FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2003 |_| 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 0-30062 CAPITAL BANK CORPORATION (Exact name of registrant as specified in its charter) North Carolina 56-2101930 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 4901 Glenwood Avenue Raleigh, North Carolina 27612 (Address of Principal executive offices) (Zip Code) Registrant's telephone number, including area code: (919) 645-6400 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. |X| Yes |_| No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). |_| Yes |X| No As of November 12, 2003, there were 6,514,096 shares outstanding of the registrant's common stock, no par value. Capital Bank Corporation CONTENTS PART I - FINANCIAL INFORMATION Page No. Item 1. Financial Statements Condensed consolidated statements of financial condition at September 30, 2003 (Unaudited) and December 31, 2002 1 Condensed consolidated statements of income (loss) for the three months ended September 30, 2003 and 2002 (Unaudited) 2 Condensed consolidated statements of income (loss) for the nine months ended September 30, 2003 and 2002 (Unaudited) 3 Condensed consolidated statements of comprehensive income (loss) for the three and nine months ended September 30, 2003 and 2002 (Unaudited) 4 Condensed consolidated statements of cash flows for the nine months ended September 30, 2003 and 2002 (Unaudited) 5 - 6 Notes to condensed consolidated financial statements 7 - 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 - 24 Item 3. Quantitative and Qualitative Disclosures About Market Risk 24 Item 4. Controls and Procedures 24 - 25 PART II - OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities and Use of Proceeds 25 Item 3. Defaults Upon Senior Securities 25 Item 4. Submission of Matters to a Vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits and Reports on Form 8-K 25 - 27 Signatures 28 CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION September 30, 2003 and December 31, 2002 September 30, December 31, 2003 2002 - --------------------------------------------------------------------------------------- (Dollars in thousands) (Unaudited) ASSETS Cash and due from banks: Interest earning $ 1,762 $ 13,925 Noninterest earning 21,071 18,912 Federal funds sold 3,371 18,696 Investment securities - available for sale, at fair value 166,940 155,304 Loans-net of unearned income and deferred fees 637,745 600,609 Allowance for loan losses (12,100) (9,390) --------- --------- Net loans 625,645 591,219 --------- --------- Premises and equipment, net 14,399 13,399 Accrued interest receivable 3,449 3,455 Deposit premium and goodwill, net 14,617 14,884 Deferred tax assets 7,130 5,174 Other assets 13,396 6,008 --------- --------- Total assets $ 871,780 $ 840,976 ========= ========= LIABILITIES Deposits: Demand, noninterest bearing $ 50,659 $ 50,238 Savings and interest bearing demand deposits 211,401 224,208 Time deposits 393,970 370,441 --------- --------- Total deposits 656,030 644,887 --------- --------- Accrued interest payable 1,223 1,450 Repurchase agreements 11,014 13,081 Borrowings 114,658 97,858 Trust preferred securities 10,000 -- Other liabilities 8,079 8,229 --------- --------- Total liabilities 801,004 765,505 --------- --------- SHAREHOLDERS' EQUITY Common stock; 20,000,000 shares authorized; shares issued 2003 - 7,113,538 and 2002 - 7,022,468 75,332 74,338 Retained earnings, substantially restricted 3,922 5,481 Accumulated other comprehensive income (loss) (160) 1,293 Treasury stock at cost, no par value; 2003 - 606,811 shares and 2002 - 426,684 shares (8,318) (5,641) --------- --------- Total shareholders' equity 70,776 75,471 --------- --------- Total liabilities and shareholders' equity $ 871,780 $ 840,976 ========= ========= See Notes to Condensed Consolidated Financial Statements -1- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS) Three Months Ended September 30, 2003 and 2002 2003 2002 - --------------------------------------------------------------------------------------- (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 8,726 $7,407 Investment securities 1,260 1,542 Federal funds and other interest income 37 98 -------- ------ Total interest income 10,023 9,047 -------- ------ Interest expense: Deposits 3,033 3,274 Borrowings and repurchase agreements 1,049 804 -------- ------ Total interest expense 4,082 4,078 -------- ------ Net interest income 5,941 4,969 Provision for loan losses 4,963 2,560 -------- ------ Net interest income after provision for loan losses 978 2,409 -------- ------ Noninterest income: Mortgage origination fees and related gains 1,768 859 Service charges and other fees 752 594 Net gain on sale of securities available for sale -- 518 Other noninterest income 560 393 -------- ------ Total noninterest income 3,080 2,364 -------- ------ Noninterest expenses: Salaries and employee benefits 4,434 2,313 Occupancy 580 399 Data processing 278 224 Directors fees 78 63 Advertising 192 67 Furniture and equipment 346 260 Amortization of deposit premium 79 46 Other expenses 1,606 747 -------- ------ Total noninterest expenses 7,593 4,119 -------- ------ Net income (loss) before income tax expense (3,535) 654 Income tax (benefit) expense (1,392) 219 -------- ------ Net income (loss) $ (2,143) $ 435 ======== ====== Earnings (loss) per share - basic $ (0.32) $ 0.08 ======== ====== Earnings (loss) per share - diluted $ (0.32) $ 0.08 ======== ====== See Notes to Condensed Consolidated Financial Statements -2- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS) Nine Months Ended September 30, 2003 and 2002 2003 2002 - --------------------------------------------------------------------------------------- (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 25,927 $21,663 Investment securities 4,244 4,591 Federal funds and other interest income 164 305 -------- ------- Total interest income 30,335 26,559 -------- ------- Interest expense: Deposits 9,263 9,332 Borrowings and repurchase agreements 3,224 2,350 -------- ------- Total interest expense 12,487 11,682 -------- ------- Net interest income 17,848 14,877 Provision for loan losses 8,259 3,790 -------- ------- Net interest income after provision for loan losses 9,589 11,087 -------- ------- Noninterest income: Mortgage origination fees and related gains 4,271 1,947 Service charges and other fees 2,154 1,701 Net gain on sale of securities available for sale 442 761 Other noninterest income 1,557 1,088 -------- ------- Total noninterest income 8,424 5,497 -------- ------- Noninterest expenses: Salaries and employee benefits 11,098 6,755 Occupancy 1,640 1,145 Data processing 866 686 Directors fees 234 199 Advertising 572 389 Furniture and equipment 1,075 825 Amortization of deposit premium 233 121 Other expenses 3,600 2,247 -------- ------- Total noninterest expenses 19,318 12,367 -------- ------- Net income (loss) before income tax expense (1,305) 4,217 Income tax expense (benefit) (728) 1,547 -------- ------- Net income (loss) $ (577) $ 2,670 ======== ======= Earnings (loss) per share - basic $ (0.09) $ 0.50 ======== ======= Earnings (loss) per share - diluted $ (0.09) $ 0.48 ======== ======= See Notes to Condensed Consolidated Financial Statements -3- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) Three and Nine Months Ended September 30, 2003 and 2002 2003 2002 - --------------------------------------------------------------------------------------- (In thousands) (Unaudited) Three month period ended September 30, 2003 and 2002: Net income (loss) $(2,143) $ 435 Reclassification of gains recognized in net income -- (518) Unrealized gains (losses) on securities available for sale, net of deferred tax effect (1,707) 869 ------- ------- Comprehensive income (loss) $(3,850) $ 786 ======= ======= Nine month period ended September 30, 2003 and 2002: Net income (loss) $ (577) $ 2,670 Reclassification of gains recognized in net income (442) (761) Unrealized gains (losses) on securities available for sale, net of deferred tax effect (1,011) 1,648 ------- ------- Comprehensive income (loss) $(2,030) $ 3,557 ======= ======= See Notes to Condensed Consolidated Financial Statements -4- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30, 2003 and 2002 2003 2002 - --------------------------------------------------------------------------------------- (In thousands) (Unaudited) Cash Flows From Operating Activities Net income (loss) $ (577) $ 2,670 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deposit premium 233 121 Depreciation 1,102 996 Gain on sale of equipment (5) -- Gains on sale of securities available for sale (442) (761) Change in loans held for sale 3,017 (7,656) Amortization of premiums on securities, net 1,678 609 Deferred income tax (benefit) expense (1,042) 88 Provision for loan losses 8,259 3,790 Noncash compensation 190 -- Changes in assets and liabilities: Accrued interest receivable and other assets (664) (2,821) Accrued interest payable and other liabilities (370) 144 --------- -------- Net cash provided by (used in) operating activities 11,379 (2,820) --------- -------- Cash Flows From Investing Activities Loan originations, net of principal repayments (46,048) (29,461) Additions to premises and equipment (2,108) (909) Proceeds from sale of equipment 11 1 Net (purchase) sale of Federal Home Loan Bank stock (681) 308 Purchase of securities available for sale (108,139) (59,376) Purchase of bank owned life insurance (6,000) -- Proceeds from maturities of securities available for sale 77,722 19,630 Proceeds from sale of securities available for sale 15,859 30,205 Capitalized purchase costs (38) (39) Net cash acquired from purchase of subsidairy -- 8,649 --------- -------- Net cash used in investing activities (69,422) (30,992) --------- -------- Cash Flows From Financing Activities Net increase in deposits 11,143 61,246 Net increase (decrease) in repurchase agreements (2,067) 2,181 Net increase (decrease) in borrowings 16,800 (7,019) Issuance of trust preferred securities 10,000 -- Payment of trust issuance cost (300) -- Cash dividends paid (989) (535) Issuance of common stock for options 804 765 Purchase of common stock (2,677) (4,549) --------- -------- Net cash provided by financing activities $ 32,714 $ 52,089 --------- -------- (continued on next page) -5- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Nine Months Ended September 30, 2003 and 2002 2003 2002 - --------------------------------------------------------------------------------------- (In thousands) (Unaudited) Net change in cash and cash equivalents $(25,329) $18,277 Cash and cash equivalents: Beginning 51,533 16,117 -------- ------- Ending $ 26,204 $34,394 ======== ======= Supplemental Disclosure of Cash Flow Information Transfer from loans to real estate acquired through foreclosure $ 346 $ 1,419 ======== ======= Dividends payable $ 989 $ 264 ======== ======= Cash paid for: Income taxes $ 1,008 $ 1,775 ======== ======= Interest $ 12,714 $11,451 ======== ======= See Notes to Condensed Consolidated Financial Statements -6- Notes to the Condensed Consolidated Financial Statements 1. Significant Accounting Policies and Interim Reporting The accompanying unaudited condensed consolidated financial statements include the accounts of Capital Bank Corporation (the "Company") and its wholly owned subsidiaries, Capital Bank (the "Bank"), Capital Bank Investment Services ("CBIS"), and Capital Bank Statutory Trust I (the "Trust"), an issuer of the Company's trust preferred securities. The interim financial statements have been prepared in accordance with generally accepted accounting principles. They do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and therefore should be read in conjunction with the audited financial statements and accompanying footnotes in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included and all significant intercompany transactions have been eliminated in consolidation. The results of operations for the nine month period ended September 30, 2003 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2003. The balance sheet at December 31, 2002 has been derived from the Company's audited consolidated financial statements. The accounting policies followed are as set forth in Note 1 of the Notes to Financial Statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2002 except for policies related to derivative financial instruments as described below. On January 1, 2001, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as subsequently amended by SFAS 137 and SFAS 138, which establishes accounting and reporting standards for derivatives and hedging activities. SFAS 133 was adopted on a prospective basis. Under SFAS 133, the Company may designate a derivative as either a hedge of the fair value for a recognized fixed rate asset or liability or an unrecognized firm commitment (fair value hedge) or a hedge of a forecasted transaction or of the variability of future cash flows of a floating rate asset or liability (cash flow hedge). All derivatives are recorded as assets or liabilities on the balance sheet at their respective fair values with unrealized gains and losses recorded either in other comprehensive income or in the results of operations, depending on the purpose for which the derivative is held. Derivatives that do not meet the criteria for designation as a hedge under SFAS 133 at inception, or fail to meet the criteria thereafter, are included in trading account assets or liabilities. At inception of a hedge transaction, the Company formally documents the hedge relationship and the risk management objective and strategy for undertaking the hedge. This process includes identification of hedging instrument, hedged item, risk being hedged and the methodology for measuring ineffectiveness. In addition, the Company assesses both at the inception of the hedge and on an ongoing quarterly basis, whether the derivative used in the hedging transaction has been highly effective in offsetting changes in fair value or cash flows of the hedged item, and whether the derivative is expected to continue to be highly effective. -7- The Company discontinues hedge accounting prospectively when either it is determined that the derivative is no longer highly effective in offsetting changes in the fair value or cash flows of a hedged item; the derivative expires or is sold, terminated or exercised; the derivative is de-designated because it is unlikely that a forecasted transaction will occur; or management determines that designation of the derivative as a hedging instrument is no longer appropriate. 2. Comprehensive Income (Loss) Comprehensive income (loss) includes net income or loss and all other changes to the Company's equity, with the exception of transactions with shareholders ("other comprehensive income"). The Company's only components of other comprehensive income (loss) relate to unrealized gains and losses on securities available for sale, net of the applicable income tax effect. The Company's comprehensive income (loss) and information concerning the Company's other comprehensive income items for the three and nine month periods ended September 30, 2003 and 2002 are as shown in the Company's Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2003 and 2002 (unaudited). 3. Earnings (Loss) Per Share The Company is required to report both basic and diluted earnings per share ("EPS"). Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock instruments, such as stock options, unless the effect is to reduce a loss or increase earnings per share. For the Company, EPS is adjusted for outstanding stock options using the Treasury Stock method in order to compute diluted EPS. The following tables provide a computation and reconciliation of basic and diluted EPS for the three and nine month periods ended September 30, 2003 and 2002. -8- 2003 2002 ------------------------- (Dollars in thousands) (Unaudited) Three month periods ended September 30, 2003 and 2002: Income available to shareholders - basic and diluted $ (2,143) $ 435 =========== ========== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 6,591,699 5,375,899 Incremental shares from assumed exercise of stock options -- 219,068 ------------------------- Weighted average number of shares outstanding - diluted 6,591,699 5,594,967 ========================= Nine month periods ended September 30, 2003 and 2002: Income available to shareholders - basic and diluted $ (577) $ 2,670 =========== ========== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 6,668,006 5,345,572 Incremental shares from assumed exercise of stock options -- 205,172 ------------------------- Weighted average number of shares outstanding - diluted 6,668,006 5,550,744 ========================= For loss periods, diluted EPS is the same as basic EPS due to the fact that including common stock equivalents computed as a result of the 674,000 stock options outstanding in the calculation of diluted EPS would be antidilutive. 4. Stock Based Compensation The Company has a stock option plan under which options to purchase Company common stock may be granted periodically to certain employees. Grants of options are made by the Board of Directors or its Compensation Committee. All grants must be at no less than fair market value on the date of grant, must be exercised no later than 10 years from the date of grant, and may be subject to some vesting provisions. The Company accounts for its stock options under the provisions of APB Opinion No. 25 ("APB 25"), Accounting for Stock Issued to Employees. However, under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 ("FAS 123"), Accounting for Stock-Based Compensation, the Company is required to disclose the pro forma effects on net income as if it had recorded compensation based on the fair value of options granted. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with certain assumptions. Option pricing models require the use of highly subjective assumptions, including expected stock price volatility, which if changed can materially affect fair value estimates. Accordingly, the model does not necessarily provide a reliable single measure of the fair value of the Company's stock options. On December 31, 2002, the Financial Accounting Standards Board ("FASB" or the "Board") issued SFAS No. 148 ("FAS 148"), Accounting for Stock-Based Compensation--Transition and Disclosure, which amends FAS 123. FAS 148 allows for three methods of transition for those companies that adopt FAS 123's provisions for fair value recognition, including two new -9- transition alternatives - the "Modified Prospective Approach" and the "Limited Retrospective Approach." The Company implemented the disclosure provisions of FAS 148 beginning with its December 31, 2002 consolidated financial statements. FAS 123 contains a prospective transition approach that would have the effect of "ramping-up" value, but under FAS 148, such transition method will not be available for enterprises that elect to initially apply the fair value method of accounting for stock-based employee compensation in fiscal years beginning after December 15, 2003. In addition, the provisions of FAS 148 require that the accumulated liability or equity balances accrued under APB 25 be reversed through additional paid-in-capital as of the beginning of the period that FAS 123 is adopted if those liabilities or contra-equity balances would not have been recognized under FAS 123 (e.g., variable stock option awards under APB 25). Additionally, companies are required to disclose for each period for which an income statement is presented an accounting policy footnote that includes (i) the method of accounting for stock options; (ii) total stock compensation cost that is recognized in the income statement and would have been recognized had FAS 123 been adopted for recognition purposes as of its effective date; and (iii) pro forma net income and earnings per share (where applicable) that would have been reported had FAS 123 been adopted for recognition purposes as of its effective date. These disclosures are required to be made in annual financial statements and in quarterly information provided to shareholders without regard to whether the entity has adopted FAS 123 for recognition purposes. The Company granted 10,000 options to purchase its shares of common stock at a price of $15.27 during the first nine months of 2003. For the three and nine month periods ended September 30, 2003 and 2002, the following table summarizes the net income and stock-based compensation expense, as reported, compared to pro forma amounts had the fair value method been applied: -10- 2003 2002 ---------------------- (Dollars in thousands) (Unaudited) Three month periods ended September 30, 2003 and 2002: Net income (loss), as reported $ (2,143) $ 435 Add: Stock-based employee compensation expense included in reported net income, net of tax effects 117 -- Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (54) (208) ---------------------- Pro forma net income (loss) $ (2,080) $ 227 ====================== Earnings (loss) per share: Basic - as reported $ (0.32) $ 0.08 Basic - pro forma $ (0.32) $ 0.04 Diluted - as reported $ (0.32) $ 0.08 Diluted - pro forma $ (0.32) $ 0.04 Nine month periods ended September 30, 2003 and 2002: Net income (loss), as reported $ (577) $ 2,670 Add: Stock-based employee compensation expense included in reported net income, net of tax effects 117 -- Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (147) (625) ---------------------- Pro forma net income $ (607) $ 2,045 ====================== Earnings (loss) per share: Basic - as reported $ (0.09) $ 0.50 Basic - pro forma $ (0.09) $ 0.38 Diluted - as reported $ (0.09) $ 0.48 Diluted - pro forma $ (0.09) $ 0.37 5. Trust Preferred Securities In June 2003, the Company formed the Trust, which issued 10,000 of its Floating Rate Capital Securities (the "trust preferred securities"), with a liquidation amount of $1,000 per capital security, in a pooled offering of trust preferred securities. The Trust also sold its common securities to the Company for an aggregate of $310,000, resulting in total proceeds from the offering equal to $10,310,000. The Trust then used these proceeds to purchase $10,310,000 in principal amount of the Company's Floating Rate Junior Subordinated Deferrable Interest Debentures (the "Debentures"). Following payment by the Company of a placement fee and other expenses of the offering, the Company's net proceeds from the offering equaled $10 million. -11- The trust preferred securities have a 30 year maturity and are redeemable after 5 years with certain exceptions. Prior to the redemption date, the trust preferred securities may be redeemed at the option of the Company after the occurrence of certain events, including without limitation events that would have a negative tax effect on the Company or the Trust, would cause the trust preferred securities to no longer qualify as Tier 1 capital, or would result in the Trust being treated as an investment company. The Trust's ability to pay amounts due on the trust preferred securities is solely dependent upon the Company making payment on the Debentures. The Company's obligation under the Debentures constitutes a full and unconditional guarantee by the Company of the Trust's obligations under the trust preferred securities. The Debentures, which are subordinate and junior in right of payment to all present and future senior indebtedness and certain other financial obligations of the Company, are the sole assets of the Trust and the Company's payment under the Debentures is the sole source of revenue for the Trust. Dividends to the holders of the trust preferred securities are included in the Company's Condensed Consolidated Statements of Income as interest expense. The trust preferred securities are presented as a separate category of long-term debt on the Condensed Consolidated Statements of Financial Condition entitled "Trust Preferred Securities." The trust preferred securities are not included as a component of shareholders' equity in the Condensed Consolidated Statements of Financial Condition. For regulatory purposes, the $10 million total of trust preferred securities qualifies as Tier 1 capital in accordance with regulatory reporting requirements. 6. Derivative Financial Instruments The Company maintains positions in derivative financial instruments to manage interest rate risk, to facilitate asset/liability management strategies, and to manage other risk exposures. The most common derivative instruments used by companies are forward rate agreements, interest rate swaps, and put and call options. In July 2003, the Company entered into interest rate swap agreements to convert portions of its fixed rate long-term debt to floating rate. Because of the effectiveness of the swap agreements against the related debt instruments, the adjustments needed to record the swaps at fair value were offset by the adjustments needed to record the related debt instruments at fair value and the net difference between those amounts were deemed to be immaterial. For the three and nine month periods ended September 30, 2003, the Company recorded net reductions in interest expense paid on debt of approximately $96,000. Item 2 Management's Discussion and Analysis Of Financial Condition and Results of Operations The following discussion presents an overview of the unaudited financial statements for the three and nine month periods ended September 30, 2003 and 2002 for Capital Bank Corporation and its wholly owned subsidiaries, Capital Bank, Capital Bank Investment Services, Inc and Capital Bank Statutory Trust I. This discussion and analysis is intended to provide pertinent information concerning financial position, results of operations, liquidity, and capital resources for the periods -12- covered. It should be read in conjunction with the unaudited financial statements and related footnotes contained in Part I, Item 1 of this report. Information set forth below contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which statements represent the Company's judgment concerning the future and are subject to risks and uncertainties that could cause the Company's actual operating results to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology, such as "may", "will", "expect", "anticipate", "estimate", "believe", or "continue", or the negative thereof or other variations thereof or comparable terminology. The Company cautions that such forward-looking statements are further qualified by important factors that could cause the Company's actual operating results to differ materially from those in the forward-looking statements, as well as the factors set forth in this discussion and analysis, and the Company's periodic reports and other filings with the Securities and Exchange Commission. Overview Capital Bank Corporation (the "Company") is a financial holding company incorporated under the laws of the state of North Carolina on August 10, 1998. The Company's primary function is to serve as the holding company for its wholly-owned subsidiaries, Capital Bank (the "Bank"), Capital Bank Investment Services, Inc. ("CBIS") and Capital Bank Statutory Trust I (the "Trust"). The Bank was incorporated under the laws of the State of North Carolina on May 30, 1997, and commenced operations as a state-chartered banking corporation on June 20, 1997. The Bank is not a member of the Federal Reserve System and has no subsidiaries. CBIS was incorporated under the laws of the State of North Carolina on January 3, 2001 and commenced operations as a full service investment company on March 1, 2001. In the third quarter of 2003, the Company discontinued the operations of CBIS. The Trust was formed on June 26, 2003 for the purpose of issuing trust preferred securities to provide additional Tier I capital for the Company. During the third quarter management performed its periodic analysis of the loan portfolio, including the engagement of two independent credit review firms. As a result, management identified loans aggregating approximately $2.7 million that were classified as a loss. In addition, the Company's allowance for loan losses was increased to approximately $12.1 million or 1.90% of the total loan portfolio from 1.46% in the prior quarter ending June 30, 2003. Also as a result of the review, the Company effected certain changes to try to protect against such credit losses going forward. Changes included procedural changes in the loan approval and credit review processes, changes in individual lending limits and moving towards centralizing the Company's lending functions into one facility. The Company has also added a lender support area where all consumer loans are centrally underwritten and approved. In addition, a new position was created, Chief Operating Officer, to manage the lending and credit functions of the Company and to run the day to day operations of the Bank. Finally, during the third quarter of 2003 the Company incurred expenses for severance payments owed to certain executive officers who have separated, or who have agreed to separate from the Company, and write downs in the carrying value of certain real estate held for sale, in an aggregate amount approximating $1.2 million. -13- As a result of the above factors, the Company incurred net losses for the three month period ended September 30, 2003 of $2.1 million. The loss for the quarter offset income from the prior two quarters with the result of a net loss of $577,000 for the nine month period ended September 30, 2003. Management believes that the results of the current quarter have no material effect on the Company's current well-capitalized position under applicable regulatory standards. In addition, management continues to believe that the current level of shareholders' equity provides adequate capital to support the Company's growth for at least the next 12 months and to maintain a well-capitalized position. The Company's corporate office is located at 4901 Glenwood Avenue, Raleigh, North Carolina 27612, and its telephone number is (919) 645-6400. In addition to the corporate office, the Company has three branch offices in Raleigh, two in Cary, one in Siler City, one in Oxford, one in Warrenton, one in Woodland, one in Seaboard, three in Sanford, three in Burlington, one in Graham, two in Asheville and one in Hickory, North Carolina. The Company also has a loan origination office in Greensboro, North Carolina. Capital Bank is a community bank engaged in the general commercial banking business in Wake, Chatham, Northampton, Granville, Warren, Alamance, Lee, Buncombe, and Catawba Counties of North Carolina. Wake County has a diversified economic base, comprised primarily of services, retail trade, government and manufacturing and includes the City of Raleigh, the state capital. Lee, Northampton, Granville, Warren and Chatham counties are significant centers for various industries, including agriculture, manufacturing, lumber and tobacco. Alamance County has a diversified economic base, comprised primarily of manufacturing, agriculture, retail and wholesale trade, government, services and utilities. Catawba County is a regional center for manufacturing and wholesale trade. The economic base of Buncombe County is comprised primarily of services, medical, tourism and manufacturing industries and includes the city of Asheville. The Bank offers a full range of banking services, including the following: checking accounts; savings accounts; NOW accounts; money market accounts; certificates of deposit; loans for real estate, construction, businesses, agriculture, personal uses, home improvement and automobiles; equity lines of credit; consumer loans; individual retirement accounts; safe deposit boxes; bank money orders; internet banking; electronic funds transfer services including wire transfers; traveler's checks; various investments; and free notary services to all Bank customers. In addition, the Bank provides automated teller machine access to its customers for cash withdrawals through nationwide ATM networks. At present, the Bank does not provide the services of a trust department. The investment services subsidiary, CBIS, previously made available a full range of non-deposit investment and insurance services to individuals and corporations, including the customers of the Bank. These investment services included full-service securities brokerage, asset management, financial planning and retirement services, such as 401(k) plans and annuities, which were provided exclusively through a strategic alliance with Raymond James Financial Services, Inc. ("Raymond James"). Raymond James is a wholly owned subsidiary of Raymond James Financial, Inc. (NYSE: RJF) and is a leading provider of third party investment services, serving more than 250 community banks nationwide. During the third quarter of 2003, the Company discontinued the operations of CBIS and the customer accounts were transferred to Raymond -14- James. In connection with the discontinuance of the operations of CBIS, its assets, primarily furniture and computers with a net book value less than $15,000, will be transferred to be used in the operation of the Bank. Management intends to leave the subsidiary intact but inactive. The Trust is a wholly owned subsidiary formed for the sole purpose of issuing trust preferred securities. The proceeds from such issuances were loaned to the Company in exchange for the Debentures, which are the sole assets of the Trust. A portion of the proceeds from the issuance of the Debentures was used by the Company to repurchase shares of Company common stock. The Company's obligation under the Debentures constitutes a full and unconditional guarantee by the Company of the Trust's obligations under the trust preferred securities. The Trust has no operations other than those that are incidental to the issuance of the trust preferred securities. See Condensed Consolidated Financial Statements - - Notes to Condensed Consolidated Financial Statements - Note 5 - Trust Preferred Securities. Financial Condition Total consolidated assets of the Company at September 30, 2003 were $871.8 million compared to $841.0 million at December 31, 2002, an increase of $30.8 million, or 4%. This increase was primarily due to normal internal growth. On September 30, 2003, loans, including loans held for sale of $7.2 million, were $637.7 million, up $37.1 million, or 6%, compared to December 31, 2002. At September 30, 2003, investment securities were $166.9 million, up $6.6 million from December 31, 2002. Federal funds sold were $3.3 million, down $15.3 million from December 31, 2002. Other assets at September 30, 2003 were $13.4 million compared to $6.0 million at December 31, 2002, an increase of $7.4 million, or 123%. This increase is primarily attributable to the purchase by the Company of $6.0 million of Bank Owned Life Insurance ("BOLI"). Earning assets represented 92.89% of total assets as of September 30, 2003. The allowance for loan losses as of September 30, 2003 was $12.1 million and represented approximately 1.90% of total loans. The allowance for loan losses increased $2.7 million or 29% from the December 31, 2002 balance of $9.4 million due to increased loan volume and the identification of some credit quality issues as a result of management's review of the portfolio. Management believes that the amount of the allowance is adequate to absorb potential losses inherent in the current loan portfolio. See additional discussion on the allowance in the Asset Quality section of "Management's Discussion and Analysis of Financial Condition and Results of Operations". Deposits as of September 30, 2003 were $656.0 million, an increase of $11.1 million or 2% from December 31, 2002, primarily as a result of internal growth. During the first six months of this year, the Company experienced a shift of approximately $12.8 million from money markets and interest checking into time deposits. This movement was largely attributable to a decrease in money market rates offered by the Company, primarily as a result of a promotion started in 2002 that expired during the first quarter. At September 30, 2003, certificates of deposit represented 60.1% of total deposits compared to 57.4% at December 31, 2002. During the nine month period ended September 30, 2003, certificates of deposit increased to $394.0 million, an increase of $23.5 million, or 6% from $370.4 million at December 31, 2002. At the same time, non-interest bearing demand deposit accounts increased to $50.7 million at September 30, 2003, an increase of $421,000, or 1%, from $50.2 million at December 31, 2002. Savings, interest bearing demand deposit, and money market accounts decreased to $211.4 million at September 30, 2003, a -15- decrease of $12.8 million, or 6%, from $224.2 million at December 31, 2002. Borrowings increased to $114.7 million, or 17%, at September 30, 2003 from $97.9 million as of December 31, 2002. Additional borrowings were used to fund strong loan growth. Total consolidated shareholders' equity was $70.7 million as of September 30, 2003, a decrease of $4.7 million from December 31, 2002. The decrease can be primarily attributed to the repurchase of approximately 182,500 shares of common stock, which decreased overall shareholders' equity by $2.7 million. In addition, retained earnings decreased by $1.6 million, reflecting a net loss of $577,000 during the period and approximately $982,000 of dividends paid during the year. Finally, accumulated other compressive income decreased by $1.5 million as a result of declines in the market value of the Company's held for sale investment portfolio. Results of Operations Three month period ended September 30, 2003 For the three month period ended September 30, 2003, the Company reported a net loss of $2.1 million, or $.32 per share, compared to income of $435,000, or $.09 per diluted share, for the same three month period ended September 30, 2002. The decrease of approximately $2.6 million is primarily the result of significant charges to the provision for loan losses as a result of the loan review discussed above. In addition, during the period ended September 30, 2003, as previously discussed, the Company also incurred nonrecurring expenses including severance payments owed to certain executive officers who have separated, or who have agreed to separate from the Company, and write downs in the carrying value of certain real estate held for sale, in an aggregate amount approximating $1.2 million. The results for the three month period ended September 30, 2002 do not include the relative impact of High Street Corporation, which was not acquired until December 1, 2002. Net interest income rose 20%, or $972,000, from the three month period ended September 30, 2002, from $5.0 million to $5.9 million, despite a 50 basis point drop in the prime rate in November 2002 which negatively impacted the yield on loans. The rise in net interest income is primarily the result of a $215.9 million increase in average earning assets due to internal growth as well as additional earning assets added as a result of the acquisition of High Street Corporation. The net interest margin on a fully taxable equivalent basis dropped 31 basis points year-over-year to 2.97% for the three months ended September 30, 2003 from 3.28% for the same time period for 2002. The drop in the net interest margin can be largely attributed to an asset-sensitive balance sheet in which the yield on the Company's earning assets adjusted downward at a faster rate than the interest paid on deposits. For the three month period ended September 30, 2003, the provision for loan losses was $5.0 million versus $2.6 million for the same period in 2002, an increase of $2.4 million. The increase in the provision during the quarter was necessary to offset the large decrease in the allowance for loan losses as a result of significant loan charge-offs discussed above and to increase the allowance to cover credit quality issues identified as a result of the loan review discussed above. At September 30, 2003, the allowance for loan losses was 1.90% of total loans compared with 1.56% at December 31, 2002. Non-interest income for the three month period ended September 30, 2003, was $3.1 million compared to $2.4 million for the same period in 2002, an increase of 30%. The $716,000 growth was primarily attributable to a substantial rise in fee income recorded by the Bank's mortgage -16- department as a result of the lower interest rate environment and increased mortgage refinance business. Mortgage origination fees jumped 106% to $1.8 million in the third quarter of 2003 from the $859,000 earned in the three month period ended September 30, 2002. The increase in mortgage origination fees was partially offset by a decline in securities gains. The Company recorded $518,000 in securities gains in the three month period ended September 30, 2002 but did not sell any investments during the same period in 2003. Fees for non-sufficient funds increased to $482,000 during the three months ended September 30, 2003 from $382,000 during the same period in 2002, primarily as a result of the growth in the number of deposit accounts on which these fees are charged. Other categories that improved include service charges on checking accounts, which jumped 46% from $135,000 in the three month period ended September 30, 2002 to $197,000 in the three month period ended September 30, 2003, and other non-interest income, which includes fees earned by the government lending department and the Company's investment subsidiary, which grew from $393,000 in the three months ended September 30, 2002 to $560,000 in the same period of 2003. Non-interest expense for the three month period ended September 30, 2003 was $7.6 million compared to $4.1 million for the corresponding period in 2002. Salaries and employee benefits, representing the largest non-interest expense category, increased to $4.4 million, for the three month period ended September 30, 2003 from $2.3 million for the same period in 2002. This increase reflects an increase in the number of personnel employed by the Company due to the acquisition of High Street Corporation and management's intention to maintain adequate staffing levels to meet customer needs and keep pace with expected growth. In addition, the amount recorded for the third quarter of 2003 includes severance expenses of approximately $948,000. Increases in this expense also reflect a significant increase in commissions paid on mortgage originations and government lending as a result of increased business in those areas. Commission expense for the three month period ended September 30, 2003 was $761,000 compared to $391,000 for the same period in 2002. The increase, $370,000, or 95%, closely relates to the 106% increase in mortgage origination fees discussed above. As of September 30, 2003, the Company had 221 full-time equivalent employees compared to 179 for the same date in 2002. Occupancy costs, the second largest component of non-interest expenses, increased 45%, or $181,000, to $580,000 for the three month period ended September 30, 2003 from $399,000 for the same period in 2002. This increase is primarily associated with the addition of three branches in connection with the acquisition of High Street Corporation in December 2002. Other expenses increased from $747,000 for the three month period ended September 30, 2002 to $1.6 million for the same period in 2003. Largest components of other expenses for the third quarter of 2003 include write downs of the carrying value of certain real estate held for sale of $310,000, expenses of $142,000 associated with the collection of problem loans and professional fees of $247,000 including the costs associated with the outside loan review previously mentioned. The Company recorded an income tax benefit of $1.4 million during the three month period ended September 30, 2003 compared to an expense of $219,000 during the same period in 2002. The benefit recorded during the period was primarily the result of the tax effect of the significant charge-offs and the increase in the allowance for loan losses discussed above and the related loan loss provision recorded during the period. At September 30, 2003, the Company had net deferred -17- tax assets of $7.1 million resulting from timing differences associated primarily with the deductibility of certain expenses reflected on the financial statements. Nine month period ended September 30, 2003 For the nine month period ended September 30, 2003, the Company reported a net loss of $577,000, or $.09 per share, compared to net income of $2.7 million, or $.50 per diluted share, for the first nine months of 2002. Income during the 2003 nine month period was negatively impacted by a significant commercial loan charge-off made during the second quarter, additional charge-offs and provisions made during the third quarter and severance and write downs of real estate previously discussed. The results for the first nine months of 2002 do not include the impact of High Street Corporation, which was not acquired until December of 2002. For the nine month period ended September 30, 2003, net interest income grew 20% year-over-year, from $14.9 million for the corresponding period in 2002 to $17.8 million for the recent nine month period. During the same period, average earning assets grew $219.7 million or 38%. Net interest income grew at a slower rate due to the compression of the net interest margin over the last twelve months. Declines in short term interest rates combined with an asset-sensitive balance sheet also impacted the net interest margin for the first nine months which dropped from 3.39% during 2002 to 3.03% for 2003. For the nine month period ended September 30, 2003, the provision for loan losses was $8.3 million versus $3.8 million for the first nine months of 2002. The increase, $4.5 million or 118%, was a direct result of charge-offs and additional allowances for loan losses. Loans 90 days or more past due or in nonaccrual status totaled $5.1 million. Non-performing loans, together with foreclosed properties, totaled $5.7 million and represented 0.66% of total assets as of September 30, 2003 compared to $4.0 million and 0.48% at December 31, 2002. Non-interest income for the nine month period ended September 30, 2003, was $8.4 million compared to $5.5 million for the same period in 2002, an increase of 53%. The $2.9 million growth was primarily attributable to a substantial rise in fee income recorded by the Bank's mortgage department as a result of the lower interest rate environment and increased mortgage refinance business. Mortgage origination fees increased 119% to $4.3 million in the recent nine month period from the $1.9 million earned in the nine months ended September 30, 2002. For the first nine months of 2003, the Company recorded $442,000 in securities gains compared to $761,000 for the same period in 2002. Deposit service charges and other fees increased from $1.7 million to $2.2 million during the nine month periods ended September 30, 2002 and 2003, respectively. This increase, $453,000 or 27%, is primarily due to the increase in volume of the associated accounts as a result of internal growth and acquisitions. Other non-interest income, including fees earned by the government lending department and the Company's investment subsidiary, grew from $1.1 million in the nine month period ended September 30, 2002 to $1.6 in the same period of 2003. Non-interest expense for the nine month period ended September 30, 2003 was $19.3 million compared to $12.4 million for the corresponding period in 2002. Salaries and employee benefits, representing the largest non-interest expense category, increased to $11.1 million for the nine month period ended September 30, 2003 from $6.8 million for the same period in 2002. This increase reflects an increase in the number of personnel employed by the Company due to the acquisition of High Street Corporation and management's intention to maintain adequate staffing -18- levels to meet customer needs and keep pace with expected growth. In addition, the 2003 amount includes severance expenses of approximately $1.2 million, $948,000 of which was recorded in the third quarter as discussed above. Increases in this expense also reflect a significant increase in commissions paid on mortgage originations and lending under government backed programs as a result of increased business in those areas. Commission expense for the nine month period ended September 30, 2003 was $1.9 million compared to $906,000 for the same period in 2002. The increase, $1.0 million or 114%, closely relates to the 119% increase in mortgage origination fees discussed above. Occupancy costs, the second highest component of noninterest expenses, increased to $1.6 million for the nine month period ended September 30, 2003 from $1.1 million for the same period in 2002. This increase is primarily associated with the integration of the four additional branches in connection with the acquisition of First Community Corporation in early 2002 and three additional branches in connection with the acquisition of High Street Corporation in December 2002. Although management expects noninterest expense to increase on an absolute basis as the Company continues its growth, these expenses as a percentage of asset size and operating revenue are anticipated to decrease over time. For the nine month period ended September 30, 2003, the Company recorded an income tax benefit of $728,000 as a result of losses incurred during the period. During the same period in 2002, the Company recorded a tax expense of $1.5 million. Asset Quality Determining the allowance for loan losses is based on a number of factors. At the inception of each commercial loan, management assesses the relative risk of the loan and assigns a corresponding risk grade. To insure that the credit quality is maintained after the loan is booked, the Bank has a procedure whereby a loan review officer does an annual review of all loans over a certain threshold, all unsecured loans over a certain loan amount, a sampling of loans within a lender's authority, and a sampling of the entire loan pool. Loans are reviewed for credit quality, sufficiency of credit and collateral documentation, proper loan approval, covenant, policy and procedure adherence, and continuing accuracy of the loan grade. This officer reports directly to the Chief Credit Officer and will report on a sampling of loans each month to the Board of Directors' Loan Committee. On an as needed basis, the Bank will hire an outside third party firm to do a review of loans to ensure quality standards and accurate risk assessment. Two outside firms completed a review of all commercial loans over $100,000 in September 2003. The Company calculates the amount of allowance needed to cover the probable losses in the portfolio by applying a reserve percentage to each risk grade. Consumer loans and mortgages are not risk graded but a percentage is reserved for these loans based on historical losses. The reserve percentages have been developed based on historical losses and industry trends. In addition to this quantitative analysis, a qualitative assessment of the general economic trends, portfolio concentration and the trend of delinquencies are taken into consideration. The allowance is adjusted accordingly to an amount that management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. -19- Based on this allowance calculation and taking into consideration the significant loan charge-offs occurring in the second and third quarter of 2003 and the detail review of the loan portfolio performed by outside consultants as described above, management charged operations in the amount of $5.0 million and $8.3 million, respectively, for the three and nine month periods ended September 30, 2003 to provide for probable losses related to uncollectible loans. Loan loss reserves were 1.90% and 1.54% of gross loans, respectively, as of September 30, 2003 and 2002. The following table presents an analysis of changes in the allowance for loan losses for the three and nine month periods ended September 30, 2003 and 2002: Three Months Nine Months Ended September 30, Ended September 30, 2003 2002 2003 2002 ------- ------ ------- ------ (Dollars in thousands) Allowance for loan losses, beginning of period $ 9,454 $6,873 $ 9,390 $4,286 Net charge-offs: Loans charged off: Commercial 1,835 2,139 5,160 3,355 Consumer 316 114 471 327 Mortgage 607 76 646 122 ------- ------ ------- ------ Total charge-offs 2,758 2,329 6,277 3,804 ------- ------ ------- ------ Recoveries of loans previously charged off: Commercial 440 88 716 244 Consumer -- 11 11 47 Mortgage 3 -- 3 -- ------- ------ ------- ------ Total recoveries 443 99 730 291 ------- ------ ------- ------ Total net charge-offs 2,315 2,230 5,547 3,513 ------- ------ ------- ------ Loss provisions charged to operations 4,962 2,560 8,258 3,790 Allowances transferred during acquisition -- -- -- 2,640 ------- ------ ------- ------ Allowance for loan losses, end of period $12,101 $7,203 $12,101 $7,203 ======= ====== ======= ====== Net charge-offs to average loans during the period (annualized) 1.43% 1.88% 0.88% 0.77% Allowance as a percent of gross loans 1.90% 1.54% 1.90% 1.54% On September 30, 2003, nonperforming assets were $5.7 million, a $208,000 increase from the same date in 2002. Nonperforming assets, which includes nonperforming loans and foreclosed property, increased on an absolute basis but decreased as a percent of total assets. Nonperforming assets as a percent of total assets decreased to .66% as of September 30, 2003 from .84% as of September 30, 2002. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. Loans deemed to be impaired at September 30, 2003 and 2002 amounted to $4.1 million and $5.1 million, respectively. Average impaired loans during the third quarter of 2003 were $4.4 million. -20- The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a review of significant loans and lending relationships by both management and third party credit review firms and includes the accumulation of related data. This data includes loan payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc. It is possible that these factors and management's evaluation of the adequacy of the allowance for loan losses will change. Foreclosed property decreased to $663,000 at September 30, 2003 from $1.9 million at September 30, 2002. During the third quarter of 2003, management recorded expenses of approximately $310,000 as a result of write downs of certain real estate to fair market value. These write downs were made as a result of previously unsuccessful attempts to sell the related properties at their existing book value. The Company is actively marketing all of its foreclosed property. All nonperforming assets, including nonperforming loans and foreclosed assets, are recorded at the lower of cost or market. The following table presents an analysis of nonperforming assets as of September 30, 2003 and 2002: Period Ended September 30, 2003 2002 ------- ------- (Dollars in thousands) Nonperforming assets: Nonaccrual loans: Commercial real estate $ 1,923 $ 1,337 Construction 872 52 Commercial 287 451 Consumer 351 362 Mortgage 1,626 1,446 ------- ------- Total nonaccrual loans 5,059 3,648 Loans past due 90 days or more and still accruing interest - - ------- ------- Total nonperforming loans 5,059 3,648 Foreclosed property held 663 1,866 ------- ------- Total nonperforming assets $ 5,722 $ 5,514 ======= ======= Nonperforming loans to total loans 0.79% 0.78% Nonperforming assets to total assets 0.66% 0.84% Allowance coverage of nonperforming loans 239% 197% Liquidity and Capital Resources The Company's liquidity management involves planning to meet the Company's anticipated funding needs at a reasonable cost. Liquidity management is guided by policies formulated by the Company's senior management and the Asset/Liability Management Committee of the Company's Board of Directors. The Company had $26.2 million in its most liquid assets, cash and cash equivalents, as of September 30, 2003. The Company's principal sources of funds are loan repayments, deposits, Federal Home Loan Bank borrowings and capital. Core deposits (total deposits less certificates of deposits in the amount of $100,000 or more), one of the most stable sources of liquidity, together with equity capital, funded 69.2% of total assets at September 30, -21- 2003. In addition, the Company has the ability to take advantage of various other funding programs available from the Federal Home Loan Bank of Atlanta. During the second quarter, the Trust issued 10,000 trust preferred securities with a liquidation amount of $1,000 per capital security in a pooled offering of trust preferred securities. The Company used approximately $3.0 million of the proceeds to repurchase shares of the Company's common stock, with the remaining $7.0 million used as additional capital to fund earning asset growth. See Condensed Consolidated Financial Statements - Notes to Condensed Consolidated Financial Statements - Note 5 - Trust Preferred Securities. Shareholders' equity was $70.1 million or $10.88 per share at September 30, 2003. Management believes this level of shareholders' equity provides adequate capital to support the Company's growth for at least the next 12 months and to maintain a well-capitalized position. At September 30, 2003, the Company had a Tier 1 capital ratio of 9.11%, a total risk-based capital ratio of 10.37% and a leverage ratio of 7.47 %. These ratios exceed the federal regulatory minimum requirements for a "well-capitalized" bank. Tangible equity, which subtracts goodwill and other intangibles from shareholders' equity but includes the trust preferred debt, was $64.8 million at September 30, 2003. Effects of Inflation Inflation can have a significant effect on the operating results of all industries. However, management believes the inflationary factors are not as critical to the banking industry as they are to other industries, due to the high concentration of relatively short-duration monetary assets in the banking industry. Inflation does, however, have some impact on the Company's growth, earnings and total assets, and on its need to closely monitor capital levels. Interest rates are significantly affected by inflation, but it is difficult to assess the impact, since neither the timing nor the magnitude of the changes in the various inflation indices coincides with changes in interest rates. Inflation does impact the economic value of longer-term interest-bearing assets and liabilities, but the Company attempts to limit its long-term assets and liabilities. Risk Factors You should consider the following material risk factors carefully before deciding to invest in Capital Bank Corporation securities. If any of the events described below occur, the Company's business, financial condition, or results of operations could be materially adversely affected. In that event, the trading price of the Company's common stock may decline, in which case the value of your investment may decline as well. Our Results Are Impacted by the Economic Conditions of Our Principal Operating Area Our operations are concentrated throughout Central and Western North Carolina. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Deterioration in economic conditions in any of these market areas, particularly in the industries on which these geographic areas depend, may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations. We Are Exposed to Risks in Connection with the Loans We Make -22- A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. We have underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our loan portfolio. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations. We Compete With Larger Companies for Business The banking and financial services business in our market areas continues to be a competitive field and is becoming more competitive as a result of: o Changes in regulations; o Changes in technology and product delivery systems; and o The accelerating pace of consolidation among financial services providers. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We compete for loans, deposits and customers with various bank and nonbank financial services providers, many of which are larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services. Our Trading Volume Has Been Low Compared With Larger Banks The trading volume in the Company's common stock on the NASDAQ National Market has been comparable to other similarly-sized banks. Nevertheless, this trading is relatively low when compared with more seasoned companies listed on the NASDAQ National Market or other consolidated reporting systems or stock exchanges. Thus, the market in the Company's common stock may be limited in scope relative to other companies. We Depend Heavily on Our Key Management Personnel The Company's success depends in part on its ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. We expect to effectively compete in this area by offering financial packages that include incentive-based compensation and the opportunity to join in the rewarding work of building a growing bank. Technological Advances Impact Our Business The banking industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Company's future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources than we do to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or successfully market such products and services to our customers. -23- Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and periodic examination by the Federal Deposit Insurance Corporation and the North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as: o The payment of dividends to our shareholders; o Possible mergers with or acquisitions of or by other institutions; o Our desired investments; o Loans and interest rates on loans; o Interest rates paid on our deposits; o The possible expansion of our branch offices; and/or o Our ability to provide securities or trust services. We also are subject to capitalization guidelines set forth in federal legislation, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements may adversely affect our ability to operate profitably. There Are Potential Risks Associated With Future Acquisitions We intend to continue to explore expanding a branch system through selective acquisitions of existing banks or bank branches in the Research Triangle area and other North Carolina markets. We cannot say with any certainty that we will be able to consummate, or if consummated, successfully integrate, future acquisitions, or that we will not incur disruptions or unexpected expenses in integrating such acquisitions. In the ordinary course of business, we evaluate potential acquisitions that would bolster our ability to cater to the small business, individual and residential lending markets in North Carolina. In attempting to make such acquisitions, we anticipate competing with other financial institutions, many of which have greater financial and operational resources. In addition, since the consideration for an acquired bank or branch may involve cash, notes or the issuance of shares of common stock, existing shareholders could experience dilution in the value of their shares of the Company's common stock in connection with such acquisitions. Any given acquisition, if and when consummated, may adversely affect our results of operations or overall financial condition. Item 3 Quantitative and Qualitative Disclosures About Market Risk The Company has not experienced any material change in the risk of its portfolio of interest earning assets and interest bearing liabilities from December 31, 2002 to September 30, 2003. Item 4 Controls and Procedures As required by paragraph (b) of Rule 13a-15 under the Exchange Act, the Company's management, with the participation of the Chief Executive Officer and the Chief Accounting Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as -24- such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and the Chief Accounting Officer provide that, as of the end of the period covered by this report, the Company's disclosure controls and procedures are effective, in that they provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission's rules and forms. Other than the changes to try to protect against credit losses going forward referenced in the "Overview" section of management's discussion and analysis, there have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Part II - Other Information Item 1 Legal Proceedings There are no material pending legal proceedings to which the Company is a party or to which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on the Company's business, operating results or condition. Item 2 Changes in Securities and Use of Proceeds None Item 3 Defaults Upon Senior Securities None Item 4 Submission of Matters to a Vote of Security Holders None Item 5 Other Information None Item 6 Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 4.1 In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request. Exhibit 10.1 Employment agreement dated July 22, 2003 between B. Grant Yarber and Capital Bank Corporation -25- Exhibit 31.1 Certification of William C. Burkhardt pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Steven E. Crouse pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Certification of William C. Burkhardt pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended or the Securities Act of 1933, as amended, as the case may be.] Exhibit 32.2 Certification of Steven E. Crouse pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended or the Securities Act of 1933, as amended, as the case may be.] (b) Reports on Form 8-K From July 1, 2003 to the date hereof, the Company filed the following Current Reports on Form 8-K: (1) Current Report on Form 8-K furnished on July 23, 2003, containing a press release reporting final financial results for the quarter ended June 30, 2003, which included selected financial data for the quarter ended June 30, 2003 and for other selected periods. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. (2) Current Report on Form 8-K furnished on August 15, 2003 containing a press release reporting revisions to previously released results for the quarter ended June 30, 2003, which included selected financial data for the quarter ended June 30, 2003 and for other selected periods. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. (3) Current Report on Form 8-K furnished on October 16, 2003 containing a press release reporting preliminary financial results for the quarter ended September 30, 2003. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. (4) Current Report on Form 8-K furnished on October 30, 2003 containing a press release reporting final financial results for the quarter ended September 30, 2003, which included selected financial data for the quarter ended September 30, 2003 and -26- for other selected periods. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. -27- 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. CAPITAL BANK CORPORATION Date: November 14, 2003 By: /s/ William C. Burkhardt ------------------------ William C. Burkhardt Chief Executive Officer -28- Exhibit Index Exhibit 4.1 In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request. Exhibit 10.1 Employment agreement dated July 22, 2003 between B. Grant Yarber and Capital Bank Exhibit 31.1 Certification of William C. Burkhardt pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Steven E. Crouse pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Certification of William C. Burkhardt pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] Exhibit 32.2 Certification of Steven E. Crouse pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] -29-