055,538 | 1,712,000 |
The following summarized the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities. The net deferred tax asset is included as a component of other assets at December 31, 2004 and 2003.
2004 | 2003 | ||||
Deferred tax assets: | |||||
Allowance for loan losses | $ | 3,103,068 | 3,566,467 | ||
Amortizable intangible assets | 173,548 | 209,849 | |||
Accrued retirement expense | 454,446 | 332,575 | |||
Income from non-accrual loans | 23,309 | 23,309 | |||
Deferred gain on sale of premises | 228,932 | - | |||
Deferred gain on sale of cash flow hedges | - | 217,284 | |||
Unrealized loss on cash flow hedges | 289,009 | 15,580 | |||
Other | 28,965 | 25,047 | |||
Total gross deferred tax assets | 4,301,277 | 4,390,111 | |||
Deferred tax liabilities: | |||||
Unrealized gains on available for sale securities | 211,974 | 175,098 | |||
Unrealized gains on sale of cash flow hedges | - | 215,540 | |||
Deferred loan fees | 1,060,798 | 1,103,661 | |||
Premises and equipment | 477,285 | 421,316 | |||
Deferred income from servicing rights | 108,920 | 142,848 | |||
Total gross deferred tax liabilities | 1,858,977 | 2,058,463 | |||
Net deferred tax asset | $ | 2,442,300 | 2,331,648 |
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(9) Related Party Transactions
The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers be made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2004:
Beginning balance | $ | 9,945,349 | |
New loans | 3,734,875 | ||
Repayments | 5,115,079 | ||
Ending balance | $ | 8,565,145 |
At December 31, 2003, the Company had approximately $3.7 million in potential problem loans to related parties, with an allowance for loan losses of approximately $918,000. There were no potential problem loans to related parties at December 31, 2004.
During 2004, an individual formerly considered a related party resigned as a director of the Company and as a result approximately $3.8 million in loans to this individual and his affiliates have been removed from the beginning balance of the summary of related party loan activity. At December 31, 2003, approximately $3.7 million in loans to this individual were considered to be potential problem loans.
The Company elected four new directors in 2004. Approximately $5.7 million in loans to these directors and their affiliates have been added to the beginning balance of the summary of related party loan activity.
At December 31, 2004 and 2003, the Company had deposit relationships with related parties of approximately $13.1 million and $10.2 million, respectively.
The Company also enters into contracts from time to time with certain directors for the construction of bank facilities. At December 31, 2004, the Company had no outstanding construction contracts with these directors as compared to approximately $31,000 in construction contracts at December 31, 2003.. During the year ended December 31, 2004, 2003 and 2002, total costs for construction, remodeling and repair for bank facilities paid to directors were approximately $44,000, $531,000 and $1.5 million, respectively.
(10) Commitments and Contingencies
The Company leases various office spaces for banking and operational facilities under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2004 are as follows:
Year | |||
2005 | $ | 811,653 | |
2006 | 650,845 | ||
2007 | 674,115 | ||
2008 | 685,603 | ||
2009 | 630,947 | ||
Thereafter | 4,826,917 | ||
Total minimum obligation | $ | 8,280,080 |
Total rent expense was approximately $577,000, $481,000 and $326,000 for 2004, 2003 and 2002, respectively.
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the
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contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
In most cases, the Company requires collateral or other security to support financial instruments with credit risk.
Contractual Amount | |||||
2004 | 2003 | ||||
Financial instruments whose contract amount represent credit risk: | |||||
Commitments to extend credit | $ | 124,674,707 | 104,729,455 | ||
Standby letters of credit and financial guarantees written | $ | 3,278,326 | 3,876,430 |
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $128.0 million does not necessarily represent future cash requirements. Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.
Standby letters of credit andfinancial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Company’s delineated trade area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.
The Company has an overall interest rate-risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company attempts to minimize the credit risk in derivative instruments by entering into transactions with counterparties that are reviewed periodically by the Company and are believed to be of high quality.
In the normalcourse of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Bank or the Company.
The Company has employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive stock option, and change in control provisions.
The Company has $26.5 million available for the purchase of overnight federal funds from three correspondent financial institutions.
(11) Derivatives and Hedging Transactions
The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.
As of December 31, 2004 and 2003, the Company had cash flow hedges with a notional amount of $55.0 million. These derivative instruments consist of two interest rate swap agreements that were used to convert floating rate loans to fixed rate for a period of three years ending in April 2006 and September 2006. Interest rate swap agreements generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. The terms of the swaps are determined based on management’s assessment of future interest rates and other factors. Accrued expenses and other liabilities includes $742,000 and $40,000, which represent the adjusted fair value of these cash flow hedges resulting in an after-tax decrease in accumulated other comprehensive income of $453,000 and $24,000 as of December 31, 2004 and 2003, respectively. As of December 31, 2004, no ineffectiveness was recorded in earnings.
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The Company settled two previously outstanding interest rate swap agreements during 2003. The first swap with a notional amount of $40.0 million and scheduled to mature in June 2004 was sold for a gain of $860,000. The second swap with a notional amount of $20.0 million and scheduled to mature in July 2004 was sold for a gain of $394,000. The gains realized upon settlement were recognized over the original terms of the agreements, and during the year ended December 31, 2003, net gains of approximately $428,000 had been realized. The remaining net gain of approximately $338,000 was recognized during the year ended December 31, 2004.
(12) Employer and Director Benefit Programs
The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under this plan, the Company matches employee contributions to a maximum of five percent of annual compensation. The Company’s contribution pursuant to this formula was approximately $363,000, $306,000 and $339,000 for the years of 2004, 2003 and 2002, respectively. Investments of the plan are determined by the compensation committee consisting of selected outside directors and senior executive officers. No investments in Company stock have been made by the plan. The vesting schedule for the plan begins at 20 percent after two years of employment and graduates 20 percent each year until reaching 100 percent after six years of employment.
In December 2002, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries. Under the plan, the Company purchased life insurance contracts on the lives of the key officers and each director. The increase in cash surrender value of the contracts, less the Company’s cost of funds, constitutes the Company’s contribution to the plan each year. Plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to this plan were approximately $223,000 and $264,000 during 2004 and 2003, respectively.
The Company is currently paying medical benefits for certain retired employees. Postretirement benefits expense, including amortization of the transition obligation, as applicable, was approximately $47,000, $16,000 and $33,000, for the years ended December 31, 2004, 2003 and 2002, respectively. The following table sets forth the accumulated postretirement benefit obligation as of December 31, 2004 and 2003, which represents the liability for accrued postretirement benefit costs:
2004 | 2003 | ||||
Accumulated postretirement benefit obligation | $ | 215,985 | 222,541 | ||
Unrecognized gain (loss) | (49,038) | (52,203) | |||
Net liability recognized | $ | 166,947 | 170,338 |
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. A total of 321,860 shares were reserved for possible issuance under this Plan. All rights must be granted or awarded within ten years from the effective date.
Under the Plan, the Company has granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant. The options granted in 1999 vest over a five-year period. Options granted subsequent to 1999 vest over a three-year period. All options expire after ten years. A summary of the activity in the Plan is presented below:
2004 | 2003 | 2002 | ||||||||||
Weighted | Weighted | Weighted | ||||||||||
Average | Average | Average | ||||||||||
Option Price | Option Price | Option Price | ||||||||||
Shares | Per Share | Shares | Per Share | Shares | Per Share | |||||||
Outstanding, beginning of period | 197,024 | $ 14.59 | 198,679 | $ 14.58 | 139,703 | $ 14.82 | ||||||
Granted during the period | 4,000 | $ 18.95 | - | - | 67,550 | $ 14.10 | ||||||
Forfeited during the period | (2,055) | $ 14.51 | - | - | (8,241) | $ 14.78 | ||||||
Exercised during the period | (14,972) | $ 14.01 | (1,655) | $ 14.34 | (333) | $ 12.69 | ||||||
Outstanding, end of period | 183,997 | $ 14.73 | 197,024 | $ 14.59 | 198,679 | $ 14.58 | ||||||
Number of shares exercisable | 157,845 | $ 14.71 | 128,983 | $ 14.52 | 66,292 | $ 14.29 |
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Options outstanding at December 31, 2004 are exercisable at option prices ranging from $12.69 to $19.18, as presented in the table above. Such options have a weighted average remaining contractual life of approximately seven years.
Members of the Board of Directors are eligible to participate in the Company’s Omnibus Stock Ownership and Long Term Incentive Plan (the “Stock Benefits Plan”). Each director has been awarded 5,365 book value shares under the Stock Benefits Plan. Nine directors were awarded book value shares on September 28, 1999. The book value of the common stock on September 28, 1999 was $11.45 (adjusted to reflect a 10% stock dividend on April 24, 2000). The book value shares awarded vest 20% annually, with the first 20% vesting on September 28, 2000 and the final 20% vesting on September 28, 2004. One director was awarded 5,365 book value shares upon his election to the Board of Directors on May 3, 2001. The book value of the common stock on May 3, 2002 was $13.95. These book value shares vest at a rate of 25% annually with the first 25% having vested on May 3, 2002, and the final 25% vesting on May 3, 2005. Four directors were awarded 5,365 book value shares on May 6, 2004. The book value of the common stock on May 6, 2004 was $15.68. Their shares vest at a rate of 20% annually, with the first 20% vesting on May 6, 2005, and the final 20% vesting on May 6, 2009. The Company recorded expenses of approximately $92,000, $47,000 and $83,000 associated with the benefits of this plan in the years ended December 31, 2004, 2003 and 2002, respectively.
A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2004, 2003 and 2002 is presented below.
2004 | 2003 | 2002 | ||||||||||
Weighted | Weighted | Weighted | ||||||||||
Average | Average | Average | ||||||||||
Price of | Price of | Price of | ||||||||||
Book Value | Book Value | Book Value | ||||||||||
Shares | Shares | Shares | Shares | Shares | Shares | |||||||
Outstanding, beginning of period | 48,285 | $ 11.73 | 53,650 | $ 11.70 | 53,650 | $ 11.70 | ||||||
Granted during the period | 21,460 | $ 15.68 | - | - | - | - | ||||||
Forfeited during the period | (1,073) | $ 11.45 | (5,365) | $ 11.45 | - | - | ||||||
Exercised during the period | (4,292) | $ 11.45 | - | - | - | - | ||||||
Outstanding, end of period | 64,380 | $ 13.07 | 48,285 | $ 11.73 | 53,650 | $ 11.70 | ||||||
Number of shares exercisable | 41,577 | $ 11.70 | 37,017 | $ 11.64 | 30,311 | $ 11.56 |
(13) Regulatory Matters
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 Capital consists of the allowance for loan losses up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2004, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
The capital treatment of trust preferred securities has been reviewed recently by the Federal Reserve Bank. The Federal Reserve Bank’s proposal for capital treatment of trust preferred securities, released May 4, 2004, would continue to permit the inclusion of trust preferred securities in Tier 1 capital of bank holding companies.
As of December 31, 2004, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
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The Company’s and the Bank’s actual capital amounts and ratios are presented below:
To Be Well | |||||||||||
Capitalized Under | |||||||||||
For Capital | Prompt Corrective | ||||||||||
Actual | Adequacy Purposes | Action Provisions | |||||||||
Amount | Ratio | Amount | Ratio | Amount | Ratio | ||||||
(dollars in thousands) | |||||||||||
As of December 31, 2004: | |||||||||||
Total Capital (to Risk-Weighted Assets) | |||||||||||
Consolidated | $ 72,410 | 12.22% | 47,407 | 8.00% | N/A | N/A | |||||
Bank | $ 68,503 | 11.60% | 47,240 | 8.00% | 59,050 | 10.00% | |||||
Tier 1 Capital (to Risk-Weighted Assets) | |||||||||||
Consolidated | $ 65,021 | 10.97% | 23,704 | 4.00% | N/A | N/A | |||||
Bank | $ 61,114 | 10.35% | 23,620 | 4.00% | 35,430 | 6.00% | |||||
Tier 1 Capital (to Average Assets) | |||||||||||
Consolidated | $ 65,021 | 9.50% | 27,374 | 4.00% | N/A | N/A | |||||
Bank | $ 61,114 | 8.95% | 27,328 | 4.00% | 34,161 | 5.00% | |||||
As of December 31, 2003: | |||||||||||
Total Capital (to Risk-Weighted Assets) | |||||||||||
Consolidated | $ 69,294 | 11.75% | 47,187 | 8.00% | N/A | N/A | |||||
Bank | $ 65,421 | 11.13% | 47,042 | 8.00% | 58,802 | 10.00% | |||||
Tier 1 Capital (to Risk-Weighted Assets) | |||||||||||
Consolidated | $ 61,914 | 10.50% | 23,594 | 4.00% | N/A | N/A | |||||
Bank | $ 58,041 | 9.87% | 23,521 | 4.00% | 35,282 | 6.00% | |||||
Tier 1 Capital (to Average Assets) | |||||||||||
Consolidated | $ 61,914 | 9.37% | 26,424 | 4.00% | N/A | N/A | |||||
Bank | $ 58,041 | 8.80% | 26,382 | 4.00% | 32,977 | 5.00% |
(14) Shareholders’ Equity
In November 2004, the Company’s Board of Directors authorized the repurchase of up to $3,000,000 in common shares of the Company’s outstanding common stock effective through the end of November 2005. During 2004, the Company repurchased a total of 15,100 shares at a total price of $290,826.
The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.
The Board of Directors of the Bank may declare a dividend of all of its retained earnings as it may deem appropriate, subject to the requirements of the General Statutes of North Carolina, without prior approval from the requisite regulatory authorities. As of December 31, 2004, this amount was approximately $16.0 million.
(15) Other Operating Expense
Other operating expense for the years ended December 31 included the following items that exceeded one percent of total revenues:
2004 | 2003 | 2002 | ||||
Advertising | $ | 619,731 | 540,970 | 218,726 |
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(16) Fair Value of Financial Instruments
The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.
Cash and Cash Equivalents
For cash, due from banks and federal funds sold, the carrying amount is a reasonable estimate of fair value.
Investment Securities Available for Sale
Fair values for investment securities are based on quoted market prices.
Other Investments
For other investments, the carrying value is a reasonable estimate of fair value.
Loans and Mortgage Loans Held for Sale
The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value. Mortgage loans held for sale are valued based on the current price at which these loans could be sold into the secondary market.
Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.
Mortgage Servicing Rights
Fair value of mortgage servicing rights is determined by estimating the present value of the future net servicing income, on a disaggregated basis, using anticipated prepayment assumptions.
Deposits and Demand Notes Payable
The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.
FHLB Advances
The fair value of FHLB advances is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.
Junior Subordinated Debentures
Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.
Derivative Instruments
For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.
Commitments to Extend Credit and Standby Letters of Credit
Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial
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instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2004 and 2003 are as follows:
2004 | 2003 | |||||||
Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value | |||||
(dollars in thousands) | ||||||||
Assets: | ||||||||
Cash and cash equivalents | $ | 16,791 | 16,791 | 20,783 | 20,783 | |||
Investment securities available for sale | 105,598 | 105,598 | 79,460 | 79,460 | ||||
Other investments | 5,397 | 5,397 | 4,217 | 4,217 | ||||
Mortgage loans held for sale | 3,783 | 3,783 | 588 | 588 | ||||
Loans, net | 527,419 | 525,818 | 542,404 | 541,770 | ||||
Cash surrender value of life insurance | 6,034 | 6,034 | 5,045 | 5,045 | ||||
Mortgage servicing rights | 283 | 283 | 371 | 371 | ||||
Liabilities: | ||||||||
Deposits and demand notes payable | 557,706 | 556,993 | 550,246 | 551,558 | ||||
FHLB advances | 59,000 | 61,637 | 58,000 | 62,175 | ||||
Junior subordinated debentures | 14,433 | 14,433 | 14,433 | 14,433 | ||||
Derivative instruments | 742 | 742 | 40 | 40 |
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(17) | Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements |
Balance Sheets | ||||||
December 31, 2004 and 2003 | ||||||
Assets | 2004 | 2003 | ||||
Cash | $ | 517,652 | 689,613 | |||
Interest-bearing time deposit | 2,000,000 | 2,000,000 | ||||
Investment in subsidiaries | 61,463,299 | 59,115,062 | ||||
Other investments | 1,050,749 | 788,439 | ||||
Other assets | 613,727 | 601,425 | ||||
Total assets | $ | 65,645,427 | 63,194,539 | |||
Liabilities and Shareholders' Equity | ||||||
Accrued expenses | $ | 274,575 | 207,643 | |||
Junior subordinated debentures | 14,433,000 | 14,433,000 | ||||
Shareholders' equity | 50,937,852 | 48,553,896 | ||||
Total liabilities and shareholders' equity | $ | 65,645,427 | 63,194,539 |
Statements of Earnings | ||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||
Revenues: | 2004 | 2003 | 2002 | |||
Dividends from subsidiaries | $ | 1,962,551 | 3,948,455 | 3,526,824 | ||
Interest and dividend income | 63,875 | 43,684 | - | |||
Total revenues | 2,026,426 | 3,992,139 | 3,526,824 | |||
Expenses: | ||||||
Interest | 676,547 | 667,526 | 757,733 | |||
Other operating expenses | 280,002 | 211,788 | 208,591 | |||
Total expenses | 956,549 | 879,314 | 966,324 | |||
Earnings before income tax benefit and equity in | ||||||
undistributed earnings of subsidiaries | 1,069,877 | 3,112,825 | 2,560,500 | |||
Income tax benefit | 296,700 | 277,200 | 320,800 | |||
Earnings before undistributed earnings in subsidiaries | 1,366,577 | 3,390,025 | 2,881,300 | |||
Equity in undistributed earnings in subsidiaries | 3,064,359 | - | 554,256 | |||
Dividends paid in excess in earnings | - | (1,386,434) | - | |||
Net earnings | $ | 4,430,936 | 2,003,591 | 3,435,556 |
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Statements of Cash Flows | ||||||
For the Years Ended December 31, 2004, 2003 and 2002 | ||||||
2004 | 2003 | 2002 | ||||
Cash flows from operating activities: | ||||||
Net earnings | $ | 4,430,936 | 2,003,591 | 3,435,556 | ||
Adjustments to reconcile net earnings to net | ||||||
cash provided by operating activities: | ||||||
Amortization | 17,742 | 17,742 | 16,668 | |||
Book value shares accrual | 66,933 | 47,078 | 82,800 | |||
Equity in undistributed earnings of subsidiaries | (3,064,359) | 1,386,434 | (554,256) | |||
Deferred income tax benefit | (25,806) | (19,173) | (27,991) | |||
Change in: | ||||||
Accrued income | (9,033) | - | - | |||
Other | - | 7,814 | (33,092) | |||
Net cash provided by operating activities | 1,416,413 | 3,443,486 | 2,919,685 | |||
Cash flows from investing activities: | ||||||
Net change in interest-bearing time deposit | - | (2,000,000) | - | |||
Purchases of investment securities available for sale | (250,000) | - | - | |||
Net cash used by investing activities | (250,000) | (2,000,000) | - | |||
Cash flows from financing activities: | ||||||
Transaction costs associated with junior | ||||||
subordinated debentures | - | - | (105,450) | |||
Cash dividends paid | (1,257,254) | (1,253,430) | (1,256,592) | |||
Common stock repurchased | (290,826) | - | (1,314,250) | |||
Proceeds from exercise of stock options | 209,706 | 23,737 | 4,225 | |||
Net cash provided (used) by financing activities | (1,338,374) | (1,229,693) | (2,672,067) | |||
Net change in cash | (171,961) | 213,793 | 247,618 | |||
Cash at beginning of year | 689,613 | 475,820 | 228,202 | |||
Cash at end of year | $ | 517,652 | 689,613 | 475,820 |
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