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 September 30, 2003 |_| TRANSITION REPORT PURSUANT TO 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________ Commission file number 0-21855 Stewardship Financial Corporation (Exact name of registrant as specified in its charter) New Jersey 22-3351447 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 630 Godwin Avenue, Midland Park, NJ 07432 (Address of principal executive offices) (Zip Code) (201) 444-7100 (Registrant's telephone number, including area code) - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by a checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X| The number of shares outstanding of the Issuer's Common Stock, no par value, as of November 12, 2003 was 3,005,418. Stewardship Financial Corporation INDEX PAGE NUMBER ------ PART I - CONSOLIDATED FINANCIAL INFORMATION ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS Consolidated Statements of Financial Condition at September 30, 2003 (Unaudited) and December 31, 2002 ..... 1 Consolidated Statements of Income for the Nine Months ended September 30, 2003 and 2002 (Unaudited) ........ 2 Consolidated Statements of Income for the Three Months ended September 30, 2003 and 2002 (Unaudited) ........ 3 Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2003 and 2002 (Unaudited) ........ 4 Consolidated Statement of Changes in Stockholders' Equity for the Nine Months ended September 30, 2003 and September 30, 2002 (Unaudited) .............................. 5 Notes to Consolidated Financial Statements (Unaudited) ...... 6 - 14 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ................................................. 15 - 25 ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK .......................................... 25 ITEM 4 - CONTROLS AND PROCEDURES ..................................... 25 - 26 PART II - OTHER INFORMATION ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS................... 27 ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K ............................ 27 Stewardship Financial Corporation and Subsidiary Consolidated Statements of Financial Condition September 30, December 31, 2003 2002 --------------------------------- (Unaudited) Assets Cash and due from banks $ 16,783,000 $ 14,039,000 Other interest-earning assets 596,000 9,854,000 Federal funds sold 9,150,000 9,525,000 --------------------------------- Cash and cash equivalents 26,529,000 33,418,000 Securities available for sale 35,511,000 12,812,000 Securities held to maturity; estimated fair value of $54,764,000 (2003) and $62,273,000 (2002) 53,641,000 60,887,000 FHLB-NY stock, at cost 1,322,000 1,059,000 Loans, net of allowance for loan losses of of $2,791,000 (2003) and $2,689,000 (2002) 249,696,000 213,579,000 Mortgage loans held for sale 863,000 2,099,000 Premises and equipment, net 3,409,000 3,733,000 Accrued interest receivable 1,704,000 1,640,000 Intangible assets, net of accumulated amortization of $518,000 (2003) and $486,000 (2002) 231,000 264,000 Other assets 2,527,000 1,596,000 --------------------------------- Total assets $ 375,433,000 $ 331,087,000 ================================= Liabilities and stockholders' equity Liabilities Deposits: Noninterest-bearing $ 78,938,000 $ 69,344,000 Interest-bearing 257,171,000 233,391,000 --------------------------------- Total deposits 336,109,000 302,735,000 Securities sold under agreements to repurchase 4,139,000 2,435,000 Trust preferred securities 7,000,000 -- Accrued expenses and other liabilities 2,081,000 2,100,000 --------------------------------- Total liabilities 349,329,000 307,270,000 --------------------------------- Commitments and contingencies -- -- Stockholders' equity Common stock, no par value; 5,000,000 shares authorized; 3,151,979 and 1,975,437 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively 19,079,000 15,058,000 Retained earnings 7,152,000 8,600,000 Accumulated other comprehensive (loss) income (127,000) 159,000 --------------------------------- Total stockholders' equity 26,104,000 23,817,000 --------------------------------- Total liabilities and stockholders' equity $ 375,433,000 $ 331,087,000 ================================= See notes to unaudited consolidated financial statements. 1 Stewardship Financial Corporation and Subsidiary Consolidated Statements of Income (Unaudited) Nine Months Ended September 30, -------------------------------- 2003 2002 -------------------------------- Interest income: Loans $ 11,931,000 $ 10,908,000 Securities held to maturity Taxable 968,000 998,000 Non-taxable 526,000 534,000 Securities available for sale 361,000 496,000 Other interest-earning assets 155,000 271,000 -------------------------------- Total interest income 13,941,000 13,207,000 -------------------------------- Interest expense: Deposits 3,359,000 3,929,000 Borrowed money 66,000 19,000 -------------------------------- Total interest expense 3,425,000 3,948,000 -------------------------------- Net interest income before provision for loan losses 10,516,000 9,259,000 Provision for loan losses 315,000 100,000 -------------------------------- Net interest income after provision for loan losses 10,201,000 9,159,000 -------------------------------- Noninterest income: Fees and service charges 1,563,000 1,296,000 Gain on sales of mortgage loans 402,000 191,000 Miscellaneous 286,000 175,000 -------------------------------- Total noninterest income 2,251,000 1,662,000 -------------------------------- Noninterest expenses: Salaries and employee benefits 3,990,000 3,426,000 Occupancy, net 537,000 491,000 Equipment 544,000 477,000 Data processing 667,000 498,000 Advertising 197,000 188,000 FDIC insurance premium 36,000 32,000 Amortization of intangible assets 32,000 34,000 Charitable contributions 351,000 327,000 Stationery and supplies 171,000 175,000 Miscellaneous 1,898,000 1,631,000 -------------------------------- Total noninterest expenses 8,423,000 7,279,000 -------------------------------- Income before income tax expense 4,029,000 3,542,000 Income tax expense 1,419,000 1,217,000 -------------------------------- Net income $ 2,610,000 $ 2,325,000 ================================ Basic earnings per share $ 0.83 $ 0.76 ================================ Diluted earnings per share $ 0.82 $ 0.75 ================================ Weighted average number of common shares outstanding 3,134,131 3,066,623 ================================ Weighted average number of diluted common shares outstanding 3,173,463 3,092,527 ================================ Share data has been restated to reflect a 3 for 2 stock split that occured on July 1, 2003 and a 5% stock dividend declared September 16, 2003 and payable November 15, 2003. See notes to unaudited consolidated financial statements. 2 Stewardship Financial Corporation and Subsidiary Consolidated Statements of Income (Unaudited) Three Months Ended September 30, ------------------------------ 2003 2002 ------------------------------ Interest income: Loans $ 4,061,000 $ 3,762,000 Securities held to maturity Taxable 247,000 360,000 Non-taxable 172,000 183,000 Securities available for sale 179,000 147,000 Other interest-earning assets 46,000 115,000 ------------------------------ Total interest income 4,705,000 4,567,000 ------------------------------ Interest expense: Deposits 1,038,000 1,318,000 Borrowed money 32,000 6,000 ------------------------------ Total interest expense 1,070,000 1,324,000 ------------------------------ Net interest income before provision for loan losses 3,635,000 3,243,000 Provision for loan losses 90,000 30,000 ------------------------------ Net interest income after provision for loan losses 3,545,000 3,213,000 ------------------------------ Noninterest income: Fees and service charges 536,000 437,000 Gain on sales of mortgage loans 164,000 58,000 Miscellaneous 77,000 38,000 ------------------------------ Total noninterest income 777,000 533,000 ------------------------------ Noninterest expenses: Salaries and employee benefits 1,393,000 1,171,000 Occupancy, net 181,000 163,000 Equipment 179,000 164,000 Data processing 251,000 166,000 Advertising 72,000 51,000 FDIC insurance premium 12,000 11,000 Amortization of intangible assets 11,000 11,000 Charitable contributions 117,000 120,000 Stationery and supplies 69,000 59,000 Miscellaneous 650,000 540,000 ------------------------------ Total noninterest expenses 2,935,000 2,456,000 ------------------------------ Income before income tax expense 1,387,000 1,290,000 Income tax expense 492,000 454,000 ------------------------------ Net income $ 895,000 $ 836,000 ============================== Basic earnings per share $ 0.28 $ 0.27 ============================== Diluted earnings per share $ 0.28 $ 0.27 ============================== Weighted average number of common shares outstanding 3,147,443 3,092,036 ============================== Weighted average number of diluted common shares outstanding 3,197,693 3,118,138 ============================== Share data has been restated to reflect a 3 for 2 stock split that occured on July 1, 2003 and a 5% stock dividend declared September 16, 2003 and payable November 15, 2003. See notes to unaudited consolidated financial statements. 3 Stewardship Financial Corporation and Subsidiary Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, ----------------------------------- 2003 2002 ----------------------------------- Cash flows from operating activities: Net income $ 2,610,000 $ 2,325,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization of premises and equipment 499,000 421,000 Amortization of premiums and accretion of discounts, net 637,000 229,000 Accretion of deferred loan fees (126,000) (35,000) Provision for loan losses 315,000 100,000 Originations of mortgage loans held for sale (32,317,000) (16,986,000) Proceeds from sale of mortgage loans 33,955,000 19,151,000 Gain on sale of mortgage loans held for sale (402,000) (191,000) Gain on sale of fixed assets (54,000) -- Gain on sale of securities available for sale (49,000) -- Deferred income tax benefit (63,000) (154,000) Amortization of intangibles 32,000 34,000 Increase in accrued interest receivable (64,000) (99,000) (Increase) decrease in other assets (599,000) 57,000 (Decrease) increase in other liabilities (18,000) 291,000 ----------------------------------- Net cash provided by operating activities 4,356,000 5,143,000 ----------------------------------- Cash flows from investing activities: Purchase of securities available for sale (31,643,000) (3,208,000) Proceeds from maturities and principal repayments on securities available for sale 4,138,000 2,344,000 Proceeds from calls and sales of securities available for sale 4,271,000 2,903,000 Purchase of securities held to maturity (21,027,000) (27,318,000) Proceeds from maturities and principal repayments on securities held to maturity 14,374,000 4,600,000 Proceeds from call on securities held to maturity 13,375,000 6,630,000 Purchase of FHLB-NY stock (263,000) (173,000) Net increase in loans (36,306,000) (18,297,000) Sales of premises and equipment 227,000 19,000 Additions to premises and equipment (350,000) (321,000) ----------------------------------- Net cash used in investing activities (53,204,000) (32,821,000) ----------------------------------- Cash flows from financing activities: Net increase in noninterest-bearing deposits 9,594,000 6,444,000 Net increase in interest-bearing deposits 23,779,000 33,326,000 Net increase in securities sold under agreements to repurchase 1,704,000 576,000 Issuance of Trust Preferred Securities 7,000,000 -- Purchase of treasury stock -- (164,000) Cash dividends paid on common stock (606,000) (499,000) Options exercised 59,000 344,000 Common stock issued under stock plans 429,000 369,000 ----------------------------------- Net cash provided by financing activities 41,959,000 40,396,000 ----------------------------------- Net (decrease) increase in cash and cash equivalents (6,889,000) 12,718,000 Cash and cash equivalents - beginning 33,418,000 34,074,000 ----------------------------------- Cash and cash equivalents - ending $ 26,529,000 $ 46,792,000 =================================== Supplemental disclosures of cash flow information: Cash paid during the year for interest $ 3,560,000 $ 3,700,000 Cash paid during the year for income taxes 1,482,000 1,351,000 See notes to unaudited consolidated financial statements. 4 Stewardship Financial Corporation and Subsidiary Consolidated Statement of Changes in Stockholders' Equity (Unaudited) For the Nine Months Ended September 30, 2003 ----------------------------------------------------------------------- Accumulated Other Comprehensive Common Stock Retained Income, Shares Amount Earnings Net Total ----------------------------------------------------------------------- Balance -- December 31, 2002 1,975,437 $ 15,058,000 $ 8,600,000 $ 159,000 $ 23,817,000 Dividends paid -- -- (606,000) -- (606,000) Stock split - 3 for 2 997,129 -- -- -- -- 5% stock dividend (payable November 15, 2003) 150,094 3,452,000 (3,452,000) -- -- Common stock issued under stock plans 23,863 429,000 -- -- 429,000 Exercise of stock options 5,456 59,000 -- -- 59,000 Tax Benefit - exercise of stock options -- 81,000 -- -- 81,000 Comprehensive income: Net income for the nine months ended September 30, 2003 -- -- 2,610,000 -- 2,610,000 Unrealized holding losses on securities available for sale arising during the period (net tax benefit of $184,000) -- -- -- (286,000) (286,000) ------------ Total comprehensive income, net of tax 2,324,000 ----------------------------------------------------------------------- Balance -- September 30, 2003 3,151,979 $ 19,079,000 $ 7,152,000 $ (127,000) $ 26,104,000 ======================================================================= For the Nine Months Ended September 30, 2002 -------------------------------------------------------------------------------------------- Accumulated Other Comprehensive Common Stock Treasury Stock Retained Income, Shares Amount Shares Amount Earnings Net Total -------------------------------------------------------------------------------------------- Balance -- December 31, 2001 1,829,231 $ 12,638,000 -- $ -- $ 7,886,000 $ 29,000 $ 20,553,000 Dividends paid -- -- -- -- (499,000) -- (499,000) Treasury stock (8,832) (164,000) (164,000) 5% stock dividend (payable November 15, 2002) 93,730 1,734,000 (56) (1,000) (1,733,000) -- Common stock issued under stock plans 13,333 234,000 7,723 135,000 -- -- 369,000 Exercise of stock options 32,035 344,000 344,000 Comprehensive income: Net income for the nine months ended September 30, 2002 -- -- -- -- 2,325,000 -- 2,325,000 Unrealized holding gains on securities available for sale arising during the period (net tax of $83,000) -- -- -- -- -- 130,000 130,000 ------------ Total comprehensive income, net of tax 2,455,000 -------------------------------------------------------------------------------------------- Balance -- September 30, 2002 1,968,329 $ 14,950,000 (1,165) $ (30,000) $ 7,979,000 $ 159,000 $ 23,058,000 ============================================================================================ See notes to unaudited consolidated financial statements. 5 Stewardship Financial Corporation and Subsidiary Notes to Consolidated Financial Statements (Unaudited) Note 1. Summary of Significant Accounting Policies Certain information and footnote disclosures normally included in the unaudited consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-KSB for the fiscal year ended December 31, 2002. Principles of consolidation The consolidated financial statements include the accounts of Stewardship Financial Corporation, (the "Corporation") and its wholly owned subsidiary, Atlantic Stewardship Bank (the "Bank"). The Bank includes its wholly owned subsidiary, Stewardship Investment Corp. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements. Certain prior period amounts have been reclassified to conform to the current presentation. The consolidated financial statements of the Corporation have been prepared in conformity with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the statements of financial condition and revenues and expenses during the reporting periods. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant changes relate to the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions in the market area. Stock-Based Compensation The Corporation has two stock-based employee compensation plans and two director compensation plans. The Corporation accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. 6 Nine Months Ended Three Months Ended September 30, September 30, 2003 2002 2003 2002 ------------------------------ ---------------------------- Net Income: Net income as reported $ 2,610,000 $ 2,325,000 $ 895,000 $ 836,000 Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (43,000) (29,000) (15,000) (15,000) ------------- ------------- ------------- ------------- Pro forma net income $ 2,567,000 $ 2,296,000 $ 880,000 $ 821,000 ============= ============= ============= ============= Earnings per share: As reported Basic earnings per share $ 0.83 $ 0.76 $ 0.28 $ 0.27 As reported Diluted earnings per share 0.82 0.75 0.28 0.27 Pro forma Basic earnings per share 0.82 0.75 0.28 0.27 Pro forma Diluted earnings per share 0.81 0.74 0.28 0.26 The fair value of options granted for employees and directors is estimated on the date of the grant using the Black-Scholes option pricing model with the following assumptions used: Directors Employee Employee Employee Employee Stock Options Stock Options Stock Options Stock Options Stock Options 2001 2000 1999 1998 1997 ---------------------------------------------------------------------------------- Dividend yield 1.62% 1.57% 1.25% 1.12% 1.15% Expected volatility 39.76% 20.27% 23.63% 16.24% 14.07% Risk-free interest rate 5.07% 5.16% 6.65% 5.58% 6.64% Expected Life 7 years 7 years 7 years 7 years 7 years Fair value at grant date $ 4.04 $ 2.96 $ 3.46 $ 2.03 $ 1.92 7 Note 2. Basis of presentation The interim unaudited consolidated financial statements included herein have been prepared in accordance with instructions for Form 10-Q and the rules and regulations of the Securities and Exchange Commission ("SEC") and, therefore, do not include information or footnotes necessary for a complete presentation of consolidated financial condition, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. However, all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the three months and nine months ended September 30, 2003 are not necessarily indicative of the results which may be expected for the entire year. All share and per share amounts have been restated for stock splits and stock dividends. 8 Stewardship Financial Corporation and Subsidiary Notes to Consolidated Financial Statements Continued (Unaudited) Note 3. Securities Available for Sale The following table sets forth the amortized cost and carrying value of the Corporation's securities available for sale as of September 30, 2003 and December 31, 2002. In accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", securities available for sale are carried at estimated fair value. September 30, 2003 ----------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Carrying Cost Gains Losses Value ----------------------------------------------------------------------- U.S. Treasury securities $ 505,000 $ -- $ 5,000 $ 500,000 U.S. Government agencies 17,024,000 29,000 94,000 16,959,000 Obligations of state and political subdivisions 1,163,000 15,000 5,000 1,173,000 Mortgage-backed securities 17,031,000 62,000 214,000 16,879,000 ----------------------------------------------------------------------- $35,723,000 $106,000 $ 318,000 $35,511,000 ======================================================================= December 31, 2002 ----------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Carrying Cost Gains Losses Value ----------------------------------------------------------------------- U.S. Government agencies 2,706,000 27,000 -- 2,733,000 Obligations of state and political subdivisions 797,000 24,000 -- 821,000 Mortgage-backed securities 9,050,000 208,000 -- 9,258,000 ----------------------------------------------------------------------- $12,553,000 $259,000 $ -- $12,812,000 ======================================================================= Note 4. Securities Held to Maturity The following table sets forth the carrying value and estimated fair value of the Corporation's securities held to maturity as September 30, 2003 and December 31, 2002. Securities held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts. September 30, 2003 ------------------------------------------------------------------------- Gross Gross Estimated Carrying Unrealized Unrealized Fair Value Gains Losses Value ------------------------------------------------------------------------- U.S. Treasury securities $ 1,012,000 $ 60,000 $ -- $ 1,072,000 U.S. Government agencies 13,123,000 106,000 23,000 13,206,000 Obligations of state and political subdivisions 19,600,000 281,000 58,000 19,823,000 Mortgage-backed securities 19,906,000 757,000 -- 20,663,000 ------------------------------------------------------------------------- $53,641,000 $1,204,000 $ 81,000 $54,764,000 ========================================================================= December 31, 2002 ------------------------------------------------------------------------- Gross Gross Estimated Carrying Unrealized Unrealized Fair Value Gains Losses Value ------------------------------------------------------------------------- U.S. Treasury securities $ 1,514,000 $ 70,000 $ -- $ 1,584,000 U.S. Government agencies 13,125,000 182,000 13,307,000 Obligations of state and political subdivisions 20,060,000 712,000 -- 20,772,000 Mortgage-backed securities 26,188,000 462,000 40,000 26,610,000 ------------------------------------------------------------------------- $60,887,000 $1,426,000 $ 40,000 $62,273,000 ========================================================================= 9 Stewardship Financial Corporation and Subsidiary Notes to Consolidated Financial Statements Continued (Unaudited) Note 5. Loans The Corporation's primary market area for lending is the small and medium sized business and professional community, as well as the individuals residing, working and shopping in Bergen, Passaic and Morris counties, New Jersey. The following table set forth the composition of loans as of the periods indicated. September 30, December 31, 2003 2002 ---------------------------------------- Mortgage Residential $ 43,805,000 $ 39,705,000 Commercial 106,195,000 88,593,000 Commercial 43,903,000 38,228,000 Equity 16,673,000 12,471,000 Installment 42,009,000 37,293,000 Other 221,000 241,000 ---------------------------------------- Total loans 252,806,000 216,531,000 ---------------------------------------- Less: Deferred loan fees 319,000 263,000 Allowance for loan losses 2,791,000 2,689,000 ---------------------------------------- 3,110,000 2,952,000 ---------------------------------------- Loans, net $ 249,696,000 $ 213,579,000 ======================================== Note 6. Allowance for loan losses Nine Months Ended September 30, 2003 2002 ---------------------------------------- Balance, beginning of period $ 2,689,000 $ 2,602,000 Provision charged to operations 315,000 100,000 Recoveries of loans charged off -- 9,000 Loans charged off (213,000) (18,000) ---------------------------------------- Balance, end of period $ 2,791,000 $ 2,693,000 ======================================== 10 Stewardship Financial Corporation and Subsidiary Notes to Consolidated Financial Statements Continued (Unaudited) Note 7. Loan Impairment The Corporation has defined the population of impaired loans to include all nonaccrual loans, loans more than 90 days past due and restructured loans. The following table sets forth information regarding the impaired loans as of the periods indicated. September 30, December 31, 2003 2002 ------------- ------------ Impaired loans With related allowance for loan losses $ 906,000 $ 499,000 Without related allowance for loan losses 202,000 848,000 ------------ ------------ Total impaired loans $ 1,108,000 $ 1,347,000 ============ ============ Related allowance for loan losses $ 70,000 $ 189,000 ============ ============ 11 Stewardship Financial Corporation and Subsidiary Notes to Consolidated Financial Statements Continued (Unaudited) Note 8. Earnings Per Share Basic earnings per share is calculated by dividing net income by the average daily number of common shares outstanding during the period. Common stock equivalents are not included in the calculation. Diluted earnings per share is computed similar to that of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if all potential dilutive common shares were issued. The following is a reconciliation of the calculation of basic and diluted earnings per share. Three Months Nine Months Ended September 30, Ended September 30, 2003 2002 2003 2002 ---- ---- ---- ---- Net income $ 895 $ 836 $2,610 $2,325 Weighted average shares 3,147 3,092 3,134 3,067 Effect of dilutive stock options 51 26 39 26 ------ ------ ------ ------ Total weighted average dilutive shares 3,198 3,118 3,173 3,093 Basic earnings per share $ 0.28 $ 0.27 $ 0.83 $ 0.76 Diluted earnings per share $ 0.28 $ 0.27 $ 0.82 $ 0.75 All share and per share amounts have been restated to reflect a 5% stock dividend payable November 15, 2003 and a 3 for 2 stock split that occurred on July 1, 2003. Note 9. Comprehensive Income Total comprehensive income includes net income and other comprehensive income which is comprised of unrealized holding gains and losses on securities available for sale, net of taxes. The Corporation's total comprehensive income for the nine months ended September 30, 2003 and 2002 was $2.3 million and $2.5 million, respectively. The difference between the Corporation's net income and total comprehensive income for these periods relates to the change in the net unrealized holding gains and losses on securities available for sale during the applicable period of time. Note 10. Recent Accounting Pronouncements Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," ("SFAS No. 150") was issued in May 2003. SFAS No. 150 requires instruments within its scope to be classified as a liability (or, in some cases, as an asset). SFAS No. 150 is generally effective for financial instruments 12 entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 (i.e. July 1, 2003 for calendar year entities). For financial instruments created before June 1, 2003 and still existing at the beginning of the interim period of adoption, transition generally should be applied by reporting the cumulative effect of a change in an accounting principle by initially measuring the financial instruments at fair value or other measurement attributes of the Statement. The adoption of SFAS No. 150 did not have a significant effect on the Corporation's consolidated financial statements. Statement of Financial Accounting Standards No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," ("SFAS No. 149") was issued on April 30, 2003. The statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of this Statement did not have a significant effect on the Corporation's consolidated financial statements. FASB Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46") was issued in January 2003. FIN 46 applies immediately to enterprises that hold a variable interest in variable interest entities created after January 31, 2003. It applies in the first fiscal year or interim period beginning after June 15, 2003 to enterprises that hold a variable interest in variable interest entities created before February 1, 2003. FIN 46 applies to public enterprises as of the beginning of the applicable interim or annual period, and it applies to nonpublic enterprises no later than the end of the applicable annual period. FIN 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46 provides guidance on the identification of entities controlled through means other than voting rights. FIN 46 specifies how a business enterprise should evaluate its interest in a variable interest entity to determine whether to consolidate that entity. A variable interest entity must be consolidated by its primary beneficiary if the entity does not effectively disperse risks among the parties involved. In its current form, FIN 46 may require the Corporation to de-consolidate its investment in Stewardship Statutory Trust I in future financial statements. The potential de-consolidation of subsidiary trusts of bank holding companies formed in connection with the issuance of trust preferred securities, like Stewardship Statutory Trust I, appears to be an unintended consequence of FIN 46. In July 2003, the Board of Governors of the Federal Reserve System instructed bank holding companies to continue to include the trust preferred securities in their Tier 1 capital for regulatory capital purposes until notice is given to the contrary. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier 1 capital for regulatory capital purposes. As of September 30, 2003, assuming the Corporation was not allowed to include the $7.0 million in trust preferred securities issued by Stewardship Statutory Trust I in Tier 1 capital, the Corporation would remain "well capitalized." On October 9, 2003, the effective date of FIN 46 was deferred until the end of the first interim or annual period ending after December 15, 2003, for certain interests held by a public entity in certain variable interest entities or potential variable interest entities created before February 1, 2003. 13 The adoption of FIN 46 is not expected to have a significant effect on the Corporation's consolidated financial statements. In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" (FIN 45). FIN 45 addresses disclosures to be made by a guarantor in its financial statements about its obligations under guarantees. The Corporation met the disclosure requirements as required by FIN 45. The interpretation also requires the recognition, at estimated fair value, of a liability by the guarantor at the inception of certain guarantees issued or modified after December 31, 2002. This recognition requirement did not have a material impact on the Corporation's consolidated financial statements. 14 Stewardship Financial Corporation Management's Discussion and Analysis of Financial Condition and Results of Operations This quartely report on Form 10-Q contains certain "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, and may be identified by the use of such words as "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential." Examples of forward looking statements include, but are not limited to, estimates with respect to the financial condition, results of operations and business of the Corporation that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include: changes in general, economic, and market conditions, legislative and regulatory conditions, or the development of an interest rate environment that adversely affects the Corporation's interest rate spread or other income anticipated from operations and investments. As used in this quarterly report on Form 10-Q, "we" and "us" and "our" refer to Stewardship Financial Corporation and its consolidated subsidiary, Atlantic Stewardship Bank, depending on the context. Critical Accounting Policies and Estimates "Management's Discussion and Analysis of Financial Condition and Results of Operation," as well as disclosures found elsewhere in this quarterly report on Form 10-Q, are based upon the Corporation's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Corporation to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Note 1 to the Corporation's Audited Consolidated Financial Statements for the year ended December 31, 2002 included in our Annual Report on Form 10-KSB for the year ended December 31, 2002, as supplemented by this report, contains a summary of the Corporation's significant accounting policies. Management believes the Corporation's policy with respect to the methodology for the determination of the allowance for loan losses involves a higher degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact results of operations. The Audit Committee and the Board of Directors periodically review this critical policy and its application. The allowance for loan losses is based upon management's evaluation of the adequacy of the allowance, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectibility may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management uses the best information available, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short-term change. Various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to make additional provisions for loan losses based upon information available to them at the time of their 15 examination. Furthermore, the majority of the Corporation's loans are secured by real estate in the State of New Jersey. Accordingly, the collectibility of a substantial portion of the carrying value of the Corporation's loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the northern New Jersey area experience an adverse economic shock. Future adjustments to the allowance for loan losses may be necessary due to economic, operating, regulatory and other conditions beyond the Corporation's control. Financial Condition Total assets increased by $44.3 million, or 13.4%, from $331.1 million at December 31, 2002 to $375.4 million at September 30, 2003. Net loans increased $36.1 million and securities available for sale increased $22.7 million, partially offset by a decrease of $7.2 million in securities held to maturity and a decrease of $6.9 million in cash and cash equivalents. The composition of the loan portfolio is basically unchanged at September 30, 2003 when compared with the portfolio at December 31, 2002. Total deposits totaled $336.1 million at September 30, 2003, an increase of $33.4 million, or 11.0%, from $302.7 million at December 31, 2002. Interest-bearing deposits increased $23.8 million, or 10.2%, to $257.2 million at September 30, 2003 and noninterest-bearing deposits increased $9.6 million, or 13.8%, to $78.9 million at September 30, 2003. The net increase in deposits can be attributed to customers being attracted to the safety and liquidity of banking products. The Corporation's main focus during the first nine months was to manage its liquidity position by redeploying principal repayments, maturities and calls in the investment portfolio into the loan portfolio and securities held for sale. The Corporation continues to enhance the product line of the Bank. Management developed an escrow product during the first quarter of 2003 which provides for tracking and accounting for transactions on a subaccount basis. Management completed a conversion to check imaging that provides customers with images of paid checks instead of returning original checks. In addition to creating an efficient research system, the imaging system was integrated into our Online Banking system in June 2003. This provides online customers access to images of paid checks simply by clicking on the detail of their online transaction statement. Management believes that these new products continue to enhance the delivery channels and products being offered to existing and new customers. On September 17, 2003, the Corporation, through a newly formed, wholly-owned subsidiary, Stewardship Statutory Trust I, a Connecticut statutory business trust, completed a private issuance of $7.0 million in trust-preferred securities as part of a pooled re-securitization transaction with several other financial institutions. The trust-preferred securities bear a fixed rate of interest of 6.75% until September 15, 2008, and then convert to a floating rate of LIBOR plus 2.95% reset quarterly until maturity. Under the current capital guidelines of the Federal Reserve, these preferred securities qualify for inclusion in Tier 1 capital. The securities are callable at par value beginning September 2008. Following this transaction, the Corporation completed a capital contribution of $3.0 million to Atlantic Stewardship Bank to be used to support the Bank's growth strategies. 16 The Corporation has also announced the future opening of the ninth branch of the Bank. It is anticipated that this branch will open for operations in November 2003. It is located in Wayne, Passaic County, New Jersey and represents the third branch location in this town. The branch will also house the commercial and consumer lending operations for the organization. Results of Operations Nine Months Ended September 30, 2003 and 2002 General The Corporation reported net income of $2.6 million, or $0.82 diluted earnings per share for the nine months ended September 30, 2003, compared to $2.3 million, or $0.75 diluted earnings per share for the same period in 2002. The $285,000 increase was primarily the result of increases in net interest income and noninterest income, partially offset by increases in noninterest expense and an increase in the provision for loan loss. Net interest income Net interest income increased $1.3 million, or 13.6%, for the nine months ended September 30, 2003 as compared with the corresponding period in 2002. The increase was primarily due to an increase in average net interest-earning assets, partially offset by a decrease in the net interest margin. Total interest income on a tax equivalent basis increased $736,000, or 5.5%, primarily due to an increase in the average earning assets, offset by a decrease in yields on interest-earning assets. Due to the low interest rate environment experienced since the fourth quarter of 2001, tax equivalent yields on interest earning assets continued to fall 80 basis points from 6.50% for the nine months ended September 30, 2002 to 5.70% for the same period in 2003. The average balance on interest-earning assets increased $56.2 million, or 20.3%, from $276.5 million for the nine months ended September 30, 2002 to $332.7 million for the same period in 2003, primarily caused by an increase to the Corporation's average deposit base. The Corporation continued to experience an increase in loan demand which caused loans on average to increase $41.4 million to an average $237.0 million for the nine months ended September 30, 2003, from an average $195.5 million for the comparable period in 2002. The Corporation also increased its taxable investment portfolio by $15.8 million to an average of $74.2 million at September 30, 2003. Interest paid on deposits and borrowed money decreased by $523,000, or 13.2%, due primarily to a decrease in cost of funds related to the general low interest rate environment. The average balance of total interest-bearing deposits increased to $252.7 million for the nine months ended September 30, 2003 from $211.3 million for the comparable 2002 period, primarily as a result of the Corporation's expanding customer base and the overall flight to quality with investors seeking safe investment alternatives to the stock market. Yields on deposits and borrowed money decreased from 2.50% for the nine month period ended September 30, 2002 to 1.81% for the comparable period in 2003. 17 Analysis of Net Interest Income (Unaudited) For the Nine Months Ended September 30, 2003 2002 ------------------------------------ ------------------------------ Average Average Interest Rates Interest Rates Average Income/ Earned/ Average Income/ Earned/ Balance Expense Paid Balance Expense Paid ------- ------- ---- ------- ------- ---- (Dollars in thousands) Assets Interest-earning assets: Loans(1) $236,958 $ 11,931 6.73% $195,509 $10,908 7.46% Taxable investment securities(1) 53,992 1,309 3.24 38,767 1,461 5.04 Tax-exempt investment securities(1)(2) 20,205 788 5.21 19,560 807 5.52 Other interest-earning assets 21,549 155 0.96 22,663 271 1.60 -------- --------- -------- ------- Total interest-earning assets 332,704 14,183 5.70 276,499 13,447 6.50 --------- ------- Non-interest-earning assets: Allowance for loan losses (2,833) (2,652) Other assets 20,918 19,129 -------- -------- Total assets $350,789 $292,976 ======== ======== Liabilities and Stockholders' Equity Interest-bearing liabilities: Interest-bearing demand deposits $113,290 $ 839 0.99% $ 95,947 $ 976 1.36% Savings deposits 40,924 243 0.79 29,629 225 1.02 Time deposits 93,995 2,277 3.24 85,001 2,728 4.29 Borrowing 4,447 66 1.98 772 19 3.29 -------- --------- -------- ------- Total interest-bearing liabilities 252,656 3,425 1.81 211,349 3,948 2.50 --------- ------- Non-interest-bearing liabilities: Demand deposits 70,911 57,929 Other liabilities 2,062 1,857 Stockholders' equity 25,160 21,841 -------- -------- Total liabilities and stockholders' equity $350,789 $292,976 ======== ======== Net interest income(taxable equivalent basis) $ 10,758 $ 9,499 ========= ======= Net interest spread(taxable equivalent basis) 3.89% 4.00% ==== ==== Net yield on interest-earning assets(taxable equivalent basis)(3) 4.32% 4.59% ==== ==== - ---------- (1) For purpose of these calculations, nonaccruing loans are included in the average balance. Fees are included in loan interest. Loans and total interest-earning assets are net of unearned income. Securities are included at amortized cost. (2) The tax equivalent adjustments are based on a marginal tax rate of 34% and the provisions of Section 291 of the Internal Revenue Code. (3) Net interest income (taxable equivalent basis) divided by average interest-earning assets. 2003 2002 (Dollars in thousands) Reconciliation of net interest income (tax equivalent basis): Net interest income 10,516 9,259 Tax equivalent basis adjustment 242 240 ------ ----- Net interest income (tax equivalent basis) 10,758 9,499 ====== ===== 18 Provision for loan losses The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the inherent risks associated with its loan portfolio, after giving consideration to changes in general market conditions and in the nature and volume of the Corporation's loan activity. The allowance for loan losses is based on estimates, and ultimate losses are charged to operations during the period in which such additions are deemed necessary. The provision charged to operations totaled $315,000 and $100,000 during the nine months ended September 30, 2003 and 2002, respectively. The increase in the provision was primarily due to the strong growth in loans experienced during the first nine months of 2003 and a chargeoff in the amount of $163,000. See "Asset Quality" section for summary of allowance for loan losses and nonperforming assets. The Corporation monitors its loan portfolio and intends to continue to provide for loan loss reserves based on its ongoing periodic review of the loan portfolio and general market conditions. Noninterest income Noninterest income increased $589,000, or 35.4%, from $1.7 million for the nine month period ending September 30, 2002 to $2.3 million for the comparable period in 2003. Deposit related fees increased $267,000 due to an increase in the deposit base and income derived from the merchant credit card processing and debit card programs. Increases in mortgage activity and the volume of mortgage loans sold contributed to an increase of $211,000 in the gain on sales of mortgage loans. During the first quarter of 2003, the Corporation sold a property located in Hawthorne, New Jersey and realized a profit of $54,000. This property had been originally purchased in December 2000 as a strategy to improve our branch facility on Lafayette Avenue, Hawthorne, New Jersey. This strategy did not materialize, the Corporation opened a branch on Goffle Road, Hawthorne, New Jersey, and management found it no longer could utilize the additional property. In addition, the Corporation realized gains on sales of securities available for sale in the amount of $49,000. Noninterest expense Noninterest expense increased by approximately $1.1 million, or 15.7%, to $8.4 million for the nine months ended September 30, 2003, compared to $7.3 million for the same period in 2002 . Salaries and employee benefit expense, the major component of noninterest expense, increased $564,000, or 16.5%, during the nine months ended September 30, 2003. This increase was due to increases in staffing in the lending department and deposit and branch operations areas and general increases for merit and performance. Occupancy and equipment expense increased $113,000, or 11.7%, primarily due to the increase in the Corporation's branch facilities. Data processing expense increased $169,000, or 33.9%, due to the increase in the Corporation's deposit base, the enhancements to our online banking and bill payment functions and the implementation of the check imaging upgrade. Miscellaneous expenses increased $267,000, or 16.4% to provide for the general growth of the Corporation. 19 Income taxes Income tax expense totaled $1.4 million for the nine months ended September 30, 2003, for an effective tax rate of 35.2%. For the nine months ended September 30, 2002, income tax expense totaled $1.2 million, for an effective tax rate of 34.4%. Results of Operations Three Months Ended September 30, 2003 and 2002 General The Corporation reported net income of $895,000, or $0.28 diluted earnings per share, for the three months ended September 30, 2003, compared to $836,000, or $0.27, diluted earnings per share for the same period in 2002. The $59,000 increase was primarily the result of increases in net interest income and noninterest income, partially offset by increases in noninterest expense and an increase in the provision for loan loss. Net interest income Net interest income increased $392,000, or 12.1%, for the three months ended September 30, 2003 as compared with the corresponding period in 2002. The increase was primarily due to an increase in average net interest-earning assets, partially offset by a decrease in the net interest margin. Total interest income on a tax equivalent basis increased $135,000, or 2.9%, primarily due to an increase in the average earning assets, offset by a decrease in the yields on interest-earning assets. Due to the low interest rate environment experienced since the fourth quarter of 2001, tax equivalent yields on interest earning assets continued to fall 86 basis points from 6.31% for the three months ended September 30, 2002 to 5.45% for the same period in 2003. The average balance on interest-earning assets increased $56.4 million, or 19.3%, from $292.2 million for the three months ended September 30, 2002 to $348.6 million for the same period in 2003, primarily caused by an increase to the Corporation's average deposit base. The Corporation continued to experience an increase in loan demand which caused loans on average to increase $46.2 million to an average $246.6 million for the three months ended September 30, 2003, from an average $200.3 million for the comparable period in 2002. The Corporation also increased its investment portfolio by $16.1 million to an average $79.3 million at September 30, 2003. Interest paid on deposits and borrowed money decreased by $254,000, or 19.2%, due primarily to a decrease in cost of funds related to the general low interest rate environment. The average balance of total interest-bearing deposits increased to $262.7 million for the three months ended September 30, 2003 from $223.9 million for the comparable 2002 period, primarily as a result of the Corporation's expanding customer base. Yields on deposits and borrowed money decreased from 2.35% for the three month period ended September 30, 2002 to 1.62% for the comparable period in 2003. 20 Analysis of Net Interest Income (Unaudited) For the Three Months Ended September 30, 2003 2002 ----------------------------------- ------------------------------------ Average Average Interest Rates Interest Rates Average Income/ Earned/ Average Income/ Earned/ Balance Expense Paid Balance Expense Paid ------- ------- ---- ------- ------- ---- (Dollars in thousands) Assets Interest-earning assets: Loans(1) $ 246,572 $ 4,061 6.53% $ 200,331 $ 3,762 7.45% Taxable investment securities(1) 59,025 419 2.82 42,724 496 4.61 Tax-exempt investment securities(1)(2) 20,245 259 5.08 20,461 277 5.37 Other interest-earning assets 22,778 46 0.80 28,671 115 1.59 --------- --------- --------- --------- Total interest-earning assets 348,620 4,785 5.45 292,187 4,650 6.31 --------- --------- Non-interest-earning assets: Allowance for loan losses (2,920) (2,679) Other assets 21,289 19,565 --------- --------- Total assets $ 366,989 $ 309,073 ========= ========= Liabilities and Stockholders' Equity Interest-bearing liabilities: Interest-bearing demand deposits $ 120,954 $ 237 0.78% $ 101,314 $ 353 1.38% Savings deposits 42,919 76 0.70 31,507 80 1.01 Time deposits 93,354 725 3.08 90,143 885 3.90 Borrowing 5,469 32 2.32 925 6 2.57 --------- --------- --------- --------- Total interest-bearing liabilities 262,696 1,070 1.62 223,889 1,324 2.35 --------- --------- Non-interest-bearing liabilities: Demand deposits 76,249 60,482 Other liabilities 2,208 2,015 Stockholders' equity 25,836 22,687 --------- --------- Total liabilities and stockholders' equity $ 366,989 $ 309,073 ========= ========= Net interest income(taxable equivalent basis) $ 3,715 $ 3,326 ========= ========= Net interest spread(taxable equivalent basis) 3.83% 3.97% ==== ==== Net yield on interest-earning assets(taxable equivalent basis)(3) 4.23% 4.52% ==== ==== - ---------- (1) For purpose of these calculations, nonaccruing loans are included in the average balance. Fees are included in loan interest. Loans and total interest-earning assets are net of unearned income. Securities are included at amortized cost. (2) The tax equivalent adjustments are based on a marginal tax rate of 34% and the provisions of Section 291 of the Internal Revenue Code. (3) Net interest income(taxable equivalent basis) divided by average interest-earning assets. 2003 2002 (Dollars in thousands) Reconciliation of net interest income (tax equivalent basis): Net interest income 3,635 3,243 Tax equivalent basis adjustment 80 83 ----- ----- Net interest income(tax equivalent basis) 3,715 3,326 ===== ===== 21 Provision for loan losses The Corporation maintains an allowance for loan losses at a level considered by management to be adequate to cover the inherent risks associated with its loan portfolio, after giving consideration to changes in general market conditions and in the nature and volume of the Corporation's loan activity. The allowance for loan losses is based on estimates, and ultimate losses are charged to operations during the period in which such additions are deemed necessary. The provision charged to operations totaled $90,000 and $30,000 during the three months ended September 30, 2003 and 2002, respectively. The increase in the provision was due primarily to the continued growth in the loan portfolio. In addition, the Corporation experienced a charge off of $163,000. See "Asset Quality" section for summary of allowance for loan losses and nonperforming assets. The Corporation monitors its loan portfolio and intends to continue to provide for loan loss reserves based on its ongoing periodic review of the loan portfolio and general market conditions. Noninterest income Noninterest income increased $244,000, or 45.8%, from $533,000 for the three month period ended September 30, 2002 to $777,000 for the comparable period in 2003. Deposit related fees increased $99,000 due to an increase in the deposit base and income derived from the merchant credit card processing and debit card programs. Increases in mortgage activity and the volume of mortgage loans sold attributed to an increase of $106,000 in the gain on sales of mortgage loans. Noninterest expense Noninterest expense increased by approximately $479,000, or 19.5%, to $2.9 million for the three months ended September 30, 2003, compared to $2.5 million for the same period in 2002. Salaries and employee benefit expense, the major component of noninterest expense, increased $222,000, or 19.0%, during the three months ended September 30, 2003. This increase was due to increases in staffing in the lending department and deposit and branch operations areas and general increases for merit and performance. Occupancy and equipment expense increased $33,000, or 10.1%, primarily due to the increase in branch facilities. Data processing expense increased $85,000, or 51.2% due to the increase in the Corporation's deposit base, the enhancements to online banking and bill payment functions and the implementation of a check imaging upgrade. Miscellaneous expenses increased $110,000, or 20.4%, primarily caused by increased costs associated with the general growth of the Corporation. Income taxes Income tax expense totaled $492,000 for the three months ended September 30, 2003, for an effective tax rate of 35.5%. For the three months ended September 30, 2002, income tax expense totaled $454,000, for an effective tax rate of 35.2%. 22 Asset Quality The Corporation's principal earning assets are its loans to businesses and individuals located in northern New Jersey. Inherent in the lending function is the risk of deterioration in the ability of borrowers to repay their loans under their existing loan agreements. Risk elements include nonaccrual loans, past due and restructured loans, potential problem loans, loan concentrations and other real estate owned. The following table shows the composition of nonperforming assets at the end of the last four quarters: 09/30/03 06/30/03 03/31/03 12/31/02 -------- -------- -------- -------- (Dollars in Thousands) Nonaccrual loans:(1) $ 245 $ 407 $ 409 $ 495 Loans past due 90 days or more:(2) 22 19 4 4 Restructured loans: 841 832 854 848 -------- -------- -------- -------- Total nonperforming loans $ 1,108 $ 1,258 $ 1,304 $ 1,347 ======== ======== ======== ======== Allowance for loan losses $ 2,791 $ 2,885 $ 2,788 $ 2,689 ======== ======== ======== ======== Nonaccrual loans to total loans 0.10% 0.17% 0.18% 0.23% Nonperforming loans to total loans 0.44% 0.53% 0.56% 0.62% Nonperforming loans to total assets 0.30% 0.35% 0.39% 0.41% Allowance for loan losses to total loans 1.10% 1.22% 1.19% 1.24% (1) Generally represents loans to which the payments of interest or principal are in arrears for a period of more than 90 days. Interest previously accrued on these loans and not yet paid is reversed and charged against income during the current period. Interest earned thereafter is only included in income to the extent that it is received in cash. (2) Represents loans to which payments of interest or principal are contractually past due 90 days or more but which are currently accruing income at the contractually stated rates. A determination is made to continue accruing income on those loans which are sufficiently collateralized and on which management believes all interest and principal owed will be collected. There were no loans at September 30, 2003 other than those included in the above table, where the Corporation was aware of any credit conditions of any borrowers that would indicate a strong possibility of the borrowers not complying with the present terms and conditions of repayment and which may result in such loans being included as non-accrual, past due or restructured at a future date. The Corporation's lending activities are concentrated in loans secured by real estate located in northern New Jersey. Accordingly, the collectibility of a substantial portion of the Corporation's loan portfolio is susceptible to changes in real estate market conditions in northern New Jersey. Market Risk The Corporation's primary exposure to market risk arises from changes in market interest rates ("interest rate risk"). The Corporation's profitability is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Corporation's net interest income to adverse movements in interest rates. Although the Corporation manages 23 other risks, as in credit and liquidity risk, in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Corporation's financial condition. The Corporation manages its interest rate risk by utilizing an asset/liability simulation model and by measuring and managing its interest sensitivity gap. Interest sensitivity gap is determined by analyzing the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within the same period of time. The Asset Liability Committee of the Board of Directors reviews and discusses these measurements on a monthly basis. The Corporation does not have any material exposure to foreign currency exchange rate risk or commodity price risk. The Corporation did not enter into any market sensitive instruments for trading purposes nor did it engage in any hedging transactions utilizing derivative financial instruments during the nine months ended September 30, 2003. The Corporation is, however, a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These instruments, which include commitments to extend credit and standby letters of credit, involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statement of condition. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded on the Corporation's consolidated balance sheet until the instrument is exercised. Capital Adequacy The Corporation is subject to capital adequacy guidelines promulgated by the Board of Governors of the Federal Reserve System ("FRB"). The Bank is subject to similar capital adequacy requirements imposed by the Federal Deposit Insurance Corporation. The FRB has issued regulations to define the adequacy of capital based upon the sensitivity of assets and off-balance sheet exposures to risk factors. Four categories of risk weights (0%, 20%, 50% and 100%) were established for application to different types of balance sheet assets and off-balance sheet exposures. The aggregate of the risk weighted items (risk-based assets) is the denominator of the ratio, the numerator is risk-based capital. Under the regulations, risk-based capital has been classified into two categories. Tier 1 capital includes common and qualifying perpetual preferred stockholders' equity less goodwill. Tier 2 capital includes mandatory convertible debt, allowance for loan losses, subject to certain limitations, and certain subordinated and term debt securities. Total qualifying capital consists of Tier 1 capital and Tier 2 capital; however; the amount of Tier 2 capital may not exceed the amount of Tier 1 capital. At September 30, 2003, the minimum risk-based capital requirements to be considered adequately capitalized were 4% for Tier 1 capital and 8% for total capital. 24 Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures. The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (non risk-adjusted) for the preceding quarter. At September 30, 2003 the minimum leverage ratio requirement to be considered well capitalized was 4%. The following table reflects the Corporation's capital ratios at September 30, 2003. Required Actual Excess -------- ------ ------ Risk-based Capital Tier 1 4.00% 13.11% 9.11% Total 8.00% 14.22% 6.22% Leverage Ratio 4.00% 9.00% 5.00% Liquidity and Capital Resources The Corporation's primary sources of funds are deposits, amortization and prepayments of loans and mortgage-backed securities, maturities of investment securities and funds provided from operations. While scheduled loan and mortgage-backed securities amortization and maturities of investment securities are a relatively predictable source of funds, deposit flow and prepayments on loans and mortgage-backed securities are greatly influenced by market interest rates, economic conditions and competition. The Corporation's liquidity, represented by cash and cash equivalents, is a product of its operating, investing and financing activities. The primary source of cash from operating activities is net income. Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments, such as federal funds sold. The Corporation anticipates that it will have sufficient funds available to meet its current loan commitments. At September 30, 2003, the Corporation has outstanding loan commitments of $32.5 million and unused lines and letters of credit totaling $56.1 million. Certificates of deposit scheduled to mature in one year or less, at September 30, 2003, totaled $52.3 million. Management believes that a significant portion of such deposits will remain with the Corporation. Cash and cash equivalents decreased $6.9 million during the first nine months of 2003. Operating activities and financing activities provided $4.4 million and $42.0 million, respectively. These amounts were offset by $53.2 million in investing activities. ITEM 3. Quantitative and Qualitative Disclosures about Market Risk Disclosure about quantitative and qualitative market risk is located in the Market Risk section of Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 4. Controls and Procedures The Corporation's management, with the participation of the Corporation's chief executive officer and principal accounting officer, has evaluated the effectiveness of the Corporation's 25 disclosure controls and procedures as of September 30, 2003. Based on this evaluation, the Corporation's chief executive officer and principal accounting officer concluded that the Corporation disclosure controls and procedures are effective for recording, processing, summarizing and reporting the information the Corporation is required to disclose in the reports it files under the Securities Exchange Act of 1934, within the time periods specified in the SEC's rules and forms. Such evaluation did not identify any change in the Corporation's internal control over financial reporting that occurred during the quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Corporation's internal control over financial reporting. 26 Stewardship Financial Corporation Part II -- Other Information Item 2. Changes in Securities and Use of Proceeds On September 17, 2003, the Corporation, through a newly formed, wholly-owned subsidiary, Stewardship Statutory Trust I (the "Trust"), a Connecticut statutory business trust, completed a private placement of $7.0 million of Fixed/Floating Rate Capital Securities (the "Trust Preferred Securities"). An aggregate of 7,000 Trust Preferred Securities were issued at $1,000.00 per Trust Preferred Security. FTN Financial Capital Markets and Keefe Bruyette & Woods, Inc. were placement agents of the Trust Preferred Securities. The Trust issued and sold the Trust Preferred Securities to Preferred Term Securities XI, Ltd. The Trust Preferred Securities were aggregated with other similar securities for resale to institutional and retail investors. These securities were exempt from registration under Section 4(2) of the Securities Act of 1933. Item 6. Exhibits and Reports on Form 8K (a) Exhibits See exhibit index (b) Reports on Form 8-K 1) On July 21, 2003, the Corporation filed a current report on Form 8-K, attaching a press release reporting results for the quarter ended June 30, 2003. 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. Stewardship Financial Corporation Date: November 14, 2003 By:/s/ Paul Van Ostenbridge --------------------- ----------------------------------- Paul Van Ostenbridge President and Chief Executive Officer (authorized officer on behalf of registrant) Date: November 14, 2003 By: /s/ Julie E. Holland --------------------- ----------------------------------- Julie E. Holland Vice President and Treasurer (principal accounting officer) 28 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION 10.1 Placement Agreement dated September 9, 2003. 31.1 Certification of Paul Van Ostenbridge required by Rule 13a-14(a) or Rule 15d-14(a) 31.2 Certification of Julie Holland required by Rule 13a-14(a) or Rule 15d-14(a) 32.1 Certification of Paul Van Ostenbridge and Julie Holland required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350 29