SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2003 OR [ ] 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: 000-25328 FIRST KEYSTONE FINANCIAL, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Pennsylvania 23-0469351 - --------------------------------- ------------------------ (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 22 West State Street Media, Pennsylvania 19063 - --------------------------------------- ---------- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (610) 565-6210 Indicate by check mark whether the Registrant (1) has filed all reports required 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 by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes [ ] No [X] Number of shares of Common Stock outstanding as of February 10, 2004: 1,891,237 Transitional Small Business Disclosure Format Yes [ ] No [X] FIRST KEYSTONE FINANCIAL, INC. CONTENTS PAGE ---- PART I FINANCIAL INFORMATION: Item 1. Financial Statements Consolidated Statements of Financial Condition as of December 31, 2003 (Unaudited) and September 30, 2003 1 Unaudited Consolidated Statements of Income for the Three Months Ended December 31, 2003 and 2002 2 Unaudited Consolidated Statement of Changes in Stockholders' Equity for the Three Months Ended December 31, 2003 3 Unaudited Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2003 and 2002 4 Notes to Unaudited Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 16 Item 4. Disclosure Controls and Procedures 17 PART II OTHER INFORMATION Item 1. Legal Proceedings 18 Item 2. Changes in Securities and Use of Proceeds 18 Item 3. Defaults Upon Senior Securities 18 Item 4. Submission of Matters to a Vote of Security Holders 18 Item 5. Other Information 18 Item 6. Exhibits and Reports on Form 8-K 19 SIGNATURES 20 -i- FIRST KEYSTONE FINANCIAL, INC. CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (dollars in thousands, except share amounts) (Unaudited) December 31 September 30 2003 2003 ----------- ------------ ASSETS Cash and amounts due from depository institutions $ 8,330 $ 10,439 Interest-bearing deposits with depository institutions 7,269 10,751 ----------- ------------ Total cash and cash equivalents 15,599 21,190 Investment securities available for sale 73,179 77,700 Mortgage-related securities available for sale 119,957 124,656 Loans held for sale 250 4,498 Investment securities held to maturity - at amortized cost (approximate fair value of $6,450 at December 31, 2003 and $6,450 at September 30, 2003) 6,308 6,315 Mortgage-related securities held to maturity - at amortized cost (approximate fair value of $15,160 at December 31, 2003 and $3,560 at September 30, 2003) 15,076 3,487 Loans receivable (net of allowance for loan loss of $2,017 and $1,986 at December 31, 2003 and September 30, 2003, respectively) 290,874 286,421 Accrued interest receivable 2,746 2,654 Real estate owned 1,420 1,420 Federal Home Loan Bank stock at cost 8,274 8,294 Office properties and equipment, net 3,548 3,427 Cash surrender value of life insurance 15,644 15,365 Prepaid expenses and other assets 3,099 4,185 ----------- ------------ TOTAL ASSETS $ 555,974 $ 559,612 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits $ 346,700 $ 362,605 Advances from Federal Home Loan Bank and other borrowings 150,108 136,272 Junior subordinated debt 21,584 21,593 Accrued interest payable 1,050 1,111 Advances from borrowers for taxes and insurance 1,944 958 Deferred income taxes 249 581 Accounts payable and accrued expenses 2,903 4,104 ----------- ------------ Total liabilities 524,538 527,224 ----------- ------------ Stockholders' Equity: Preferred stock, $.01 par value, 10,000,000 shares authorized; none issued Common stock, $.01 par value, 20,000,000 shares authorized; issued and outstanding: 1,890,897 shares at December 31, 2003 and 1,925,337 shares at September 30, 2003 14 14 Additional paid-in capital 13,514 13,443 Employee stock ownership plan (786) (830) Treasury stock at cost: 821,659 shares at December 31, 2003 and 787,219 shares at September 30, 2003 (12,336) (11,378) Accumulated other comprehensive income 2,425 3,069 Retained earnings - partially restricted 28,605 28,070 ----------- ------------ Total stockholders' equity 31,436 32,388 ----------- ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 555,974 $ 559,612 =========== ============ See notes to unaudited consolidated financial statements. -1- FIRST KEYSTONE FINANCIAL, INC. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENTS OF INCOME (dollars in thousands, except per share data) Three months ended December 31 --------------------- 2003 2002 --------- --------- INTEREST INCOME: Interest on: Loans $ 4,445 $ 5,050 Mortgage-related securities 1,229 1,110 Investment securities: Taxable 639 606 Tax-exempt 241 300 Dividends 64 95 Interest-bearing deposits 18 56 --------- --------- Total interest income 6,636 7,217 --------- --------- INTEREST EXPENSE: Interest on: Deposits 1,588 1,967 Federal Home Loan Bank advances and other borrowings 1,739 1,740 Trust preferred securities 413 429 --------- --------- Total interest expense 3,740 4,136 --------- --------- NET INTEREST INCOME 2,896 3,081 PROVISION FOR LOAN LOSSES 75 195 --------- --------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 2,821 2,886 --------- --------- NON-INTEREST INCOME: Service charges and other fees 267 272 Net gain on sales of: Loans held for sale 7 136 Investment securities 405 11 Increase in cash surrender value 273 167 Other income 112 38 --------- --------- Total non-interest income 1,064 624 --------- --------- NON-INTEREST EXPENSE: Salaries and employee benefits 1,530 1,156 Occupancy and equipment 305 286 Professional fees 231 215 Federal deposit insurance premium 13 14 Data processing 111 120 Advertising 98 120 Net cost of operation of other real estate 87 5 Other 558 594 --------- --------- Total non-interest expense 2,933 2,510 --------- --------- INCOME BEFORE INCOME TAX EXPENSE 952 1,000 INCOME TAX EXPENSE 209 219 --------- --------- NET INCOME $ 743 $ 781 ========= ========= BASIC EARNINGS PER COMMON SHARE $ 0.40 $ 0.41 ========= ========= DILUTED EARNINGS PER COMMON SHARE $ 0.37 $ 0.39 ========= ========= See notes to unaudited consolidated financial statements. -2- FIRST KEYSTONE FINANCIAL, INC. AND SUBSIDIARIES UNAUDITED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (dollars in thousands) Accumulated Retained Additional Employee other earnings- Total Common paid-in stock ownership Treasury comprehensive partially stockholders' stock capital plan stock income restricted equity ------ ---------- --------------- -------- ------------- ---------- ------------- BALANCE AT OCTOBER 1, 2003 $ 14 $ 13,443 $ (830) $(11,378) $3,069 $ 28,070 $ 32,388 Net income 743 743 Other comprehensive income, net of tax: Net unrealized loss on securities net of reclassification adjustment(1) (644) (644) ------ -------- Comprehensive income 99 -------- ESOP stock committed to be released 44 44 Excess of fair value above cost of ESOP shares committed to be released 86 86 Purchase of treasury stock (1,044) (1,044) Exercise of stock options (15) 86 71 Dividends - $.11 per share (208) (208) ---- ---------- ------ -------- ------ -------- -------- BALANCE AT DECEMBER 31, 2003 $ 14 $ 13,514 $ (786) $(12,336) $2,425 $ 28,605 $ 31,436 ==== ========== ====== ======== ====== ======== ======== (1) Disclosure of reclassification amount, net of tax for the three months ended December 31, 2003: Net unrealized depreciation arising during the period $(911) Less: reclassification adjustment for net gains included in net income 267 ----- Net unrealized loss on securities $(644) ===== See notes to unaudited consolidated financial statements. -3- FIRST KEYSTONE FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (dollars in thousands) Three months ended December 31 -------------------- 2003 2002 -------- -------- OPERATING ACTIVITIES: Net income $ 743 $ 781 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Provision for depreciation and amortization 109 106 Amortization of premiums and discounts 22 176 Increase in cash surrender value of life insurance (279) (Gain) loss on sales of: Loans held for sale (7) (136) Investment securities (405) (11) Real estate owned -- (2) Provision for loan losses 75 195 Amortization of employee stock ownership plan 130 79 Changes in assets and liabilities which provided (used) cash: Origination of loans held for sale (1,923) (9,318) Loans sold in the secondary market 1,988 9,189 Accrued interest receivable (92) 20 Prepaid expenses and other assets 1,086 (291) Accrued interest payable (61) (93) Accrued expenses (1,201) 622 -------- -------- Net cash provided by operating activities 185 1,317 -------- -------- INVESTING ACTIVITIES: Loans originated (27,122) (40,823) Purchases of: Mortgage-related securities available for sale (7,060) (26,970) Investment securities available for sale -- (3,998) Mortgage-related securities held to maturity (11,951) -- Redemption (purchase) of FHLB stock 20 (493) Proceeds from sales of real estate owned -- 15 Proceeds from sales of investment securities 2,204 2,011 Principal collected on loans 26,860 38,121 Proceeds from maturities, calls, or repayments of: Investment securities available for sale 2,295 5,497 Mortgage-related securities available for sale 11,112 19,834 Mortgage-related securities held to maturity 360 2,432 Purchase of property and equipment (230) (55) -------- -------- Net cash used in investing activities (3,512) (4,429) -------- -------- FINANCING ACTIVITIES: Net (decrease) increase in deposit accounts (15,905) 7,609 Net increase in FHLB advances 13,836 42 Net increase in advances from borrowers for taxes and insurance 986 1,224 Exercise of stock options 71 28 Purchase of treasury stock (1,044) (92) Cash dividend (208) (201) -------- -------- Net cash (used in) provided by financing activities (2,264) 8,610 -------- -------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (5,591) 5,498 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 21,190 24,623 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 15,599 $ 30,121 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash payments for interest on deposits and borrowings $ 3,801 $ 3,800 Transfer of loans held for sale to loan portfolio 4,186 -- See notes to unaudited consolidated financial statements. -4- FIRST KEYSTONE FINANCIAL, INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (dollars in thousands, except per share amounts) 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in accordance with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of results for the periods. The results of operations for the three month period ended December 31, 2003 are not necessarily indicative of the results to be expected for the fiscal year ending September 30, 2004 or any other period. The consolidated financial statements presented herein should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Company's Form 10-K for the year ended September 30, 2003. 2. INVESTMENT SECURITIES The amortized cost and approximate fair value of investment securities available for sale and held to maturity, by contractual maturities, are as follows: December 31, 2003 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Approximate Cost Gain Loss Fair Value --------- ---------- ---------- ----------- Available for Sale: U.S. Government and agency bonds Less than 1 year $ 3,015 $ 2 $ -- $ 3,017 1 to 5 years 10,000 13 111 9,902 5 to 10 years 3,000 -- 62 2,938 Municipal obligations Over 10 years 14,118 447 -- 14,565 Corporate bonds 1 to 5 years 5,970 564 -- 6,534 5 to 10 years 996 126 -- 1,122 Over 10 years 9,049 227 104 9,172 Asset-backed securities 5 to 10 years 1,615 9 -- 1,624 Mutual funds 14,009 -- 91 13,918 Preferred stocks 5,474 15 974 4,515 Other equity investments 2,876 2,996 -- 5,872 --------- ------ ------ -------- Total $ 70,122 $4,399 $1,342 $ 73,179 ========= ====== ====== ======== Held to Maturity: Municipal obligations 5 to 10 years $ 2,594 $ 26 $ -- $ 2,620 Over 10 years 667 3 -- 670 Corporate bonds Less than 1 year 1,005 25 -- 1,030 1 to 5 years 2,042 88 -- 2,130 --------- ------ ------ -------- Total $ 6,308 $ 142 $ -- $ 6,450 ========= ====== ====== ======== -5- September 30, 2003 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Approximate Cost Gain Loss Fair Value --------- ---------- ---------- ----------- Available for Sale: U.S. Government and agency bonds 1 to 5 years $13,020 $ 35 $ 51 $ 13,004 5 to 10 years 4,880 139 31 4,988 Municipal obligations Over 10 years 14,112 503 -- 14,615 Corporate bonds 1 to 5 years 5,584 498 -- 6,082 5 to 10 years 2,932 458 -- 3,390 Over 10 years 9,051 332 332 9,051 Asset-backed securities 5 to 10 years 1,911 11 -- 1,922 Mutual funds 14,009 -- 57 13,952 Preferred stocks 5,474 34 524 4,984 Other equity investments 3,126 2,586 -- 5,712 ------- ------ ----- -------- Total $74,099 $4,596 $ 995 $ 77,700 ======= ====== ===== ======== Held to Maturity: Municipal obligations 5 to 10 years $ 1,545 $ 5 -- $ 1,550 Over 10 years 1,715 15 -- 1,730 Corporate bonds Less than 1 year 1,007 23 -- 1,030 1 to 5 years 2,048 92 -- 2,140 ------- ------ ----- ------- Total $ 6,315 $ 135 -- $ 6,450 ======= ====== ===== ======== 3. MORTGAGE-RELATED SECURITIES Mortgage-related securities available for sale and mortgage-related securities held to maturity are summarized as follows: December 31, 2003 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Approximate Cost Gain Loss Fair Value --------- ---------- ---------- ----------- Available for Sale: FHLMC pass-through certificates $ 8,355 $ 110 $ 33 $ 8,432 FNMA pass-through certificates 48,092 328 195 48,225 GNMA pass-through certificates 10,800 504 14 11,290 Collateralized mortgage obligations 52,093 248 331 52,010 --------- ------- ----- --------- Total $ 119,340 $ 1,190 $ 573 $ 119,957 ========= ======= ===== ========= Held to Maturity: FHLMC pass-through certificates $ 2,426 $ 24 $ 20 $ 2,430 FNMA pass-through certificates 11,868 97 5 11,960 Collateralized mortgage obligations 782 -- 12 770 --------- ------- ----- --------- Total $ 15,076 $ 121 $ 37 $ 15,160 ========= ======= ===== ========= -6- September 30, 2003 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Approximate Cost Gain Loss Fair Value --------- ---------- ---------- ----------- Available for Sale: FHLMC pass-through certificates $ 6,862 $ 126 $ 38 $ 6,950 FNMA pass-through certificates 45,740 412 122 46,030 GNMA pass-through certificates 13,043 596 -- 13,639 Collateralized mortgage obligations 57,961 433 357 58,037 --------- ------- ----- --------- Total $ 123,606 $ 1,567 $ 517 $ 124,656 ========= ======= ===== ========= Held to Maturity: FHLMC pass-through certificates $ 478 $ 22 $ -- $ 500 FNMA pass-through certificates 2,123 40 3 2,160 Collateralized mortgage obligations 886 14 -- 900 --------- ------- ----- --------- Total $ 3,487 $ 76 $ 3 $ 3,560 ========= ======= ===== ========= 4. LOANS RECEIVABLE Loans receivable consist of the following: December 31 September 30 2003 2003 ----------- ------------ Real estate loans: Single-family $ 165,400 $ 166,042 Construction and land 30,394 28,975 Multi-family and commercial 61,906 59,022 Home equity and lines of credit 37,000 33,459 Consumer loans 1,495 1,438 Commercial loans 9,328 10,161 ----------- ------------ Total loans 305,523 299,097 Loans in process (12,596) (10,655) Allowance for loan losses (2,017) (1,986) Deferred loan fees (36) (35) ----------- ------------ Loans receivable - net $ 290,874 $ 286,421 =========== ============ The following is an analysis of the allowance for loan losses: Three Months Ended December 31 ------------------ 2003 2002 ------- ------- Balance beginning of period $ 1,986 $ 2,358 Provisions charged to income 75 195 Charge-offs (82) (31) Recoveries 38 8 ------- ------- Total $ 2,017 $ 2,530 ======= ======= At December 31, 2003 and September 30, 2003, non-performing loans (which include loans in excess of 90 days delinquent) amounted to approximately $1,715 and $1,556, respectively. At December 31, 2003, non-performing loans primarily consisted of single-family residential mortgage loans aggregating $1,000 and, to a lesser extent, commercial real estate loans totaling $467. -7- 5. DEPOSITS Deposits consist of the following major classifications: December 31 September 30 2003 2003 -------------------- ------------------ Amount Percent Amount Percent ------ ------- ------ ------- Non-interest bearing $ 20,540 5.9% $ 20,917 5.8% NOW 52,565 15.2 60,221 16.6 Passbook 47,758 13.8 47,089 13.0 Money market demand 53,040 15.3 55,889 15.4 Certificates of deposit 172,797 49.8 178,489 49.2 --------- ----- --------- ----- Total $ 346,700 100.0% $ 362,605 100.0% ========= ===== ========= ===== 6. EARNINGS PER SHARE Basic net income per share is based upon the weighted average number of common shares outstanding, while diluted net income per share is based upon the weighted average number of common shares outstanding and common share equivalents that would arise from the exercise of dilutive securities. All dilutive shares consist of options the exercise price of which is lower than the market price of the common stock covered thereby at the dates presented. The calculated basic and diluted earnings per share ("EPS") is as follows: Three Months Ended December 31 ----------------------- 2003 2002 ---- ---- Numerator $ 743 $ 781 Denominators: Basic shares outstanding 1,834,220 1,906,521 Effect of dilutive securities 153,630 111,212 ---------- --------- Dilutive shares outstanding 1,987,850 2,017,733 ========== ========== Earnings per share: Basic $ 0.40 $ 0.41 Diluted $ 0.37 $ 0.39 -8- 7. STOCK-BASED COMPENSATION The Company applies APB Opinion No. 25 in accounting for stock options and, accordingly, no compensation expense has been recognized in the financial statements. Had the Company determined compensation expense based on the fair value at the grant date for its stock option in accordance with the fair value method in SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below. Three Months Ended December 31 ----------- 2003 2002 ---- ---- Net income, as reported $ 743 $ 781 Less: Total stock-based employee compensation expense determined under fair value method for all options, net of tax 5 18 ----- ----- Pro forma net income $ 738 $ 763 ===== ===== Earnings per share: Basic - as reported $0.40 $0.41 Basic - pro forma $0.40 $0.40 Diluted - as reported $0.37 $0.39 Diluted - pro forma $0.37 $0.38 8. RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities." In December 2003, the FASB issued a revision of FIN 46 (FIN 46(R)). The Interpretation clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Company has participated in the issue of trust preferred securities through trusts established for such purpose. These trusts are subject to the requirements of FIN No. 46 and FIN No. 46(R). Effective December 31, 2003, the Company adopted this statement requiring the Company to deconsolidate the trust preferred security trusts. The Company previously classified its trust preferred securities after total liabilities and before stockholders' equity on the Consolidated Statement of Financial Condition. Under the provisions of FIN No. 46 and FIN No. 46(R), these securities were reclassified as borrowed funds effective December 31, 2003. Additionally, the related dividends were reclassified from non-interest expense and included in interest expense in the Consolidated Statement of Income. Reclassifications of prior period amounts were made to conform to this presentation. The adoption of FIN No. 46 and FIN No. 46(R) did not have a material impact on the Company's financial statements. However, the effect of reclassifying dividends from non-interest expense decreased the Company's net interest margin for the first quarter of 2004 by approximately 32 basis points from 2.62% to 2.30%. -9- In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This statement requires that certain financial instruments, which previously could be designated as equity, now be classified as liabilities on the balance sheet. The adoption of SFAS No. 150 did not have a material impact on the Company's financial statements. In December 2003, the FASB Emerging Issues Task Force reached consensus on several issues being addressed in EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The objectives of EITF 03-1 is to provide guidance on other-than-temporary impairment and its application to debt and marketable equity securities. The EITF reached consensus requiring disclosures, tabular and narrative, that will provide sufficient information to provide an understanding of the circumstances leading to management's conclusion that the impairments are not other-than-temporary. The requirements apply only to annual financial statements for fiscal years ending after December 15, 2003. The Company will apply the disclosure requirements to its annual financial statements for the fiscal year ending September 30, 2004. The Company does not anticipate this requirement will have a material impact on the Company's financial statements. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition to historical information, this Quarterly Report on Form 10-Q includes certain "forward-looking statements" based on management's current expectations and beliefs. The Company's actual results could differ materially, as defined in the Securities Act of 1933 and the Securities Exchange Act of 1934, from management's expectations. Such forward-looking statements include statements regarding management's current intentions, beliefs or expectations as well as the assumptions on which such statements are based. These forward-looking statements are subject to significant business, economic and competitive uncertainties and contingencies, many of which are not subject to the Company's control. Stockholders and potential stockholders are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements. Factors that could cause future results to vary from current management expectations include, but are not limited to, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the federal government, changes in tax policies, rates and regulations of federal, state and local tax authorities, changes in interest rates, deposit flows, the cost of funds, demand for loan products, demand for financial services, competition, changes in the quality or composition of the Company's loan and investment portfolios, changes in accounting principles, policies or guidelines, availability and cost of energy resources and other economic, competitive, governmental and technological factors affecting the Company's operations, markets, products, services and fees. The Company undertakes no obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results that occur subsequent to the date such forward-looking statements are made. COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND SEPTEMBER 30, 2003 Total assets of the Company decreased slightly $3.6 million from $559.6 million at September 30, 2003 to $556.0 million at December 31, 2003. Mortgage-related securities held to maturity increased to $15.1 million from $3.5 million at September 30, 2003 mainly due to the Company's strategy to reinvest the cash flows from the loan and securities portfolio into the held to maturity portfolio in order to minimize price volatility in the future as rates increase as the Company expects they will. Loans receivable increased $4.5 million, or 1.6%, from $286.4 million to $290.9 million at September 30, 2003 reflecting the Company's strategy in increasing its investment in higher yielding assets. The increase in loans receivable was in commercial real estate loans and home equity loans partially offset by decreases in single-family residential loans. Loans held for sale decreased $4.2 million due to management's reevaluation of the Company's asset liability position and decision to retain $4.2 million of the loans originally intended to be sold in the secondary market instead in its residential loan portfolio. -10- Deposits decreased $15.9 million, or 4.4%, from $362.6 million at September 30, 2003 to $346.7 million at December 31, 2003. The decrease resulted from decreases of $10.2 million, or 5.6%, in core deposits (which consist of passbook, money market, NOW and non-interest bearing accounts) combined with a decrease of $5.7 million, or 3.2%, in certificates of deposit. The decrease in deposits resulted from declines in deposit accounts maintained by title insurance companies due to a decrease in refinancing activity combined with higher rates being offered by local competition. Due to the decrease in deposits, borrowings increased $13.8 million, or 10.2%, in overnight advances with the FHLB. Stockholders' equity decreased $952,000 to $31.4 million primarily due to the Company repurchasing 40,200 shares of stock during the first quarter of fiscal 2004 combined with dividend payments of $208,000 partially offset by net income of $743,000. COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002 NET INCOME. Net income was $743,000 for the three months ended December 31, 2003 as compared to $781,000 for the same period in 2002. The $38,000, or 4.9%, decrease in net income for the three months ended December 31, 2003 was primarily due to a $185,000 decrease in net interest income combined with a $423,000 increase in non-interest expense partially offset by a $440,000 increase in non-interest income along with a $120,000 decrease in provision for loan losses. NET INTEREST INCOME. Net interest income decreased $185,000, or 6.0%, to $2.9 million for the three months ended December 31, 2003 as compared to the same period in 2002. The decrease was primarily due to a $581,000, or 8.1%, decrease in interest income which was partially offset by a $396,000, or 9.6%, decrease in interest expense as compared to the 2002 period. The $581,000 decrease in interest income was primarily due to a 85 basis point (on a fully tax equivalent basis) decrease in the weighted yield earned on the Company's interest-earning assets, partially offset by a $34.5 million, or 7.1%, increase in the average balance of such assets. The $396,000 decrease in interest expense was primarily due to a 56 basis point decrease in the weighted average rate paid on interest-bearing liabilities offset, in part, by an increase of $37.7 million, or 7.9%, in the average balance of such liabilities for the three months ended December 31, 2003, as compared to the same period in 2002. The interest rate spread and net interest margin, on a fully tax equivalent basis, were 2.28% and 2.30%, respectively, for the three months ended December 31, 2003 as compared to 2.57% and 2.62%, respectively, for the same period in 2002. The Company's adoption of SFAS 150 required the Company to reclassify $21.6 million of trust preferred securities from the mezzanine section of the Consolidated Statement of Condition to borrowed funds. The dividends paid on these financial instruments, previously classified as non-interest expense, were reclassified as interest expense adversely impacting the net interest margin by 31 and 35 basis points for the quarters ended December 31, 2003 and 2002, respectively. -11- The following table presents the average balances for various categories of assets and liabilities, and income and expense related to those assets and liabilities for the three months ended December 31, 2003 and 2002. The adjustment of tax exempt securities to a tax equivalent yield in the table below may be considered to include non-GAAP financial information. Management believes that it is a standard practice in the banking industry to present net interest margin, net interest rate spread and net interest income on a fully tax equivalent basis when a significant proportion of interest-earning assets are tax-free. Therefore, management believes, these measures provide useful information to investors by allowing them to make peer comparisons. A GAAP reconciliation is included below. FOR THE THREE MONTHS ENDED --------------------------------------------------------------- DECEMBER 31, 2003 DECEMBER 31, 2002 --------------------------------------------------------------- Average Average Average Yield/ Average Yield/ (Dollars in thousands) Balance Interest Cost Balance Interest Cost --------- -------- ------ --------- -------- ------- Interest-earning assets: Loans receivable(1)(2) $ 290,683 $ 4,445 6.12% $ 290,158 $ 5,050 6.96% Mortgage-related securities(2) 127,640 1,229 3.85 92,282 1,110 4.81 Investment securities(2) 90,407 1,040 4.60 83,623 1,110 5.31 Other interest-earning assets 12,268 18 0.58 20,399 56 1.10 --------- -------- --------- -------- Total interest-earning assets 520,998 $ 6,732 5.17 486,462 $ 7,326 6.02 --------- -------- ------ --------- -------- ------ Non-interest-earning assets 36,724 29,973 --------- --------- Total assets $ 557,722 $ 516,435 ========= ========= Interest-bearing liabilities: Deposits $ 352,429 $ 1,588 1.80 $ 331,802 $ 1,967 2.37 FHLB advances and other borrowings 143,540 1,739 4.85 126,395 1,740 5.52 Trust preferred securities 21,590 413 7.65 21,626 429 7.93 --------- -------- --------- -------- Total interest-bearing liabilities 517,559 3,740 2.89 479,823 4,136 3.45 --------- -------- ------ --------- -------- ------ Interest rate spread 2.28% 2.57% ====== ====== Non-interest-bearing liabilities 8,505 4,043 --------- --------- Total liabilities 526,064 483,866 Stockholders' equity 31,658 32,569 ========= ========= Total liabilities and stockholders' equity $ 557,722 $ 516,435 ========= ========= Net interest-earning assets $ 3,439 $ 6,639 ========= ========= Net interest income $ 2,992 $ 3,190 ======== ======== Net interest margin(3) 2.30% 2.62% ====== ====== Ratio of average interest-earning assets to average interest-bearing liabilities 100.66% 101.38% ====== ====== (1) Includes non-accrual loans. (2) Includes assets classified as either available for sale or held for sale. (3) Net interest income divided by interest-earning assets. -12- Although management believes that the above mentioned non-GAAP financial measures enhance investor's understanding of the Company's business and performance, these non-GAAP financials measures should not be considered an alternative to GAAP. The reconciliation of these non-GAAP financials measures from GAAP to non-GAAP is presented below. FOR THE THREE MONTHS ENDED ------------------------------------------------ DECEMBER 31, 2003 DECEMBER 31, 2002 ------------------------------------------------ AVERAGE AVERAGE (Dollars in thousands) INTEREST YIELD/COST INTEREST YIELD/COST -------- ---------- -------- ---------- Investment securities - nontaxable $ 944 4.18% $ 1,001 4.79% Tax equivalent adjustments 96 109 -------- -------- Investment securities - nontaxable to a taxable equivalent yield $ 1,040 4.60% $ 1,110 5.31% ======== ======== Net interest income $ 2,896 $ 3,081 Tax equivalent adjustment 96 109 -------- -------- Net interest income, tax equivalent $ 2,992 $ 3,190 ======== ======== Net interest rate spread, no tax adjustment 2.20% 2.48% Net interest margin, no tax adjustment 2.22% 2.53% PROVISION FOR LOAN LOSSES. Provisions for loan losses are charged to earnings to maintain the total allowance for loan losses at a level believed by management to cover all known and inherent losses in the loan portfolio which are both probable and reasonably estimable. Management's analysis includes consideration of the Company's historical experience, the volume and type of lending conducted by the Company, the amount of the Company's classified assets, the status of past due principal and interest payments, general economic conditions, particularly as they relate to the amount of the Company's primary market area, and other factors related to the collectibility of the Company's loan and loans held for sale portfolios. For the three months ended December 31, 2003 and 2002, the provision for loan losses amounted to $75,000 and $195,000, respectively. The decrease in provision for loan loss was primarily due to the decrease in non-performing assets from December 31, 2002. At December 31, 2003, non-performing assets increased slightly to $3.1 million, or .56%, of total assets, from $3.0 million at September 30, 2003. The coverage ratio, which is the ratio of the allowance for loan losses to non-performing assets, was 64.3% and 66.7% at December 31, 2003 and September 30, 2003, respectively. Included in non-performing assets is $1.4 million of real estate owned consisting primarily of a $1.1 commercial real estate property. The Bank owns a 25% participation interest in an 18-hole golf course and a golf house located in Avondale, Pennsylvania. The golf facility is fully operational and continues to generate revenues. However, in connection with the operations of the facility, the Company has incurred its representative share of expenses totaling of approximately $75,000 for the three months ended December 31, 2003. Management believes that the Company will continue to incur expenses in the upcoming quarters in connection with the operation of the golf facility. The Bank's participation interest in a non-performing commercial real estate loan totaling $320,000 was paid off during the quarter. Management continues to review its loan portfolio to determine the extent, if any, to which further additional loss provisions may be deemed necessary. There can be no assurance that the allowance for losses will be adequate to cover losses which may in fact be realized in the future and that additional provisions for losses will not be required. -13- NON-INTEREST INCOME. Non-interest income increased $440,000 or 70.5% to $1.1 million for the three months ended December 31, 2003 as compared to the same period in 2002. The increase for the three months ended December 31, 2003 was primarily due to a $394,000 increase on the gain on sales of investment securities resulting from taking advantage of market conditions, including a favorable tender offer for a corporate security. The Company also experienced a $118,000 increase in the cash surrender value of certain insurance policies held by the Bank to fund retirement benefits with a corresponding increase in expenses providing for retirement benefits. In addition, the Company had a $74,000 increase in other income. These increases were partially offset by a $129,000 decrease in the gain on sale of loans resulting from the significant slowdown in refinancing activity. NON-INTEREST EXPENSE. Non-interest expense increased $423,000 or 16.9% during the three months ended December 31, 2003 compared to the same period in 2002. The increase was primarily due to increases of $374,000, $82,000, and $19,000 in compensation and employee benefits, real estate operations and occupancy and equipment expenses, respectively, partially offset by a $36,000 decrease in other non-interest expense. A majority of the increase in compensation and employee benefits reflected increases in pension benefits, employee stock ownership expense and higher employee medical costs. The increase in real estate operations was primarily due to expenses related to a commercial property, as previously discussed. Management believes that the Company will continue to incur expenses in the upcoming quarters with the operation of the golf facility. INCOME TAX EXPENSE. Income tax expense decreased $10,000 to $209,000 during the three months ended December 31, 2003 as compared to the same period in 2002. The decrease reflected the decrease in income before income taxes as compared to the same period in 2002. CRITICAL ACCOUNTING POLICIES. The Company has identified the evaluation of the allowance for loan losses as a critical accounting estimate where amounts are sensitive to material variation. Critical accounting estimates are significantly affected by management judgment and uncertainties and there is a likelihood that materially different amounts would be reported under different, but reasonably plausible, conditions or assumptions. The allowance for loan losses is considered a critical accounting estimate because there is a large degree of judgment in (i) assigning individual loans to specific risk levels (pass, special mention, substandard, doubtful and loss), (ii) valuing the underlying collateral securing the loans, (iii) determining the appropriate reserve factor to be applied to specific risk levels for criticized and classified loans (special mention, substandard, doubtful and loss) and (iv) determining reserve factors to be applied to pass loans based upon loan type. To the extent that loans change risk levels, collateral values change or reserve factors change, the Company may need to adjust its provision for loan losses which would impact earnings. Management has discussed the development and selection of this critical accounting estimate with the Audit Committee of the Board of Directors and the Audit Committee has reviewed the Company's disclosure relating to it in this Management's Discussion and Analysis. Management believes the allowance for loan losses at December 31, 2003 was at a level to cover the known and inherent losses in the portfolio that were both probable and reasonable to estimate. In the future, management may adjust the level of its allowance for loan losses as economic and other conditions dictate. Management reviews the allowance for loan losses not less than quarterly. -14- LIQUIDITY AND CAPITAL RESOURCES. The Company's liquidity, represented by cash and cash equivalents, is a product of its operating, investing and financing activities. The Company's primary sources of funds are deposits, repayments, prepayments and maturities of outstanding loans and mortgage-related securities, sales of loans, maturities of investment securities and other short-term investments, borrowing and funds provided from operations. While scheduled payments from the amortization of loans and mortgage-related securities and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, the Company invests excess funds in overnight deposits and other short-term interest-earning assets which provide liquidity to meet lending requirements. The Company has been able to generate sufficient cash through its deposits as well as borrowings to satisfy its funding commitments. At December 31, 2003, the Company had short-term borrowings (due within one year or currently callable by the Federal Home Loan Bank ("FHLB")) outstanding of $121.8 million, all of which consisted of advances from the FHLB of Pittsburgh. Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits. On a longer term basis, the Company maintains a strategy of investing in various lending products, mortgage-related securities and investment securities. The Company uses its sources of funds primarily to meet its ongoing commitments, to fund maturing certificates of deposit and savings withdrawals, fund loan commitments and maintain a portfolio of mortgage-related and investment securities. At December 31, 2003, total approved loan commitments outstanding amounted to $3.9 million, not including loans in process. At the same date, commitments under unused lines of credit amounted to $31.4 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2003 totaled $110.5 million. Based upon its historical experience, management believes that a significant portion of maturing deposits will remain with the Company. As of December 31, 2003, the Bank had regulatory capital which was in excess of applicable requirements. The Bank is required under applicable federal banking regulations to maintain tangible capital equal to at least 1.5% of its adjusted total assets, core capital equal to at least 4.0% of its adjusted total assets and total capital to at least 8.0% of its risk-weighted assets. At December 31, 2003, the Bank had tangible capital and core capital equal to 8.1% of adjusted total assets and total capital equal to 15.1% of risk-weighted assets. INVESTMENT SECURITIES. At December 31, 2003, the Company's investment securities available for sale portfolio, including short-term investments, were carried at a fair value of $73.2 million and had an amortized cost of $70.1 million. The average credit quality on the portfolio is AA. The net unrealized gain on its investment assets at September 30, 2003 was $3.1 million, or 4.4% of the amortized cost basis. The net unrealized gain included gross unrealized gains of $4.4 million and gross unrealized losses of $1.3 million. The Company reviews the securities in our fixed income portfolio on a periodic basis to specifically review individual securities for any meaningful decline in market value below amortized cost. The analysis addresses all securities whose fair value is significantly below amortized cost at the time of the analysis, with additional emphasis placed on securities whose fair value has been below amortized cost for an extended period of time. As part of the periodic review process, the Company utilizes the expertise of outside professional asset managers who provide an updated assessment of each issuer's current credit situation based on recent issuer activities, such as quarterly earnings announcements or other pertinent financial news for the issuer, recent developments in a particular industry, economic outlook for a particular industry and rating agency actions. In addition to issuer-specific financial information and general economic data, the Company also considers the ability and intent of its operations to hold a particular security to maturity or until the market value of the security recovers to a level in excess of the carrying value. -15- Ten securities in portfolio have been in an unrealized loss position for a substantial period of time. Nine of these securities have an unrealized loss of less than $369,000 and/or less than 4.0% of their amortized cost. These nine securities have an average unrealized loss per security of approximately $41,000 and have fair values at September 30, 2003 that are 96% or more of the amortized cost basis. There is only one security with an unrealized loss of approximately $975,000 at December 31, 2003 with a market value of $4.0 million and a cost of $5.0 million. The security is an equity security and is rated AAA. The Company has no current plans to dispose of this security. For all securities that are in an unrealized loss position for an extended period of time, an evaluation is performed of the specific events attributable to the decline in the market value of the security. Factors that are considered are the length of time and extent to which the security's market value has been below cost as well as the general market conditions, industry characteristics and the fundamental operating results of the issuer to determine if the decline is due to changes in interest rates, changes relating to a decline in credit quality of the issuer, or general market conditions. An additional part of the evaluation is the Company's intent and ability to hold the security until its market value has recovered to a level at least equal to the amortized cost. If the security's unrealized loss is other than temporary, a realized loss is recognized in the period in which the decline in value is determined to be other than temporary. Based on our evaluation as of December 31, 2003, the Company determined the declines in market value of securities of these ten securities were temporary. The Company will continue to review these securities and evaluate the temporary nature of the impairment on a quarterly basis. IMPACT OF INFLATION AND CHANGING PRICES. The Consolidated Financial Statements of the Company and related notes presented herein have been prepared in accordance with generally accepted accounting principles which requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the price of goods and services, since such prices are affected by inflation to a larger extent than interest rates. In the current interest rate environment, liquidity and the maturity structure of the Company's assets and liabilities are critical to the maintenance of acceptable performance levels. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For a discussion of the Company's asset and liability management policies, see "Management's Discussion and Analysis of Financial Condition and Results of Operation" in the Company's Form 10-K for the year ended September 30, 2003. The Company utilizes reports prepared by the Office of Thrift Supervision ("OTS") to measure interest rate risk. Using data from the Bank's quarterly thrift financial reports, the OTS models the net portfolio value ("NPV") of the Bank over a variety of interest rate scenarios. The NPV is defined as the present value of expected cash flows from existing assets less the present value of expected cash flows from existing liabilities plus the present value of net expected cash inflows from existing off-balance sheet contracts. The model assumes instantaneous, parallel shifts in the U.S. Treasury Securities yield curve of 100 to 300 basis points, either up or down, and in 100 basis point increments. -16- The interest rate risk measures used by the OTS include an "Exposure Measure" or "Post-Shock" NPV ratio and a "Sensitivity Measure". The "Post-Shock" NPV ratio is the net present value as a percentage of assets over the various yield curve shifts. A low "Post-Shock" NPV ratio indicates greater exposure to interest rate risk and can result from a low initial NPV ratio or high sensitivity to changes in interest rates. The "Sensitivity Measure" is the decline in the NPV ratio, in basis points, caused by a 2% increase or decrease in rates, whichever produces a larger decline. The following sets forth the Bank's NPV as of December 31, 2003. NET PORTFOLIO VALUE (Dollars in thousands) - ------------------------------------------------------------------------------------------------------- Changes in Net Rates in Dollar Percentage Portfolio Value As Basis Points Amount Change Change a % of Assets Change - ------------------------------------------------------------------------------------------------------- 300 $29,203 $(22,189) (43.18)% 5.48% (354)bp 200 37,912 (13,480) (26.23) 6.95 (207)bp 100 45,691 (5,701) (11.09) 8.19 (83)bp 0 51,392 -- -- 9.02 -- (100) 50,874 (518) (1.01) 8.83 (19)bp As of December 31, 2003, the Company's NPV was $51.4 million or 9.02% of the market value of assets. Following a 200 basis point increase in interest rates, the Company's "post shock" NPV was $37.9 million or 6.95% of the market value of assets. The change in the NPV ratio or the Company's sensitivity measure was (2.07)%. As of September 30, 2003, the Company's NPV was $47.1 million or 8.24% of the market value of assets. Following a 200 basis point increase in interest rates, the Company's "post shock" NPV was $34.0 million or 6.22% of the market value of assets. The change in the NPV ratio or the Company's sensitivity measure was (2.02)%. ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and regulations and are operating in an effective manner. No change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. -17- PART II OTHER INFORMATION Item 1. Legal Proceedings No material changes have occurred with respect to the legal proceedings previously disclosed in Item 3 of the Company's Form 10-K for the year ended September 30, 2003. Item 2. Changes in Securities and Use of Proceeds Not applicable Item 3. Defaults Upon Senior Securities Not applicable Item 4. Submission of Matters to a Vote of Security Holders On January 28, 2004, the Annual Meeting of Stockholders of the Company was held to elect management's nominees for director and to ratify the appointment of the Company's independent auditors. No other nominations for directors were submitted. With respect to the election of directors, the results were as follows: Votes ------------------------- Nominee For Withheld - ------------------- --------- -------- Bruce C. Hendrixson 1,761,498 1,717 Thomas M. Kelly 1,761,652 1,563 With respect to the ratification of Deloitte & Touche LLP as the Company's independent auditors for the fiscal year ending September 30, 2004, the results were as follows: 1,757,398 votes for, 5,760 votes against and 56 votes abstaining. Item 5. Other Information None -18- Item 6. Exhibits and Reports on Form 8-K (a) List of Exhibits Exhibit Description - ------- ----------------------------------------------------------------------- 31.1 Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002 certification of the Chief Executive Officer 31.2 Pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934 and Section 302 of the Sarbanes-Oxley Act of 2002 certification of the Chief Financial Officer 32.1 Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) 32.2 Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) (b) Reports on Form 8-K Date Item and Description - ---------- ------------------------------------------------------------- 11/14/2003 Item 12. On November 12, 2003, the Company issued a press release reporting its earnings for the quarter and year ended September 30, 2003. -19- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FIRST KEYSTONE FINANCIAL, INC. Date: February 13, 2004 By: /s/ Donald S. Guthrie ------------------------------------ Donald S. Guthrie Chairman and Chief Executive Officer Date: February 13, 2004 By: /s/ Rose M. DiMarco ------------------------------------ Rose M. DiMarco Chief Financial Officer -20-