UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------- FORM 10-QSB [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to __________ Commission File Number 0-24935 SERVICE BANCORP, INC. (Exact name of registrant as specified in its charter) Massachusetts 04-3430806 (State or other jurisdiction of (I.R.S. Employer Incorporation or organization) Identification Number) 81 Main Street, Medway, Massachusetts 02053 (Address of principal executive offices) (Zip Code) (508) 533-4343 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last year.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practical date. At January 31, 1999, there were 1,712,630 shares of common stock outstanding, par value $0.01 per share. SERVICE BANCORP, INC. AND SUBSIDIARY FORM 10-QSB Index PART I FINANCIAL INFORMATION Page Item 1. Financial Statements Consolidated Balance Sheets As of December 31, 1998 and June 30, 1998 1 Consolidated Statements of Income for the three months and six months ended December 31, 1998 and 1997 2 Consolidated Statements of Changes in Stockholders' Equity for the six months ended December 31, 1998 and 1997 3 Consolidated Statements of Cash Flows for the six months ended December 31, 1998 and 1997 5 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition And Results of Operations 11 PART II OTHER INFORMATION Item 1. Legal Proceedings 20 Item 2. Changes in Securities 21 Item 3. Defaults upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 21 Item 5. Other information 21 Item 6. Exhibits and reports on Form 8-K 21 Signature page 22 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, June 30, ASSETS 1998 1998 --------- ---------- Cash and due from banks $6,483 $4,452 Short-term investments 4,494 11,931 --------- --------- Total cash and cash equivalents 10,977 16,383 Certificates of deposit 1,500 1,500 Securities available for sale 59,739 40,171 Federal Home Loan Bank stock, at cost 731 731 Loans 77,300 77,312 Less allowance for loan losses (624) (577) --------- --------- Loan, net 76,676 76,735 Banking premises and equipment, net 1,474 1,455 Accrued interest receivable 1,445 1,173 Other assets 522 804 --------- --------- Total Assets $153,064 $138,952 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Deposits $120,060 $112,247 Federal Home Loan Bank advances 14,272 14,562 Due to broker -- 1,053 Other liabilities 1,171 967 --------- --------- Total Liabilities 135,503 128,829 Stockholders' Equity: Common stock, $.01 par value; 12,000 shares authorized, 1,712,630 issued and Outstanding 17 -- Additional paid-in capital 7,449 -- Retained earnings 10,197 9,700 Accumulated other comprehensive income 442 423 Unearned ESOP shares (544) -- --------- --------- Total Stockholders' Equity 17,561 10,123 --------- --------- Total Liabilities and Stockholders' Equity $153,064 $138,952 ========= ========= See accompanying notes to the unaudited consolidated financial statements. 1 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands) Three Months Ended Six Months Ended --------------------- --------------------- 12/31/98 12/31/97 12/31/98 12/31/97 -------- -------- -------- -------- Interest and dividend income: Interest and fees on loans $1,593 $1,509 $3,230 $2,995 Interest and dividends on securities available for sale and FHLB stock 761 540 1,414 975 Interest on short-term investments and certificates of deposit 198 32 341 131 -------- -------- -------- -------- Total interest and dividend income 2,552 2,081 4,985 4,101 -------- -------- -------- -------- Interest expense: Interest on deposits 1,012 929 2,027 1,816 Interest on FHLB advances 191 55 385 96 -------- -------- -------- -------- Total interest income 1,203 984 2,412 1,912 -------- -------- -------- -------- Net interest income 1,349 1,097 2,573 2,189 Provision for loan losses 25 -- 50 -- -------- -------- -------- -------- Net interest income, after provision for loan losses 1,324 1,097 2,523 2,189 -------- -------- -------- -------- Other income: Customer service fees 155 112 278 200 Gain on sales of securities available for sale, net 247 256 320 539 Gain on sales of loans 13 14 30 26 Miscellaneous 12 20 21 33 -------- -------- -------- -------- Total other income 427 402 649 798 -------- -------- -------- -------- Operating expenses: Salaries and benefits 742 505 1,307 944 Occupancy and equipment expenses 229 205 471 404 Data processing expenses 85 72 161 144 Professional fees 57 36 98 54 Advertising expenses 42 34 75 56 Other general and administrative expenses 172 120 294 203 -------- -------- -------- -------- Total operating expenses 1,327 972 2,406 1,805 -------- -------- -------- -------- Income before income taxes 424 527 766 1,182 Provision for income taxes 151 189 269 414 -------- -------- -------- -------- Net income $273 $338 $497 $768 ======== ======== ======== ======== See accompanying notes to the unaudited consolidated financial statements. 2 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997 (Dollars in thousands) Accumulated Additional Other Unearned Comprehensive Common Paid-in Retained Comprehensive ESOP Income Stock Capital Earnings Income Shares Total ------------- -------- -------- -------- ------------- ----------- ------- Balance at June 30, 1998 $ -- $ -- $ 9,700 $ 423 $ -- $ 10,123 Net proceeds from sale of common stock 17 7,449 -- -- -- 7,466 Common stock acquired by ESOP (64,394) -- -- -- -- (644) (644) Common stock held by ESOP committed to be released (10,000 shares) -- -- -- -- 100 100 Comprehensive Income Net Income $ 497 -- -- 497 -- -- 497 Change in net unrealized gain on securities available for sale, net of tax reclassification adjustment 19 -- -- -- 19 -- 19 -------- -------- -------- -------- -------- -------- -------- Comprehensive Income $ 516 ======== Balance at December 31, 1998 $ 17 $ 7,449 $ 10,197 $ 442 ($ 544) $ 17,561 ======== ======== ======== ======== ======== ======== See accompanying notes to the unaudited consolidated financial statements. 3 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997(CONCLUDED) (Dollars in thousands) Accumulated Additional Other Unearned Comprehensive Common Paid-in Retained Comprehensive ESOP Income Stock Capital Earnings Income Shares Total ------------- --------- ---------- -------- ------------- ----------- ------ Balance at June 30, 1997 $ -- $ -- $8,499 $ 196 $ -- $8,695 Comprehensive Income: Net Income $ 768 -- -- 768 -- -- 768 Change in net unrealized gain on securities available for sale net of tax reclassification adjustment 140 -- -- -- 140 -- 140 ------ --------- --------- ------ ------ ------ ------ Comprehensive Income $ 908 ====== Balance at December 31, 1997 $ -- $ -- $9,267 $ 336 $ -- $9,603 ========= ========= ====== ====== ====== ====== See accompanying notes to unaudited consolidated financial statements. 4 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Six Months Ended December 31, --------------------- 1998 1997 -------- -------- Cash flows from operating activities: Net income $ 497 $ 768 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 50 -- Gain on sales of securities available for sale, net (320) (539) Net amortization of securities available for sale 31 12 Depreciation and amortization expense 186 168 Increase in accrued interest receivable (272) (215) Deferred tax benefit (44) (15) Loans originated for sale (3,016) (3,045) Principal balance of loans sold 3,016 3,045 Other, net 511 552 -------- -------- Net cash provided by operating activities 639 731 -------- -------- Cash flows from investing activities: Proceeds from sales of securities available for sale 1,195 2,663 Proceeds from maturities of and principal payments on securities available for sale 7,490 4,737 Purchase of securities available for sale (28,979) (15,937) Net decrease (increase) in loans 9 (4,084) Purchase of banking premises and equipment (205) (350) -------- -------- Net cash used by investing activities (20,490) (12,971) -------- -------- Cash flows from financing activities: Net increase in deposits 7,813 7,811 Proceeds from Federal Home Loan Bank advances 2,006 5,000 Repayment of Federal Home Loan Bank advances (2,296) (2,079) Purchase of common stock for ESOP (644) -- Release of common stock held by ESOP 100 -- Increase in mortgagors' escrow deposits -- 58 Net proceeds from issuance of common stock 7,466 -- -------- -------- Net cash provided by financing activities 14,445 10,790 -------- -------- Net change in cash and cash equivalents (5,406) (1,450) Cash and cash equivalents at beginning of period 16,383 9,129 -------- -------- Cash and cash equivalents at end of period $ 10,977 $ 7,679 ======== ======== See accompanying notes to the unaudited consolidated financial statements. 5 SERVICE BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONCLUDED) (Dollars in thousands) Six Months Ended December 31, --------------------- 1998 1997 -------- -------- Supplementary information: Interest paid on deposits $2,029 $1,817 Interest paid on Federal Home Loan Bank advances 392 84 Income taxes paid 318 365 Decrease in due from broker 1,053 -- See accompanying notes to the unaudited consolidated financial statements. 6 SERVICE BANCORP, INC. AND SUBSIDIARY Notes to Unaudited Consolidated Financial Statements Six Months Ended December 31, 1998 and 1997 (1) Basis of Presentation and Consolidation The accompanying unaudited consolidated financial statements include the accounts of Service Bancorp, Inc. (the "Company") and its wholly-owned subsidiary, Summit Bank (the "Bank"), and the Bank's wholly-owned subsidiaries, Medway Securities Corp. and Franklin Village Security Corp., which engage solely in the purchase and sale of investment securities. All significant intercompany balances and transactions have been eliminated in consolidation. These financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP") for interim financial information and the instructions for Form 10-QSB and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation have been included. Interim results are not necessarily indicative of the results that may be expected for the entire year. (2) Reorganization and Stock Offering The Company is a Massachusetts corporation that was organized in August, 1998 at the direction of the Board of Directors of the Bank and the Board of Trustees of Service Bancorp, MHC (the "MHC"), the mutual holding company parent of the Bank, for the purpose of owning all of the outstanding capital stock of the Bank. The Company offered for sale 47% of the shares of its outstanding common stock in a public offering to eligible depositors, employees, and members of the general public (the "Offering"). The remaining 53% of the Company's shares of common stock were issued to the MHC. The Offering was completed on October 7, 1998. Prior to that date, the Company had no assets or liabilities. Completion of the Offering resulted in the issuance of 1,712,630 shares of common stock, 907,694 shares of which were issued to the MHC and 804,936 shares of which were sold to eligible depositors, employees, and the general public at $10.00 per share. The Company began trading on the OTC Bulletin Board under the symbol "SERC" on October 7, 1998. Costs related to the Offering (primarily marketing fees paid to an underwriting firm, professional fees, registration fees, and printing and mailing costs) aggregated $569,000. These costs together with funds loaned to purchase shares for the ESOP were deducted to arrive at net proceeds of $6.8 million. The Company contributed 50% of the net proceeds of the Offering to the Bank for general corporate use. On October 7, 1998, the Company loaned approximately $644,000 to the Company's Employee Stock Option Plan to fund its purchase of 64,394 shares of common stock of the Company. (3) Earnings per Share Earnings per share is not presented for the three and six months periods ended December 31, 1998 since there were no outstanding shares of common stock until the closing of the Offering on October 7, 1998. (4) Other Comprehensive Income The Company adopted Financial Accounting Standards Board Statement No. 130, "Reporting Comprehensive" (SFAS No. 130), effective January 1, 1998. SFAS No. 130 established standards for 7 SERVICE BANCORP, INC. AND SUBSIDIARY Notes to Unaudited Consolidated Financial Statements Six Months Ended December 31, 1998 and 1997 reporting comprehensive income and its components (revenue, expenses, gains and losses). The Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. Reclassification of financial statements for earlier periods provided for comparative purposes is required. The Company adopted this disclosure requirement in the quarter ended September 30, 1998. (5) Commitments At December 31, 1998, the Company had outstanding commitments to originate loans of $5.6 million, $5.0 million of which were commercial real estate loans. Unused lines of credit available to customers amounted to $5.7 million, $5.3 million of which were equity lines of credit. (6) Securities Available for Sale The following table sets forth the Company's securities available for sale at the dates indicated. December 31, 1998 June 30, 1998 ----------------------------------------------- Amortized Fair Amortized Fair Cost Value Cost Value --------- ------- --------- ------- (Dollars in thousands) Federal agency obligations $36,462 $36,902 $27,502 $27,668 Mortgage-backed securities 11,023 11,081 5,977 5,980 Other debt securities 8,598 8,625 2,253 2,252 ------- ------- ------- ------- Total debt securities 56,083 56,608 35,732 35,900 Marketable equity securities 2,964 3,131 3,785 4,271 ------- ------- ------- ------- Total securities $59,047 $59,739 $39,517 $40,171 ======= ======= ======= ======= 8 SERVICE BANCORP, INC. AND SUBSIDIARY Notes to Unaudited Consolidated Financial Statements Six Months Ended December 31, 1998 and 1997 (7) Loans The following table presents data relating to the composition of the Company's loan portfolio by type of loan on the dates indicated. Dollars listed below are in thousands. December 31, 1998 June 30, 1998 ------------------------- ------------------------ Amount Percent Amount Percent -------- ---------- -------- ---------- Real estate loans: Residential $45,396 58.69% $48,574 62.76% Commercial 17,411 22.51 12,856 16.61 Construction 2,271 2.94 4,743 6.13 -------- ---------- -------- ---------- Total real estate loans 65,078 84.14 66,173 85.50 Other loans: Consumer loans: Collateral 610 0.79 786 1.02 Home equity 4,202 5.43 4,514 5.83 Other 1,560 2.02 1,704 2.20 -------- ---------- -------- ---------- Total consumer loans 6,372 8.24 7,004 9.05 Commercial business loans 5,897 7.62 4,217 5.45 -------- ---------- -------- ---------- Total other loans 12,269 15.86 11,221 14.50 -------- ---------- -------- ---------- Total loans 77,347 100.00% 77,394 100.00% ========== ========== Net deferred loan fees (60) (102) Deferred premium 13 20 Allowance for loan losses (624) (577) -------- -------- Total loans, net $76,676 $76,735 ======== ======== (8) Deposits and Borrowed Funds The following tables indicates types and balances in deposit accounts on dates indicated. Dollars listed below are in thousands. December 31, 1998 June 30, 1998 ------------------------ ------------------------ Amount Percent Amount Percent -------- ------- -------- ------- Demand $13,325 11.10% $10,597 9.44% NOW 18,357 15.29 17,891 15.94 Money market deposits 9,400 7.83 9,162 8.16 Regular and other savings 22,617 18.84 23,112 20.59 -------- ------ -------- ------ Total non-certificate accounts 63,699 53.06 60,762 54.13 Term certificates 56,361 46.94 51,485 45.87 -------- ------ -------- ------ Total deposits $120,060 100.00% $112,247 100.00% ======== ====== ======== ====== 9 SERVICE BANCORP, INC. AND SUBSIDIARY Notes to Unaudited Consolidated Financial Statements Six Months Ended December 31, 1998 and 1997 The following is a list of maturities for advances from the Federal Home Loan Bank of Boston (the "FHLB") for the dates indicated. Dollars listed below are in thousands. December 31, 1998 June 30, 1998 ----------------------- ----------------------- Amount Percent Amount Percent ------- ------- ------- ------- Maturities less than one year $493 3.45% $2,058 14.13% Maturities greater than one year 13,779 96.55 12,504 85.87 ------- ------ ------- ------ Total borrowed funds $14,272 100.00% $14,562 100.00% ======= ====== ======= ====== 10 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation General Service Bancorp, Inc. (the "Company"), completed its stock offering on October 7, 1998. The Company offered for sale 47% of the shares of its common stock to eligible depositors, employees, and members of the general public. The remaining 53% of the Company's shares of common stock were issued to its parent, Service Bancorp, MHC, a state-chartered mutual holding company incorporated in Massachusetts. Prior to that date, the Company had no assets or liabilities. Its principal activities since that date through December 31, 1998 have been to complete the Offering, contribute 50% of the net proceeds of the Offering to the Bank and use the remaining 50% of the net proceeds to acquire short-term investments and fund a loan to the Bank's employee stock ownership plan ("ESOP"). This quarterly report on Form 10-QSB contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believe", "anticipates", "plans", "expects" and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company's actual results to differ materially from those contemplated by such forward-looking statements. These important factors include, without limitation, the Bank's continued ability to originate quality loans, fluctuation in interest rates, real estate conditions in the Bank's lending areas, general and local economic conditions, the Bank's continued ability to attract and retain deposits, the Company's ability to control costs, new accounting pronouncements, and changing regulatory requirements. The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Comparison of Financial Condition at December 31, 1998 and June 30, 1998 Assets increased by $14.1 million, or 10.2%, from $139.0 million at June 30, 1998 to $153.1 million at December 31, 1998. The increase was attributable primarily to the completion of the Company's Offering on October 7, 1998 and growth in deposits between these two dates. Net proceeds from the Offering amounted to $6.8 million, while deposits grew $7.8 million, or 7.0%, from $112.3 million to $120.1 million. Short-term investments (federal funds sold and overnight funds) decreased by $7.4 million, or 62.3%, from $11.9 million at June 30, 1998 to $4.5 million as the Company began to deploy these lower-yielding liquid funds into higher-yielding longer term investments. These short-term funds, together with the proceeds from the Offering were invested in federal agency obligations, mortgaged-backed securities, and other debt securities, with callable features or monthly payback amortization. Accordingly, federal agency obligations, mortgage-backed securities, and other debt securities increased $9.2 million, or 33.4%, $5.1 million, or 85.3%, and $6.4 million, or 283.0%, respectively. Net loans remained relatively stable from June 30, 1998 to December 31, 1998, declining $59,000, or 0.1%. However, the loan composition within this portfolio shifted from residential to commercial lending products. Commercial real estate and other commercial loans increased from $12.9 million and $4.2 million at June 30, 1998 to $17.4 million and $5.9 million at December 31, 1998 reflecting growth of $4.6 million, or 35.4% and $1.7 million, or 39.8%, respectively. Competitive interest rate conditions were primary reasons for the decline in the residential and construction loan portfolios. Residential mortgage 11 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) loans decreased $3.2 million, or 6.5% from $48.6 million at June 30, 1998 to $45.4 million at December 31, 1998, while construction loans decreased $2.5 million, or 52.1%, from $4.8 million to $2.3 million. Stockholders' equity increased from $10.1 million, or 7.29% of total assets at June 30, 1998 to $17.6 million, or 11.47% of total assets at December 31, 1998. The increase resulted primarily from the net proceeds from the Offering and net income earned. Unrealized gains on securities available for sale are reported as accumulated other comprehensive income. Non-Performing Assets and Allowance for Loan Losses The following indicates the non-performing assets and related allowance for loan loss ratios for the dates indicated. December 31, June 30, 1998 1998 ----------- ---------- (Dollars in thousands) Non-accrual loans: One-to-four family real estate loans $202 $205 Commercial loans 84 84 Consumer loans 13 -- ------ ------ Total non-accrual loans 299 289 Other real estate owned -- -- ------ ------ Total non-performing assets $299 $289 ====== ====== Allowance for loan losses $624 $577 ====== ====== Allowance for loan losses as a percent of total loans, net 0.81% 0.75% ====== ====== Allowance for loan losses as a percent of non-accrual loans 208.70% 199.65% ====== ====== Non-accrual loans as a percent of total loans, net 0.39% 0.38% ====== ====== Non-performing assets as a percent of total assets 0.20% 0.21% ====== ====== During the six months ended December 31, 1998, $50,000 was added to the loan loss provision due to the growth of the commercial loan portfolio, which because of its nature is more risky than the residential mortgage portfolio. During this period, there were $7,000 in loan charge-offs and $4,000 in recoveries from previously charged-off loans. 12 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) While management believes that, based on information currently available, the allowance for loan losses is sufficient to cover losses in the Bank's loan portfolio at this time, no assurances can be given that the level of the allowance will be sufficient to cover future loan losses or that future adjustments to the allowance will not be necessary if economic and/or other conditions differ substantially from the economic and other conditions considered by management in evaluating the adequacy of the current level of the allowance. Comparison of Operating Results for the Three Months Ended December 31, 1998 and 1997 General Operating results are primarily dependent on the Bank's net interest income, which is the difference between the interest earned on the Bank's earning assets (short-term investments, loans, and investment securities) and the interest paid on deposits and borrowings. Operating results are also affected by provisions for loan losses, the level of income from non-interest sources such as fees and sales of investment securities and other assets, operating expenses and income taxes. Operating results are also significantly affected by general economic conditions, particularly changes in interest rates, as well as government policies and actions of regulatory authorities. Net income for the three months ended December 31, 1998 was $273,000 as compared to $338,000 for the three month period ended December 31, 1997, a decrease of $65,000, or 19.2%. This decrease was primarily attributable to increases of $355,000 and $25,000, respectively in operating expenses and the provision for loan losses which were partially offset by increases of $252,000 and $25,000 in net interest income and other income, respectively. Interest rate spread (the difference between yields earned on earning assets and rates paid on deposits and borrowings) declined from 3.68% for the three months ended December 31, 1997 to 3.29% for the three months ended December 31, 1998. During the same period, interest rate margin (net interest income divided by average earning assets) declined from 4.14% to 3.84%. The interest rate margin indicates that in addition to interest-bearing liabilities, demand deposits and capital serve as a source of funding for earning assets. The decline was attributable in part to an increase in short-term investments during the current period and a decrease in longer term, higher yielding loans and investment securities. Much of the net proceeds of the Offering were placed in these short-term investments as well as funds received from callable investments and early payoffs of mortgage-backed securities and residential mortgages, as customers refinanced their existing higher-yielding mortgage loans. Also contributing to the decline were lower yields on prime rate and indexed loans and new loan originations caused by the current declining interest rate environment. If current market trends continue, management believes that interest rate spread could decline further. 13 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) The interest rate spread and margin for the periods indicated are as follows: Three months ended December 31, ----------------- 1998 1997 ----- ----- Weighted average yield earned on: Short-term investments 4.70% 6.38% Investments 6.20 6.39 Total loans, net 8.53 8.59 ---- ---- All earning assets 7.26 7.85 Weighted average rate paid on: Deposits 3.79 4.09 Borrowed funds 5.32 6.01 ---- ---- All interest-bearing liabilities 4.17 3.97 ---- ---- Weighted average rate spread 3.29% 3.68% ==== ==== Net interest margin 3.84% 4.14% ==== ==== Earnings per share data is not presented for the three months ended December 31, 1998 because the Company became a publicly owned entity on October 7, 1998 and accordingly, did not have shares outstanding throughout any of the periods presented. Interest and Dividend Income Total interest and dividend income increased by $471,000, or 22.6%, from $2.1 million for the three months ended December 31, 1997 to $2.6 million for the comparable period in 1998. This increase was primarily attributable to a $34.6 million, or 32.6%, increase in average earning assets between the two periods, which was partially offset by a decline in the yield on earning assets. The average balances in short-term investments, investment securities, and net loans increased $14.8 million, $15.3 million, and $4.5 million, respectively, while their yields declined over the same timeframe. Interest on the investment portfolio and short-term investments, increased $221,000 and $166,000, or 41.0% and 500.0%, respectively, while interest on loans increased $84,000, or 5.6%, during the same period. The reduction in yields is a reflection of the declining interest rate environment over the past year as loan payoffs, callable investment proceeds, and net Offering proceeds have been redeployed in lower yielding short-term investments and new investment security instruments. The Bank has been able to maintain a relatively stable loan yield between the periods by its emphasis on the commercial mortgage and loan portfolios, whose increased balances and higher-yields have partially offset the decline in the residential mortgage balances and yields. If interest rates continue to decline, the yields on new loan originations, and existing loans with prime and index-based rates could be adversely affected. 14 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) Interest Expense Interest expense on deposits and borrowings increased $219,000, or 22.3%, from $984,000 for the three months ended December 31, 1997, to $1.2 million for the three months ended December 31, 1998. This increase was attributable to a $16.0 million, or 17.6%, increase in average deposit balances between periods, which was partially offset by a reduction in deposit rates over the same period from 4.09% to 3.79%. The decrease in deposit interest rates was primarily due the declining interest rate environment between the two periods. The Bank increased its use of borrowings from the FHLB as part of its management of interest rate risk. Average balances in these advances were $14.4 million during the three months ended December 31, 1998, an increase of $10.7 million, or 291.9% from the three months ended December 31, 1997. Over this same timeframe, average borrowing rates declined from 6.01% to 5.32%. Other Income Total other income increased $25,000, or 6.2%, from $402,000 for the three months ended December 31, 1997 to $427,000 for the same period in 1998. Customer service fees increased by $43,000, from $112,000 to $155,000, while the gain on sale of securities available for sale declined $9,000, from $256,000 to $247,000 between the periods. Marketable equity securities are held by the Bank primarily for capital appreciation and not for trading purposes. Operating Expense Total operating expense increased $355,000, or 36.5 %, from $972,000 for the three months ended December 31, 1997 to $1.3 million for the three months ended December 31, 1998. Between the two periods, salaries and benefits, occupancy and equipment expenses, data processing expenses, and professional fees increased $237,000, $24,000, $13,000, and $21,000, respectively. No other individual expense category increased materially between periods. Much of the expense increase was attributed to the Company's asset growth as management added staff and incurred costs to service the full range of retail and loan products added to the Bank's product lines. In addition, the Company incurred $96,000 in ESOP compensation expenses during the three months ended December 31, 1998 as it implemented the ESOP in October, 1998. Income Taxes The effective income tax rate was 35.6% and 35.9% for the three months ended December 31, 1998 and 1997, respectively. The effective tax rates are below the statutory combined state and federal income tax rates because the Bank's two security corporations purchase investment securities to take advantage of the lower state tax rate afforded these types of entities. 15 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) Comparison of Operating Results for the Six Months Ended December 31, 1998 and 1997 General Net income for the six months ended December 31, 1998 was $497,000 as compared to $768,000 for the six months ended December 31, 1997, a decrease of $271,000, or 35.3%. This decrease was primarily attributable to increases of $601,000 and $50,000 in operating expenses and the loan loss provision, respectively, and a decrease on $149,000 in other income between periods, which were partially offset by an increase of $384,000 in net interest income over the same period. Interest rate spread and interest rate margin declined from 3.75% and 4.21%, respectively, for the six months ended December 31, 1997 to 3.29% and 3.79%, respectively, for the six months ended December 31, 1998. The decline was primarily attributable to lower yields in all earning assets offset in part by lower rates on deposits and borrowings. The interest rate spread and margin for the periods indicated are as follows: Six months ended December 31, ---------------- 1998 1997 ----- ----- Weighted average yield earned on: Short-term investments 5.07% 6.18% Investments 6.02 6.33 Total loans, net 8.59 8.70 ---- ---- All earning assets 7.35 7.89 Weighted average rate paid on: Deposits 3.88 4.07 Borrowed funds 5.34 6.00 ---- ---- All interest-bearing liabilities 4.06 4.14 ---- ---- Weighted average rate spread 3.29% 3.75% ==== ==== Net interest margin 3.79% 4.21% ==== ==== Interest and Dividend Income Total interest and dividend income increased by $884,000, or 21.6%, from $4.1 million for the six months ended December 31, 1997 to $5.0 million for the comparable period in 1998. This increase in interest income was primarily attributable to a $31.8 million, or 30.6%, increase in average earning assets between the two periods, which was partially offset by a decline in yield on earning assets. The average balances in short-term investments, investment securities, and net loans increased $9.2 million, $16.2 million, and $6.4 million, respectively, while their comparable yields declined over the same timeframe. 16 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) The reduction of earning asset yields is a reflection of the declining interest rate environment over the past year as loan payoffs, callable investment proceeds, and net Offering proceeds have been redeployed in lower yielding short-term investments and new investment security instruments. Interest Expense Interest expense on deposits and borrowings was $2.4 million for the six months ended December 31, 1998, an increase of $500,000, or 26.2%, from $1.9 million, for the six months ended December 31, 1997. This increase was attributable to a $15.1 million, or 17.0%, increase in average deposit balances between periods, which was partially offset by a reduction in deposit rates over the same period from 4.07% to 3.88%. This decrease in deposit interest rates was primarily due the declining interest rate environment between the two periods. The Bank increased its use of borrowings from the FHLB as part of its management of interest rate risk. Average balances in these advances were $14.4 million during the six months ended December 31, 1998, an increase of $11.2 million, or 350.6% from the six months ended December 31, 1997. Over this same timeframe, average borrowing rates declined from 6.00% to 5.34%. Other Income Total other income decreased $149,000, or 18.7%, from $798,000 for the six months ended December 31, 1997 to $649,000 for the same period in 1998. This decrease was caused primarily by a $219,000 decrease in the gain on sale of securities available for sale from $539,000 for the six months ended December 31, 1997 to $320,000 for the current period. This was partially offset by an increase in customer service fees of $78,000 over the same timeframe. Operating Expense Total operating expense increased $601,000, or 33.3%, from $1.8 million for the six months ended December 31, 1997 to $2.4 million for the six month period ended December 31, 1998. Between the two periods, salaries and benefits, occupancy and equipment expenses, advertising expenses, and professional fees increased $363,000, $67,000, $19,000, and $44,000, respectively. Much of the expense increase was attributed to the Company's asset growth as management added staff and incurred costs to service the full range of retail and loan products added to the Bank's product lines. In addition, the Company incurred $96,000 in ESOP compensation expenses during the six months ended December 31, 1998 as it implemented the ESOP in October, 1998. Income Taxes The effective income tax rate was 35.1% and 35.0%, respectively, for the six months ended December 31, 1998 and 1997. The effective tax rate are below the statutory combined state and federal income tax rates because the Bank's two security corporations purchase investment securities to take advantage of the lower state tax rate afforded these types of entities. 17 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) Asset/Liability Management A principal operating objective of the Bank is to produce stable earnings by achieving a favorable interest rate spread that can be sustained during fluctuations in prevailing interest rates. Since the Bank's principal interest-earning assets generally have longer terms to maturity than its primary source of funds, i.e. deposit liabilities, increases in general interest rates will generally result in an increase in the Bank's cost of funds before the yield on its asset portfolio adjusts upward. Financial institutions have generally sought to reduce their exposure to adverse changes in interest rates by attempting to achieve a closer match between the repricing periods of interest rate sensitive assets and liabilities. Such matching, however, is carefully monitored so as not to sacrifice net interest margin performance for the perfect matching of these interest rate sensitive instruments. The Bank has established an Asset/Liability Management Committee ("ALCO") made up of members of senior management to assess the asset/liability mix and recommend strategies that will enhance income while managing the Bank's vulnerability to changes in interest rate. This committee meets regularly to discuss interest rate conditions and potential product lines that would enhance the Bank's income performance. Certain strategies have been implemented to improve the match between interest rate sensitive assets and liabilities. These strategies include, but are not limited to: daily monitoring of the Bank's cash requirements, originating adjustable and fixed rate mortgage loans, both residential and commercial, for the Bank's own portfolio, managing the cost and structure of deposits, and generally using the matched borrowings to fund specific purchases of loan packages and large loan originations. Occasionally, management may choose to deviate from specific matching of maturities of assets and liabilities, if an attractive opportunity to enhance yield becomes available. Quarterly, ALCO modeling is performed with the assistance of an outside investment advisor which projects the Bank's financial performance over the next twenty four months using loan and deposit projections, projections of changes in interest rates, and anticipated changes in other income and operating expenses to reveal the full impact of the Bank's operating strategies on financial performance. The results of the ALCO process are reported to the Board at least on a quarterly basis. Liquidity and Capital Resources The Bank's primary sources of funds consist of deposits, borrowings, repayment and prepayment of loans, sales of loans and investments, maturities and early calls of investments, and funds provided from operations. While scheduled repayments of loans and maturities of investments are predictable sources of funds, deposit flows and loan prepayments are greatly influenced by the general level of interest rates, economic conditions, and competition. The Bank uses its liquidity resources primarily to fund existing and future loan commitments, to fund net deposit outflows, to invest in other interest-earning assets, to maintain liquidity, and to pay operating expenses. From time to time, the Bank utilizes advances from the FHLB primarily in connection with its management of the interest rate sensitivity of its assets and liabilities. Total advances outstanding at December 31, 1998 amounted to $14.3 million. The Bank's ability to borrow from the FHLB is dependent upon the amount and type of collateral the Bank has to secure the loans. Such collateral consists of, but is not limited to, one-to-four family owner-occupied residential property, mortgage-backed securities guaranteed by the U.S. government or a government agency, and funds on deposit with 18 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) the FHLB. As of June 30, 1998, the end of the latest fiscal year, the Bank's total borrowing capacity was $51 million. A major portion of the Bank's liquidity consists of cash and cash equivalents, short-term investments, U.S. Government and federal agency obligations, mortgage-backed securities, and other debt securities. The level of these assets is dependent upon the Bank's operating, lending, and financing activities during any given period. At December 31, 1998, the Bank had $5.6 million of outstanding commitments to originate loans. The Bank anticipates that it will have sufficient funds available to meet these commitments. Certificates of deposit, which are scheduled to mature in one year or less, totaled $49.8 million at December 31, 1998. Based upon historical experience, management believes that a significant portion of such deposits will remain with the Bank. At December 31, 1998, the Company and the Bank exceeded all regulatory capital requirements. Year 2000 ("Y2K") Compliance Changing from the year 1999 to 2000 has the potential to cause problems in data processing and other data-sensitive systems, a problem known as the Year 2000 or Y2K dilemma. The Company uses computer systems to perform financial calculations, track deposits and loan payments, transfer funds and make direct deposits. The processing of the Company's loan and deposit transactions is outsourced to a third-party data processing vendor. The Company is following a comprehensive process to assure that such systems are ready for the year 2000 date change. To become Y2K compliant, the Company is following a five-step process mandated by the federal bank regulatory agencies. A description of each of the steps and the status of the Company's efforts in completing the steps is as follows: Step 1. Awareness and Understanding of the Problem. The Company has formed a Year 2000 team that has investigated the problem and its potential impact on the Company's systems. An independent consulting firm has been engaged to assist the Company's development of its approach to becoming Y2K compliant. This phase also includes education of the Company's employees and customers about Y2K issues. The awareness and understanding phase of this step has been completed. Training and communication has taken place and will continue in 1999. Step 2. Identification of All Potentially Affected Systems. This step has included a review of all major information technology ("IT") and non-information technology ("non-IT") systems to determine how they are affected by Y2K issues. An inventory has been prepared of all vendors who render IT and non-IT services to the Company. This step is considered complete. Step 3. Assessment and Planning. The Y2K team has completed its assessment of which systems and equipment are most prone to placing the Company at risk if they are not Y2K compliant. The project team has developed an inventory of vendors, an inventory of actions to be taken, identification of the team members responsible for completion of each action, a completion timetable, and project tracking methodology. Significant vendors have been requested to advise the Company in writing of their Y2K 19 SERVICE BANCORP, INC. AND SUBSIDIARY ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operation (Continued) readiness, including actions to become compliant if they are not already compliant. A plan has been developed to repair or replace systems and equipment not currently Y2K compliant. This step is substantially complete. Responses from certain vendors have not yet been received, but Y2K team members will contact these vendors to ensure that all vendors respond regarding their Y2K compliance on a timely manner. Step 4. Correction and Testing. The Company's third party data processing servicer as well as vendors who provide significant technology-related services have modified their systems to become Y2K compliant. The Company has developed scripts involving typical transactions to test the proper functioning of the modified systems. It has also arranged for repair or replacement of equipment programs affected by Y2K issues. All required testing will be completed by the end of March, 1999. The monitoring of certain non-IT vendors will continue into 1999. Step 5. Implementation. This step includes the repair or replacement of systems and computer equipment and the development of contingency plans. The repair and replacement phase is substantially completed. Contingency plans on how the Company would resume business if unanticipated problems arise from non-performance by IT and non-IT vendors are being developed and are expected to be completed by June 30, 1999, as dictated by the regulatory authorities. The Company's efforts to become Y2K compliant are being monitored by its federal banking regulators. Failure to be Y2K compliant could subject the Company to formal supervisory or enforcement actions. The Company expensed $9,000 for the six months ended December 31, 1998, and an additional $31,500 from January through June, 1998 for Y2K compliance needs. It expects to incur additional costs throughout 1999 to become Y2K compliant, but does not expect such costs to be material to the operating expenses of the Company. Some of the costs are not expected to be incremental to the Company, but rather represent new equipment and software that would otherwise be purchased in the normal course of the Company's business. The Company is monitoring Y2K compliance for each of its large borrowers and will adjust the loan loss allowance accordingly if any Y2K noncompliance affects their ability to fulfill the terms and conditions of any loan agreement. The Company presently believes the Y2K issue will not pose significant operating problems for the Company. However, if implementation and testing plans are not completed in a satisfactory and timely manner, in particular by third parties on which the Company is dependent, or other unforeseen problems arise, no assurance can be given with respect to the cost or timing of such efforts or any potential adverse effects on the Company's business, financial condition, or results of operation. PART II - OTHER INFORMATION Item 1. Legal Proceedings The Company and its subsidiary are not involved in any litigation, nor is the Company aware of any pending litigation, other than legal proceedings incident to the business of the Company. Management condition or results of operations of the Company. 20 SERVICE BANCORP, INC. AND SUBSIDIARY PART II - OTHER INFORMATION (Continued) Item 2. Changes in Securities The Company is a Massachusetts corporation that was organized in August, 1998 at the direction of the Board of Directors of the Bank and the Board of Trustees of the MHC for the purpose of owning all of the capital stock of the Bank. The Company offered for sale 47% of the shares of its common stock an to eligible depositors, employees, and members of the general public (the "Offering"). The remaining 53% of the Company's shares of common stock were issued to the MHC. The Offering was completed on October 7, 1998. Prior to that date, the Company had no assets or liabilities. Completion of the Offering resulted in the issuance of 1,712,630 shares of common stock, 907,694 shares (53%) of which were issued to the MHC and 804,936 shares (47%) of which were sold to eligible depositors, employees, and the general public at $10.00 per share. Costs related to the Offering (primarily marketing fees paid to an underwriting firm, professional fees, registration fees, and printing and mailing costs) aggregated $569,000. These costs together with funds loaned to purchase shares for the ESOP were deducted to arrive at net proceeds of $6.8 million. The Company contributed 50% of the net proceeds of the Offering to the Bank for general corporate use. On October 7, 1998, the Company loaned approximately $644,000 to the Company's Employee Stock Option Plan to fund its purchase of 64,394 shares of common stock of the Company. Item 3. Default Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K Exhibit 27 EDGAR financial data schedule. There were no reports filed on Form 8-K. 21 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SERVICE BANCORP, INC. Date: February 10, 1999 By: /s/ Eugene G. Stone ----------------------------------------- Eugene G. Stone President and Chief Executive Officer Date: February 10, 1999 By: /s/ Warren W. Chase, Jr. ----------------------------------------- Warren W. Chase, Jr. Vice President and Treasurer 22